While many of my articles have focused on Salesforce.com (NYSE:CRM), there are other cloud bubbles that have a lot in common with CRM-- and in some cases, might even be worse off than it. This article will focus on two of them: Netsuite (NYSE:N) and SuccessFactors (NYSE:SFSF).
While Salesforce.com is mostly a CRM (Customer Relationship Management) vendor, Netsuite is more diversified. It sells a cloud-based ERP (Enterprise Resource Planning) alternative, with some focus on Financial, but also with a CRM component. SuccessFactors aims at yet another enterprise niche-- in this case, the Human Resources departments-- where it offers a comprehensive cloud-based solution.
These two companies are quite significantly smaller than Salesforce.com, with Netsuite on track towards $240 million in revenues this year (2011), and SuccessFactors aiming for $335 million. This compares with $2.25 billion for Salesforce. Worthy of mention is that Netsuite’s market is arguably larger than Salesforce’s, so either the opportunity is yet to be fully realized, or the market is harder to penetrate with cloud-based solutions.
There are other similarities between Netsuite / SuccessFactors and Salesforce.com. The first of them is that both Netsuite and SuccessFactors show GAAP losses-- just like Salesforce.com-- with these losses only turning into non-GAAP earnings by the willful exclusion of stock-based compensation. This is something we have already talked about regarding Salesforce.com. The same conclusion applies here – it doesn’t make much sense to ignore such costs.
The similarities continue. The main reason why Netsuite and SuccessFactors can generate operating cash is the inclusion in this cash flow of the stock-based compensation (or rather, its exclusion from earnings). In the last 9 months, stock-based compensation constituted 114% of Netsuite’s operating cash flow, and 130% of SuccessFactor’s. This is a lot more than what is happening at Salesforce, and should be seen in light of the effect described in this article. Indeed, both companies are showing strong dilution in this last year, with Netsuite diluting its shareholders 5.5% over the last 12 months, while SuccessFactors diluted by 11.4%.
It doesn’t stop here – it is also obvious that the Bull thesis in these two companies is similar to Salesforce.com’s, being based on:
- Cloud hype;
- Cash-flow generation, which-- as we have seen-- stems directly from stock-based compensation;
- The subscription model, and the analyst’s conviction that somewhere down the line these companies will be able to turn down their “investment in growth”, namely, in marketing, and reap much higher earnings and cash-flow. It is thus not a surprise that marketing costs accounted for 51.2% of the revenues at Netsuite over the last 9 months, and 45.8% at SuccessFactors over the same period-- a figure that compares to 51.5% at Salesforce.com. Regarding this, the same conclusions could be drawn, as in this article. Namely, that it’s far from being a given that a slowdown in revenue growth can be met with much lower expenditure on marketing, though obviously there must be some truth to the theory, and hence, it might be possible to at least post rather better earnings. Still, if it was never achieved in the past, it is a giant leap of faith to hope for a miracle in the future.
And this is the main problem – a miracle is priced in. The stocks show continuous losses and dubious cash flow, yet trade at a giant valuation premium to the whole market, with Netsuite commanding 190 times 2012’s non-GAAP earnings (on strongly declining estimates!), and SuccessFactors going even farther and asking for 230 times 2012 non-GAAP estimates. Simply put, these stocks trade as if there is some kind of certainty regarding their future in a highly competitive space. Such certainty never existed-- even in the giants of yesterday. So how can we expect it in much less clear situations?
Before one can think of shorting these obvious bubbles, two more variables must be taken into account.
- Short interest is already high. This makes short squeezes easy to come by. Netsuite boasts a short interest around 14% of its float (but only 5% of the outstanding shares), and SuccessFactors has around 15.4% of its float and outstanding shares in short interest;
- Market capitalization is rather low. Now, market capitalization is not low in terms of valuation, but moving a $2.15 (SFSF) – $2.72 (N) billion market cap is a lot easier than moving a $15 billion market cap (Salesforce.com), so the risk of getting caught in a short squeeze is greatly increased here.
Netsuite and SuccessFactors are obvious bubbles; however, shorting them is dangerous due to their short interest and rather low market capitalization. If one was to short these stocks, it would have to be done in such a size as to survive any conceivable short squeeze, and thus, would have to be a very small part of a diversified hedging strategy for a much larger portfolio.