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Demandware Inc. (Nasdaq: DWRE) stock has doubled since May, a hefty gain like the rest of the "cloud" stocks rather than the likes of NetSuite Inc. (NYSE:N), Oracle Corp. (ORCL), IBM Corp. (IBM), eBay Inc. (NASDAQ:EBAY) or SAP AG. (SAP), who offer somewhat similar solutions. The company's biggest difference from its competitors has been its gravity defying trading multiples of 17 times book value and similar ratio times sales.

Rising competition and poor earnings leverage shown by the business may dent the multiple expansion possibilities even amid the seasonal strength of the business and the decent revenue growth rates.

The bull-case is built upon the usual "cloud" story:

  1. New entrant out to revolutionize the industry with the digital e-commerce platform.
  2. Earnings leverage associated with the "cloud" business model would help the company grow into the sky-high valuations.

Demandware - a quick snapshot

Demandware Inc. provides a pre-built platform for retailers and other branded manufacturers to set up their digital presence on a short notice, which can be via customized website, mobile site & apps or other digital storefronts. The customer buys subscription directly from the company or through its indirect channel partners.

Customers usually buy these Demandware like services to quickly set up sites for marketing promotions or other short-term sites. Till last quarter, Demandware had 162 customers running 667 sites on its platform with average revenue per customer of $495,000.

Strong reliance on the retail sector may bite

Even though the stock is flying high on a "cloud" story, there is no missing the fact that the business relies heavily on the retail sector. The company, with its e-commerce "enablement" services is heavily skewed towards the retail sector with apparel & footwear customers making 55% of the revenues last year, so while revenue guidance might be strong due to seasonality but that alone might not be able to satisfy the high expectations of the investors.

Besides, apparel and footwear, the majority of the company's customers are from health & beauty, home & garden, sporting goods and merchandise. Most of them rely on high amount of digital promotion activities.

This retail reliance makes the fourth quarter strong, which gets reflected in fourth quarter making up close to 1/3rd of the full year revenues but expect bookings to stay weak after the strong first half. Even Thomas Ebling, CEO, had this to say on the most recent conference call.

"We still will experience significant booking seasonality in our business. And we've planned our business that way. So it's no surprise. We planned for bookings to be highest as the sort of the cutoff for the holiday season approaches, so late Q1 and early Q2."

Third quarter is the strongest launch quarter as retailers prepare promotional sites and other digital assets for the holiday season. Even if the company continues to show near term progress on the revenue growth front, retail weakness and poor earnings leverage will affect the multiple expansion part of the story.

Earnings leverage is missing

Even amid a decent revenue growth, there is little sign of investors making good from this growth, as the earnings leverage seems still elusive, which might seriously dent the stock's ability to benefit from multiple expansions.

Total Revenue Growth

37%

Subscription revenue

37%

Services revenue

-24%

Q2 2013

Q2 2012

Gross Margin Subscription

80%

80%

Flat

Gross Margin Services

-3%

3%

Declining

As % of Revenue

Sales & Marketing

61%

52%

Rising

Research & Development

23%

22%

Rising

General & Administration

24%

20%

Rising

Data Source: SEC Filings and Demandware press releases

All the major expense heads are rising as they come to represent an even larger portion of the revenues.

There needs to be some serious effort on the company's part to increase productivity. This quarter, total headcount increased by 27.7% and commissions & sales bonuses increased 54.6%, while revenues increased by 37%. Reading following comments from Thomas Ebling, CEO, from the recent conference call does not invoke much confidence.

"But by and large, our overall productivity, by both indicators, are ahead of our expectations and predictions. So we're feeling very comfortable with that."

The competition is serious and rising

Some of the competitive solutions to watch are Oracle ATG commerce, IBM Websphere, Magento (part owned by eBay), NetSuite Suitecommerce and SAP Hybris.

The competitive landscape has certainly changed for the company. Some of the larger companies have started to pace their efforts in the space to offer a single integrated solution that embed their legacy platforms. Some prominent developments that can help these companies do the same:

  1. Netsuite acquiring Ordermotion to offer better order management
  2. SAP acquiring Hybris
  3. IBM building up Websphere solution with acquisition likes Worklight, Coremetrics or Sterling Commerce.
  4. Oracle with the acquisitions of ATG in 2011 along with Endeca and Fatwire systems

Industry consolidation of recent times has certainly helped the company. Most of its biggest competitors are not a pure-play in the space, which has helped Demandware in the short-term as the company gathered some ground while the acquisitions were being consolidated but as the competitors start to roll out their full solutions, it is bound to affect the market and Demandware.

Demandware relies heavily on the systems integrators as 90% of its new customers were "primed" by the company's network partners to lead the implementations.

Near term numbers might be strong but that may not be enough

Questions raised in this article are not at all a reflection on the current quarter or the guidance but how the stock might react to the news. Don't be surprised if the market "sells the news"

Most of the analysts are expecting a strong quarter and looking at the seasonality of the business itself, one can safely assume that near term numbers should be strong but looking at the stock performance everybody expects the same. The key question is where to go from here?

Almost 1/3rd of the revenues for the company are done in the fourth quarter as retail customers prepare for the holiday season with web promotions, new brand launches and other digital store roll outs.

Street estimates are calling for revenues of $100 million and a loss per share of 32 cents. As per estimates, company's new bookings in the first half of 2013 have been at par with 2012 bookings.

Valuation does matter especially in such stretched scenarios

At times, it is hard to argue with the "bulls" that claim valuations don't matter if the fundamentals of the business can grow into the expectations. Working on the numbers in the worksheet below, added to the poor earnings leverage, it's hard to make the case for fundamentals growing into the high valuations.

Market Cap ($M)

$1,520

Cash ($M)

$71

Enterprise Value ($M)

$1,449

Trailing ARPU

$495,000

Live customers

162

EV/ Customer ($M)

$9

Live sites

667

EV/ Live site ($M)

$2

Data Source: SEC Filings

Enterprise value per customer is more than 20 times its average revenue per customer, which gets worse to look when one looks at the rising operating costs as percentage of revenue. Other ratios are equally worrisome.

Stock

P/E 2013

P/E 2014

EV/ EBITDA ttm

P/Book

Rev growth 13

Rev growth 14

DWRE

$50

Loss

Loss

Negative

17.5

26%

36%

Integrated

N

$105

389

244

Negative

39.6

33%

28%

ORCL

$33

11

10

8

3.5

3%

5%

SAP

$72

21

19

12

4.7

6%

9%

IBM

$185

11

10

9

11.5

-2%

2%

EBAY

$54

20

17

15

3.3

15%

16%

The trend from the relative valuation sheet is clear; investors are paying quite high for the growth, even a semblance of question mark over which would put a serious dent.

Conclusion

As the investors focus on the next leg of growth from here, concerns like rising competition, lack of earnings leverage and high valuation are bound to affect the stock. The stock can decline 40% and would still be expensive for expected loss making 2014 or book value for $3. "Bulls" on the story, like the macro digitization of retail, may also get affected by the poor retail environment especially apparel and footwear.

Source: Retail Sector Weakness Can Negatively Affect Demandware