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I am a deep value investor looking for stocks trading at a significant discount. I also look for egregiously overvalued stocks with a view to short them. I believe in combination of long and short positions in this volatile market. I have been investing in stocks/options in the last 23 years. I... More
  • Why Netsuite (N) Is A Compelling Short 0 comments
    Sep 2, 2012 4:14 PM | about stocks: N

    Introduction:

    Salesforce.com (NYSE:CRM) is often posted in various forums as a overvalued stock in SaaS (Software as a service) business.

    However, I think Netsuite Inc (NYSE:N) is much more overvalued in the same space and hence is much more compelling short.

    Recent runup in the stock price after second quarter results makes it an even better short.

    My fair value estimate is $ 15.35 based on free cash flow and $23.39 based on P/S ratio. So, either way, I think, this stock is grossly overvalued and hence a very compelling short.

    What does Netsuite do?:

    NetSuite provides an integrated suite of business software applications to small and medium-sized customers in a subscription model. Business application software such as SAP, Oracle allow companies to run their businesses using software package that integrates various functions such as Finance, manufacturing, Payroll etc using packaged software called ERP. Traditional software is installed on the customers' servers and accessed from the computers. NetSuite is one of the vendors that install software on large data centers at a central location and allow customers to access the software using web on the customer computers. Customers pay NetSuite monthly for this service. This type of software implementation is also called SaaS (Software as a service).

    The firm generates the majority of its revenue from the Americas, with international sales accounting for more than 25% of total revenue.

    Recently, Net suite is making efforts to increase sales of OneWorld--NetSuite's service targeted at large enterprises.

    Why I think Netsuite (N) is grossly overvalued?

    1. NetSuite is losing money in 2012 (EPS -0.48) and is estimated to have a small profit (EPS $0.24) in 2013. Based on future P/E (2013) of 238, I think, this stock is way overvalued considering expected growth rate around 30% in the next five years.
    2. Price/Sales ratio of NetSuite of 14.59 is way above this ratio of even other overvalued and bigger companies such as salesforce.com (P/S 7.53) in SaaS space.
    3. Growth rate is likely to slow down in the coming years due to combination of factors such as increased competition and SaaS market getting more saturated.
    4. Intense competition: SAP (BusinessByDesign), Oracle (Fusion), Microsoft (Cloud based ERP) are putting more emphasis on cloud based offerings and hence Netsuite (N) faces intense competition from these much bigger rivals in coming months. Bigger competitors such as SAP and Oracle have following inherent advantages over smaller rivals such as Net suite(N):
      1. It is much easier for them to reach their large existing traditional ERP customers to sell their cloud based offerings.
      2. Customers like to go with existing vendors since it will be easier to integration of various functions and interfaces will be minimized.
      3. They can invest more money on product development of cloud offerings since they have strong cash flows from Traditional ERP and other existing businesses.
      4. They can offer bigger discounts since they have strong cash flows from Traditional ERP and other businesses.
      5. They can leverage their large existing sales channels and partnerships with implementation partners to sell their cloud based offerings.
      6. Their ERP packages have much richer functionality since they have developed this functionality over more than 30 years and with few thousand developers. So, It will be easier for them to offer much better functionality for their cloud offerings.

    I think, due to these advantages, among others, SAP and Oracle could take away most of the market share in SCM (Supply Chain Management) from I2 and Manugistics. I2 and Manugistics were number 1 and 2 in this market when SAP was a new entrant in this market in the year 2000. Now, I2 and Manugistics are almost non-existent.

    I think it is a very similar situation for SAP and Oracle in SaaS business.

    The rapid growth of Microsoft's Dynamics CRM in recent past demonstrates the company's commitment and renewed ability to execute well in the small and midmarket enterprise applications space. Further, Microsoft and Oracle's hybrid approach to cloud solutions gives these firms a unique value proposition that could particularly resonate with upper midmarket and larger customers.

    Impact of increased competition seems to be showing up on Average selling Price (NYSE:ASP) of NetSuite in recent quarters. The number of deals for OneWorld--NetSuite's service targeted at large enterprises has increased significantly in the recent quarters. However, overall average selling price in the quarter was flat and management expects ASP to remain flat for the remainder of the year. This suggests that the growth in large enterprise deals is not sufficient to offset the lower ASPs from continued growth in the midmarket segment. This means, NetSuite had to offer significant discounts to get new customers.

    1. Not a likely acquisition target: At current valuation of Netsuite (P/S of 14.59), this company is unlikely to be acquired by any big companies such as SAP or Oracle. Smaller SaaS (Software-as-a-Service) companies recently acquired are SuccessFactors (bought by SAP, for 7.5x sales) and Taleo ((bought by Oracle for 5.0x sales). Both these companies were obviously trading at much lower P/S ratio before acquisition.
    2. Insider sales: Stock worth several million dollars were sold in the last one year at stock prices from $38 to more recently at $56-57 etc by several insiders of NetSuite. Not a single share was purchased by any insider during this period.

    Valuation:

    I think a really generous valuation would be 30 X TTM free cash flow, which works out to a fair value of $15.35 per share as shown below:

    Free cash flow (NYSE:TTM): $36M

    Number of shares: 70.37M

    Fair value based on 30 times TTM Free cash flow: 36 *30/70.37 = $15.35

    Price/Sales (P/S) ration is often used for valuation of such internet companies.

    NetSuite(N) has P/S of 14.59 based on latest revenue.

    Salesforce.com (CRM) which is considered as one of the overvalued stocks has P/S 7.53.

    Smaller SaaS (Software-as-a-Service) companies recently acquired are SuccessFactors (bought by SAP, for 7.5x sales) and Taleo (bought by Oracle for 5.0x sales). Both these companies were obviously trading at much lower P/S ratio before acquisition.

    So, based P/S ratio of 6 (which, I think is generous based on above), fair value for NetSuite (N) would be $23.39.

    So, I think, fair value of stock should be between $15.35 and $23.39.

    Risks:

    1. Market seems to be very excited about anything to do with cloud at this time. This excitement could last for some more time. It appears to be like Internet bubble of 2000. However, any earnings or revenue miss or even reduction of guidance could be catastrophic on such high priced stocks.
    2. In theory, this company could be acquired by one of larger competitors. However, this is highly unlikely at the current valuation considering the valuation at which other competitors were acquired recently. To be acquired at those prices, Netsuite(N) stock will have to fall by about 60-70%.

    Catalysts:

    1. Quarterly revenue and/or earnings miss or slashing revenue/earnings guidance of NetSuite is likely to happen in the next two to three quarters due to following reasons:
      1. Aggressive selling from bigger competitors such as SAP, Oracle and Microsoft.
      2. Businesses in US and other parts of world are likely to cut spending in the next couple of quarters due to impending fiscal cliff, Euro zone crisis and slowdown witnessed in emerging countries such as China, Brazil, India and Russia. Big impact of such cuts is likely in discretionary spending such as investment in cloud offerings.
      3. NetSuite reports earnings are reported in USD. Any future depreciation of Euro due to ongoing crisis in Euro zone could have negative impact on revenue and earnings in the coming quarters.

    Any revenue/earnings miss or slashing of revenue/earnings guidance could have big drop in stock price.

    1. There could be a downgrade from Analysts based on valuation.

    Disclosure: I am short N, CRM.

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