By David Sterman
Even as the broader stock market shows signs of a clear pullback, some of the hottest stocks in the market remain near their 52-week highs -- and they still carry very high valuations to boot. But if history is any guide, then these are now among the most vulnerable stocks in the market. Any further big drops in the broader market could prove especially painful for these highflyers.
Richly-valued stocks can stay aloft at the beginning of a big market pullback, but as we saw in 2001 and again in 2008, they eventually can suffer massive corrections as investors shift to defense and start to focus on value instead of growth. If you own high-flying names like Salesforce.com (NYSE: CRM) or VMWare (NYSE: VMW), for example, then you need to seriously reconsider just how vulnerable stocks like these can be.
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As the economy emerged from the recession of 2008, this provider of customer-management software became a key focus area for investment technology (IT) managers. Sales grew 21% in fiscal (January) 2010 and another 27% in fiscal 2011. Look for similar results in the current fiscal year now that many IT spending plans for the rest of this year are in place.
But signs are also emerging that results in the coming years may not be good enough to justify the stock's triple-digit price-to-earnings (P/E) ratio. First, operating margins may have already peaked. They hit 16% in fiscal 2010, slipped to 14% in fiscal 2011 and were just 11% in the first quarter of fiscal 2012. Fast-growing sales should always yield margin gains, and this is a sign the company is working harder to secure new sales wins. The fact that marketing expenses remain so high (at more than 40% of sales) tells you this is not an easy sell. Free cash flow, which had risen for eight straight years, fell more than 50% in fiscal 2011.
Second, the company now has a target on its back. It occupies one of the few bright spots of the technology sector. Companies like Oracle (Nasdaq: ORCL), SAP (NYSE: SAP) and Microsoft (Nasdaq: MSFT) are taking the customer relationship software niche more seriously, and those firms have a tendency to compete very aggressively on price.
Last, an economic slowdown typically leads to a pullback in corporate IT spending. Expectations of 30% year-over-year sales growth are built on expectations that IT managers will spend all of their allotted resources by year-end, in what's known as a budget flush. But they can just as easily hold off spending their full allotted budgets until conditions improve.
Make no mistake, Salesforce.com has built an excellent track record, but its shares, at nearly 10 times projected (January) 2012 sales and more than 100 times projected 2012 profits, and more than 200 times trailing free cash flow, are simply too rich for these sober economic times.
Perhaps the hottest area of high-tech is "cloud computing." An increasing number of companies are moving their enterprise data off of their corporate campuses and into data centers so key information can be even more readily accessible. Consumers are expected to follow the same trend, storing their songs and other media " in the cloud" on Internet servers.
VMWare has established a pole position in the field. Its software can handle massive amounts of cloud-based data in a very efficient manner. The company boosted sales 41% in 2010, growth could hit 30% in 2011 and another 20% in 2012, according to consensus forecasts. Are you spotting a trend? Sales growth is starting to cool as the company's revenue base grows larger and competition heats up.
Part of the company's impressive growth was due to a first-mover advantage in large data environments. To keep growth at high rates, VMWare is aiming at the desktop market, focusing on smaller data volumes that can be managed from simple terminals. Trouble is, that field is already dominated by firms like Citrix Systems (Nasdaq: CTRX) and RedHat Software (NYSE: RHT). Citrix in particular represents a major challenge. The company is increasingly aligning itself with Cisco Systems (Nasdaq: CSCO), which had historically been a key partner for VMWare.
As those firms and others start to develop their own cloud-based technologies, VMWare should start to lose its impressive pricing power. Even as the customer base keeps growing at a solid clip, revenue growth may become more muted.
In addition to concerns about rising competition and tougher pricing, investors need to account for the impact of a slowing economy. It's getting harder to see how IT spending levels will continue to keep growing as more companies see a toughening economic environment. And that makes it harder to justify a stock that trades for around 50 times projected 2011 profits and more than 10 times projected 2011 sales.
The stock market is now back down to levels seen in late March. Many stocks have already corrected by a significant amount. It may just be a matter of time before these richly-valued highflyers also feel the impact of a tough economic environment. If you hold one of these stocks, you should seriously think about selling.