Enterprise Software Valuations Are Still Sky High

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 |  Includes: ATHN, AZPN, CRM, CSOD, GWRE, N, NOW, SPLK, SWI, ULTI, WDAY
by: Lenny Grover

On May 2, 2012, I argued that some sub-sectors within technology had seen valuations increase to unsustainable levels. At the time, two of the specific sub-sectors that seemed frothy were social media and cloud. In the social media space, Youku (NYSE:YOKU) and Jive (NASDAQ:JIVE) have seen their share prices decline since the article was posted, LinkedIn (NYSE:LNKD) has continued to hit new highs. Other public social media companies that were not specifically called out are trading well below their IPO valuations, including Zynga (NASDAQ:ZNGA), Groupon (NASDAQ:GRPN), Renren (NYSE:RENN), and Facebook (NASDAQ:FB).

Unlike the social media space, mid-cap and large-cap enterprise software (primarily cloud/on-demand software) valuations are sky high pretty much across the board. Below are a number of the larger cloud companies, listed with their market caps, revenues, and enterprise value/revenue multiples. Since many of these companies are only marginally profitable or unprofitable, it makes sense to look at revenue multiples for the industry rather than multiples of EBITDA or other profitability metrics.

Symbol

Company

Revenue

Mkt Cap

Enterprise Value Over Revenue

Share Price

CRM

salesforce.com

3.1B

24.8B

8.067x

169.52

ATHN

athenahealth

422.3M

3.4B

7.6872x

94.66

ULTI

Ultimate Software Group

332.3M

2.8B

8.2784x

98.09

N

NetSuite

308.8M

5.8B

18.1671x

79.1

WDAY

Workday

273.7M

10.2B

34.5185x

61.3

SWI

SolarWinds

269M

3.9B

13.6619x

51.97

NOW

ServiceNow

243.7M

4.6B

17.754x

35.19

AZPN

Aspen Technology

243.1M

2.8B

9.7148x

30.37

GWRE

Guidewire Software

232.1M

2.1B

7.9899x

36.49

SPLK

Splunk Inc

121M

4.3B

22.9678x

42.26

CSOD

Cornerstone OnDemand

117.9M

1.7B

13.7642x

33.32

Click to enlarge

The list contains 11 companies in the same industry whose EV/Revenue ratios are all higher than 7.6x. While Workday is still a clear outlier, with a ratio of 34+x revenue, none of these companies is cheap by any stretch of the imagination. Longs argue that subscription enterprise software companies should be highly valued for two key reasons:

1) A disproportionate share of revenues are recurring software subscription revenues. As a recurring revenue stream should almost always be worth more than a 1x revenue stream, because of its predictability and the ease with which it can be grown (as it is presumably easier to renew a customer than sign a new customer), higher multiples should apply to subscription software companies than traditional software companies like Oracle (NASDAQ:ORCL) and Microsoft (NASDAQ:MSFT).

2) Many of these companies have high growth rates. In fact, all grew revenues more than 20% YoY. In a low interest rate environment (low discount rate), and with companies whose revenues are small relative to their addressable markets (growth is likely to continue), the premium one is willing to pay for these sorts of growth companies can justify a high valuation.

Those who have read my past articles know that I am extremely skeptical of companies whose valuations are at lofty multiples of 7+x *revenues*. In addition, the reasons above are problematic:

1) Many subscription software companies do not report their renewal rates. Even some of the most highly valued ones, where high growth and retention rates are needed to justify their valuations, either claim to have inadequate data to report on renewal rate or simply choose not to report it. As a result, a conservative assumption would be that a substantial portion of revenues are not recurring (because of cancellations). In addition, many of these companies sell one-time services in addition to subscription software. If you apply a lower multiple to the 1x revenues (that are similar to 1x technical consulting revenues from companies with much lower valuations), then that implies an even higher multiple that is being applied to the subset of revenues that are recurring.

2) If you actually run a DCF valuation using analyst estimates for these companies, it is unlikely that any would justify the current price levels. With low margins and 7+x *revenue* multiples, an awful lot of revenue and earnings growth would need to be assumed. Furthermore, only one of these companies has revenues greater than $1B; it is unlikely that they can all sustain ultra-high early stage growth rates as their revenues increase and they mature. In addition, because these are earlier stage businesses, higher discount rates should probably be applied to current forecasts to account for the possibility that margins will shrink and competition will increase as their markets mature over time. Stated differently, newer markets are more difficult to forecast than established, mature, markets and that uncertainty should result in a higher discount rate being applied.

I have already bought a small number of Workday puts and keep these companies on my watchlist as a potential for additional put positions. There is also a potential long-short play here as revenue and earnings multiples for other cyclical technology companies are not nearly as frothy. As with social, it is possible that a few of these companies do ultimately grow into their valuations but it is highly unlikely that the entire sub-sector will be able to maintain valuations at these levels.

Disclosure: I am short WDAY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own puts on WDAY and am long MSFT.