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
SalesForce.com (NYSE:CRM) 122.4 74.6
Autodesk Inc. (Nasdaq:ADSK) - 21.1
Constant Contact (Nasdaq:CTCT) - 49.0
Kenexa (Nasdaq:KNXA) - 15.2
NetSuite (Nasdaq:N) - 102.7
Rightnow (Nasdaq:RNOW) 124.9 32.4
SuccessFactors (Nasdaq:SFSF) - 129.8
Taleo (Nasdaq:TLEO) - 25.1

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!

Related Articles
  1. Investing News

    Canada in Recession

    On September 1, 2015, Statistics Canada reported that the economy has contracted by 0.5% in Q2 2015, after falling 0.8% in previous quarter.
  2. Economics

    Is a Recession Coming?

    In the space of a week, the VIX Index, a measure of market volatility, spiked from 13, suggesting extreme complacency, to over 50, evidencing total panic.
  3. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  4. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  5. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  6. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  7. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  10. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. The New Deal

    A series of domestic programs designed to help the United States ...
  3. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  4. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  5. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  6. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    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 >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    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 >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!