Why NetSuite No Longer Makes Sense For Investors

NEW YORK ( TheStreet) -- Banking on high growth while ignoring fundamentals is nothing new for investors in the tech sector.

This has been my main point of contention with stocks such as Salesforce.com ( CRM) and Red Hat ( RHT), which sport P/Es that often offend value investors. Nonetheless, those that are filled with illusions of grandeur care very little that the current fundamentals of these companies may not support the inflated valuations.

This is particularly true with stocks having anything to do with the "software as a service" (SaaS) space, or "the cloud." But I wonder, how can one sector fully support the growth expectations of its entire group?

Oracle ( ORCL) and IBM ( IBM) compete for the same set of customers, so a few companies will have to be left out. They can't all win.

This is where I've come to wonder whether NetSuite ( N) still makes sense for investors. I don't think it does, for many reasons.

Aside from the competitive threats, NetSuite's stock has already appreciated by over 50% this year, rewarding investors handsomely with roughly $2 billion in premiums. But this is unlikely to continue.

What will also hurt NetSuite is its less-than-stellar fundamentals, which suggests there is a significant amount of speculation with its recent rise. Investors would be wise to secure profits now before the market wakes up to this mistake. What will follow will be the inevitable correction. Butthe stock is unlikely to recover.

The competitive threats and the recent unsupported run-up in the stock are bad enough, but the main concern here with NetSuite is that it is still unprofitable. If it has not been able to generate positive earnings with less competition over the past five years, there will be more uncertainty now.

But its valuation suggests investors are convinced that it will generate those positive earnings. The bulls argue that NetSuite's billings are growing and that it has had a couple of years of positive cash flow. But evidence suggests that it's unsustainable.

How much time are investors willing to give the company to prove that its model can be effective? One way to prove this is to turn a profit.

Although the company is doing a decent job growing its revenue now, at some point margins will start to matter. Otherwise, what is the point? It makes no sense for investors to continue to pay such high premiums on yields of only above-average revenue growth.

Absent significant returns on its assets or investor equity there is little justification for investors to continue placing such a high bet. This is an area in which NetSuite has failed to produce consistently for investors over the past three years. Remarkably, these same investors appear to not care.

What's more, the fact that it has failed to earn a profit over the past five years, coupled with its string of recent losses, should make you doubt the competence and execution of the company's management.

This makes it even tougher to consider any bullish argument when NetSuite is up against the brilliance of management teams leading Oracle, SAP ( SAP) and IBM. Making matters worse is NetSuite will start to face increased competition from Microsoft ( MSFT), which has an underrated cloud product of its own called Dynamics CRM. Investors would be wise to appreciate that Microsoft's strong enterprise footprint can easily eat away at NetSuite's mid-sized business market.

Bottom Line

It is hard to not give the benefit of the doubt to tech companies in fast-growing industries. However, it's harder to look at certain businesses and overlook the many holes that exist -- particularly such glaring ones as having little to no as margin leverage and profitability.

NetSuite's stock is priced for perfection. Based on its history, I just don't think it has the management structure in place to execute perfectly. In a year or two, I would love to be proven wrong. Today, however, given its current fundamentals, owning the stock doesn't make sense.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Richard Saintvilus is a private investor with an information technology and engineering background and has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.