After Salesforce.com Inc. (NYSE:CRM) and Autodesk Inc. (Nasdaq:ADSK) both topped estimates on Tuesday, it would have been easy to stoke enthusiasm for the so-called "Software as a Service" (SaaS) industry. A closer look at the bigger picture, however, highlights a couple of looming problems for most of these stocks.
IN PICTURES: 20 Tools For Building Up Your Portfolio
A Mixed Bag
Autodesk Inc., though it isn't a pure SaaS provider, offers an online, subscription-based version of AutoCAD. Revenue fell 31% on a quarter-over-quarter basis, while net income per share fell from 45 cents per share to 13 cents. Analysts were expecting 22 cents. (For more on analyst expectations, be sure to read Analyst Forecasts Spell Disaster For Some Stocks.)
Salesforce.com, which as the moniker implies offers an online customer relationship management service, fared better. Quarterly profits doubled from 8 cents to 16 cents per share on a 20% improvement in revenue.
Though not rock solid results, the fact that both companies could at least turn a profit, with one of them increasing income, suggests that cloud computing and the services it can include may finally be finding a groove. It's not the whole picture though.
As A Whole
Earnings trends are one thing, but valuations are another. And, the valuations of Salesforce.com, Autodesk and most other Software-as-a-Service providers are valued at levels that (1) leave little room for more upside, and/or (2) leave no room for error.
To make the point, some current and forward-looking values have been collected for companies with a cloud-based, software service such as Google (Nasdaq:GOOG) and Amazon (Nasdaq:AMZN) that technically offer cloud-based services, but are not included in the group since the bulk of their revenue is not derived from SaaS subscriptions. A couple of problems surface right away.
|Company||TTM Price/Earnings||Next Fiscal Year\'s Projected P/E|
|Autodesk Inc. (Nasdaq:ADSK)||-||21.1|
|Constant Contact (Nasdaq:CTCT)||-||49.0|
Clearly a P/E ratio isn't the entire story, but an average, forward-looking price multiple of 56 is tough to justify, particularly when six of the eight companies in question didn't turn a profit at all in the last twelve months.
Were it a case of none of these companies turning a profit now, and consistently-high projected P/Es, one might compare it to the tech bubble of the late '90s when stocks rallied despite a lack of profits. This cat's already out of the bag though. It's not that earnings can't be created right now, it's just that they're very difficult to come by. Plus, we can't forget that earnings forecasts often have a funny way of being excessively optimistic.
Overall, there may be too many companies trying to grab too few dollars right now. But even that isn't the whole story.
Forecast: A Long Incubation
Don't think for a minute that SaaS isn't a major opportunity. Gartner research projects the industry to generate $7.5 billion in sales this year, up 17.7% from last year. By 2013, the figure should be $14 billion. That translates into about a 15% revenue improvement per year. Even half that rate would be impressive.
And, as cliché as it has become to blame the recession for every fiscal problem facing companies, the SaaS industry may have one of the most legitimate claims on the excuse. Since much of the software these companies offer is provided on a subscription basis, more unemployed workers means fewer paying customers.
The tripwire is still the average valuation. Assuming these stocks should trade with a P/E that's equal to the industry's growth rate, the forward-looking price-to-earnings ratios should be closer to 20. They'll get there eventually, but it could be a rocky few years between then and now as the excess is bled off - a moderate concern for current owners.
In the meantime, I suspect we'll see some consolidation within the groups (CRM, HR, content management, accounting, etc.), as well as cross-consolidations. The companies that aren't acquired may go the way of the Edsel, being unable to compete with the dominant players and unable to justify persistently expensive valuations. The wide range of forecasted price multiples above confirms that not all these companies are built the same.
The Bottom Line
Clearly this is a call to pick carefully, and plan expectations accordingly. On the flipside, it's an affirmation that cloud computing and SaaS are here, viable and will support at least one company within each category.
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
Stock AnalysisThese three stocks are resilient, fundamentally sound and also pay generous dividends.
Investing NewsAre stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
Investing NewsHere are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
Investing NewsHere are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
Stock AnalysisIf you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
Mutual Funds & ETFsExplore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
Mutual Funds & ETFsLearn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
Investing NewsWill Ferrari's shares move fast off the line only to sputter later?
Stock AnalysisHere are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
InvestingThe further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>