NetSuite - A Short Candidate For Future Consideration

| About: NetSuite Inc. (N)

Let me start by saying that rarely does one find a short candidate such as NetSuite (NYSE:N). I have seen the story many times over, and it's is more or less the same. Once in a while, market participants will value a company with sky-high multiples based on sky-high expectations, hoping that the fundamentals will catch up to reality. But they never do.

NetSuite has a price/book value of 31, price/sales of 16.5, profit margins of -12%, operating margin of almost 11%, return on assets of -6.5%, and return on equity of -25%.

Click to enlarge images.

N Price / Book Value Chart

This stock is not a short candidate by accident. Testimony to this is that short sellers have taken notice of its valuation. As of Aug. 21, NetSuite had about 3 million shares short. There are 71 million shares outstanding with the float at 28 million shares, which means that about 11.6% of the float is currently short. That is slightly lower than the previous month, when there were about 3.5 million shares short.

The shares that were covered over the previous period probably explain (to some extent) the upbeat price action, and since the stock closed at all-time highs on Friday, that means anyone who has ever shorted this stock is losing money.

Insiders, however, are making money hand over fist. A brief look at insider transactions will reveal insider selling as far as the eye can see. I personally don't think we will ever see insider buying at these valuations.

A sky-high valuation is not the only problem this stock has. Any stock can be expensive and at the same time earn money, but that's not the case here. The company lost $23 million in 2009, $27 million in 2010, and about $32 million in 2011. So far for 2012, the company has lost about $17.5 million and is on track to match (if not surpass) last year's losses.

While shareholders equity has remained almost the same, the market cap has risen almost logarithmically.

N Shareholders Equity Chart

In my book, sales growth of 30% on a yearly basis does not qualify any stock to have such a rich valuation. In the first six months of 2012, the company issued $23 million in stock for employee compensation. While this practice is not unusual for companies in their early stage of development, they cannot do it forever. Sooner or later the dilution effect will kick in, and it will take a toll on the stock price. I have seen this many times over and the story always ends with tears.

Furthermore, as per the company's Aug. 6, 2012, 10-Q filing, Lawrence Ellison, his immediate family, trust and other beneficiaries own about 52% of the common stock. Since when does a stock with so much insider concentration have the right to command such a high multiple?

In all my years of investing I have yet to see a stock that can command such a high valuation for an extended period of time. I don't know what will be the catalyst that will bring the valuation of this stock down to planet earth, but one thing is for sure -- it will happen.

How to Play NetSuite

Because the market can remain a bubble longer than a short seller can remain solvent, one must be very careful shorting this stock. My advice is to simply keep it on your screen and follow it. You need to have confirmed technical weakness in order to feel comfortable with this stock on the downside. And because the chart exhibits no such weakness at the moment, it's too early to try to short this stock for the long term.

However, when you do see signs of technical weakness, then you can use any of the major technical analysis indicators you feel comfortable with. Just make sure the chart interval is weekly and not daily.

NetSuite has made some people a lot of money on the way up and will probably make some people a lot of money on the way down. It's not the first time I've seen a stock with such a rich valuation and it won't be the last. And even if stock tickers change through the years, the predicted behavior of stocks with sky-high valuations is more or less the same. When they pop, they pop big time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.