Robust valuations are nothing new in the cloud/SaaS space, but NetSuite (NYSE:N) looks premium-priced, even by those lofty standards. Although this company certainly is posting strong billings growth today and free cash flow is ramping up nicely, it's hard to see how the industry can support the growth expectations for all of its members and I don't know that NetSuite's rampant success is as certain as the valuation would suggest.
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Anchored in the Mid-Sized Market, but Tracking Bigger Game
NetSuite's original business plan certainly made ample sense - target small/mid-sized businesses with SaaS-based enterprise resource planning (ERP), customer relationship management (CRM) and e-commerce software. While smaller customers tend to switch providers more often (more attrition/turnover), they generally cannot afford the rates that on-site installations that Oracle (Nasdaq:ORCL) and SAP (NYSE:SAP) charge larger enterprise customers.
Although companies like Intuit (Nasdaq:INTU) have done well with a focus on smaller clientele, NetSuite is expanding its ambitions and targeting larger customers. The company's OneWorld takes its existing suite of products and adds to it, offering a relatively competitive package to many customers.
While many large enterprises have expressed some reservations about relying on a SaaS model for "mission-critical" functions, it's not an all-or-nothing market. For instance, Procter & Gamble (NYSE:PG) uses SAP for its corporate ERP, but its distributors interact with the company through NetSuite.
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Bullets Flying in All Directions
One of the challenging aspects of the software sector is that competitors are always readjusting their targets. Many investors may think of Microsoft (Nasdaq:MSFT) primarily as a provider to individuals or small businesses with products such as Windows and Office, but the company's Dynamics CRM and cloud-based ERP should be seen as a threat in the mid-sized business space.
Likewise, while SAP and Oracle are generally focused on larger customers, that doesn't mean they can't move down-market. SAP has its Business One and Business ByDesign hosted ERP service, while Oracle has apparently been working on applications for smaller enterprises within its Fusion platform.
At a minimum, this means that NetSuite has to stay on its toes and focus on responding to the needs of its clients. On a positive note in this regard, the company has recently improved the extent to which its e-commerce offerings can be customized by clients.
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The Financials Will Matter Eventually
One thing that jumps out about NetSuite is the quality of its financials. This is a company that has thus far never reported a GAAP operating profit, although it does have two years of positive free cash flow in the bag now. Even less-demanding analyses don't help much - NetSuite's EBITDA margin is about 70 to 75% of that of other growth cloud/SaaS plays.
Profitability and margin leverage is a common complaint of mine, not only with NetSuite, but also with companies like Red Hat (NYSE:RHT) and Salesforce.com (NYSE:CRM). Investors don't seem to care right now (and free cash flow should continue to grow nicely over the next few years), but at some point they will - meaning that NetSuite has an indefinite amount of time to prove that its model can eventually couple impressive billings growth with hard cash profits.
The Bottom Line
Not surprisingly, I don't see how NetSuite's stock makes much sense for investors today, apart from those who are insensitive to valuations and instead invest on the basis of growth and/or momentum. How expensive is NetSuite? Using a 10% discount rate, NetSuite has to grow free cash flow by nearly 40% a year for the next decade just to justify today's price (which implies a revenue base of $2 billion to $3 billion versus an estimate of $304 million for 2012).
I just don't see how NetSuite's products are so overwhelming or dominating that they can deliver that sort of growth. I'm not saying NetSuite can't or won't be a very successful company, but I just can't see where the upside is from a valuation perspective today.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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