NetSuite: Short-Term Short Idea, Long-Term Long

| About: NetSuite Inc. (N)

While analyzing potential Enterprise Resource Planning [ERP] solutions for a client, CleanFish, last year, I came across NetSuite as a contender that offered accounting, sales force automation, inventory management and CRM capabilities in a single integrated hosted solution. A single solution that can address the needs of a growing organization without having to spend millions or install infrastructure is music to the ears of any CTO who has worked with disparate systems before and has had to make them talk to each other. After considering industry specific solutions as well as NetSuite's competitor (CRM), we finally decided to sign up with NetSuite. A few weeks after we started implementation, I wrote a detailed blog entry titled NetSuite: Another Hot Tech IPO? about the company and why I was excited by the IPO months before it actually came out.

However by the time the actual IPO took place in December, interest in the company was so high that they revised their dutch auction IPO price upwards twice from the original range of $13 to $16 all the way up to $19 to $22 and the auction finally closed at $26 per share. This gave the company a valuation of over $1.5 billion, much higher than the $750 million valuation I mentioned in my blog entry and a P/S of 13 based on my 2007 revenue estimates of $115.35 (actual 2007 revenue came in at $108.5 million). Investor enthusiasm for NetSuite was unabated and the IPO opened at $26 per share and closed its first day of trading at $35 per share. After rising to an intraday peak of $45.98 the following day, the stock began a slow and steady decline. Our experience with NetSuite has gone down a similar downward slope over the last few months.

During an investor presentation, NetSuite CEO Zach Nelson said "we have by far the best development team on the planet". As a customer I am very happy to hear that they have an outstanding team but when you look at the issues that are brought up over and over again by customers in the internal NetSuite forums, I have to say that the company really needs to focus on QA, support and development. Despite purchasing their Gold Support (they refused to sell the product without this support), our experience with NetSuite support has been downright terrible and we are not the only customer who feels this way.

According to their recently released annual report, NetSuite derives 18% of their revenue from international sales and one of the key areas the company plans to focus on is expanding their international sales. Selling in different countries requires localizing the software not only to the language of the target country but also customizing it to local laws and accounting standards. With a core application that is far from satisfactory, I believe the company needs to focus its resources on building a rock solid foundation instead of spreading itself thin by taking on the complexity of international sales. I am very tempted to list some of the issues their application faces but that is outside the scope of this newsletter and probably only of interest to existing or potential customers of NetSuite and the NetSuite management team.

I started out writing this newsletter about NetSuite with the goal of adding NetSuite to our watch list as a long opportunity. However when I look at various financial metrics, the stock appears to be a better short candidate at this point. Comparing NetSuite with other companies like (NYSE:CRM), Rightnow Technologies (NASDAQ:RNOW), SuccessFactors (NYSE:SFSF) and DemandTec (NASDAQ:DMAN) in the "Software as a Service" (SaaS) landscape, it looks like NetSuite has the richest valuation of the lot on a Price/Sales basis (as reported by Yahoo Finance).

According to their amended S1 filing, the company plans on spending between $10 and $15 million on capital expenditure including a second data center facility in 2008. The company will most likely take an earnings hit on account of these expenditures as well as for expensing options that are exercised by management and employees. Investors in are well aware of this situation as option exercises are one of the reasons why tends to post tiny net income numbers. NetSuite's target audience of small businesses is likely to hurt the most during an economic downturn and are likely to postpone plans to implement ERP solutions. The impact of economic weakness on small businesses was one of the reasons we started a position in the UltraShort Russell 2000 (NYSEARCA:TWM) for our model portfolio.

The news is not all gloomy for NetSuite. The company is growing at a very healthy pace, posting revenue growth of 71.64%, 64.28%, 56.35% and 57% in the four quarters of 2007 and expects to grow revenue 44% in 2008. While the software is complicated, it is very powerful and well integrated across various modules. As NetSuite works out all the kinks in its application and heads towards profitability, I plan to add the company to our watch list as a potential short opportunity in the short-term and eventually as a long opportunity if the price declines to a reasonable valuation.

Disclosure: none