NetSuite (N) has been one of the more notable overpriced cloud stocks since it came on the market in late 2007. Despite appearing overpriced by every major valuation metric, the stock has been performing very well. In the last year, shares are up 84.5 percent and have been on a consistent, upward trend with no significant downturn. In this article I explain why this strong bull run is unlikely to continue.
The company's upward trend has been very unusual for a few reasons. First, liquidity of the stock is not really an issue compared to its cloud counterparts. Only about 40 percent of NetSuite shares are institutionally owned, which is low compared to Salesforce.com (CRM) with 100 percent and Rackspace Hosting (RAX) with 81 percent. This means that a larger percentage of outstanding shares can flood the market if investors become unhappy.
Second, NetSuite does not appear to be a big acquisition target. Other cloud based software as a service companies like Workday (WDAY) normally justify their high valuations based off of the expectation of an acquisition. At this point. Oracle (ORCL) and SAP (SAP) would be the only two companies in the industry who would buy NetSuite and Oracle CEO Larry Ellison has recently announced that he has no intention to buy the company. This leaves SAP as a possible acquirer, which is unlikely because of Ellison's personal involvement in the company.
In addition, the company is getting to the end of its rope in terms of high organic revenue growth, but it is still not profitable in terms of GAAP and looks unlikely to bring in any major profit margins when the company does mature. In 2017, NetSuite will probably have revenue around $700 million when looking at current growth trends with an EPS around 81 cents. At its current price of $62.07, NetSuite is not properly valued for its current growth expectations.
I currently have a Sell recommendation on NetSuite. I believe it is best to short shares via long term out of the money puts. As shares have been moving upwards, this is a cheap strategy, but it also makes the strategy a little more risky, so I suggest making this play a very small portion of your portfolio. In the current cloud market, NetSuite is overvalued by about 20 to 30 percent. This is saying a lot since the cloud market as a whole is very overpriced right now. Expect a correction over the next year.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.