ZachStocks

A recent article about Salesforce.com (CRM) prompted questions about a primary competitor and newly public company, Netsuite (N).  Netsuite was brought to market in late December in an environment awash in skeptics and risk averse investors.  Despite difficult headwinds following a tumultuous November, the stock received a warm welcome to the NYSE trading to a high of $35.70 on the first day after pricing the offering at $26.00.  Over the following several days the stock extended its gains, drawing in investor optimism ahead of the new year.  January changed everything as a mini-market crash drove valuations lower on growth stocks, value stocks, international stocks, and just about any other kind of stocks.  Netsuite was not immune and soon found itself trading below the IPO price.

A quick look into the fundamentals reveal a company with a very attractive suite of on demand software products which are marketed to the small to mid size business community.  The suite covers a broad range of applications which can be purchased either as stand alone products or as a bundled package.  Much like Salesforce.com, the company does not require customers to buy and load the software on their own equipment, but instead offers licenses to log into the web-based product.  The setup is attractive to small clients who may not have the resources to go out and buy a software package, a server to load it on, and a staff to maintain the program.  The lower up front cost pulls in clients that would typically not be interested in a comprehensive software package.  Netsuite has a benefit as well in that the company creates a revenue stream with a high degree of visibility.  It is very unlikely that a customer will implement Netsuite’s products and then default to a competitor as the transition frustrations may not outweigh any cost savings or other perks offered by a competitor.

The biggest issue with purchasing a stock such as Netsuite is the fact that the company has yet to turn a profit.  Despite bringing on an additional 430 customers in the fourth quarter for a total of over 5,600, revenues have not yet caught up with the increased spending necessary to facilitate the rapid growth.  Because of the lack of profits, Wall Street is having a very difficult time coming up with a valuation for the company.  Typically analysts resort to a price to revenue model, but that has more than a few issues as increasing revenues do not necessarily result in a stronger company.  A better approach is to take a long-term valuation of future profits because profits are what truly drives creation of wealth.  However, it is very difficult to figure out exactly when the company will begin to turn a profit and exactly what level that profit will be and what rate the growth will likely maintain.  Compounding that uncertainty is the potential for a domestic (and quite possibly global) recession that would cause small businesses to reduce spending and would likely bite into Netsuite’s profits (or lack thereof).

At this point there are approximately 6,200,000 shares in float which is a relatively small portion of the company’s capitalization.  In June, it appears there will be an additional 53.3 million shares for which a lockup period expires.  This could result in a flood of stock to the market over the summer.  The law of supply and demand states that when excess supply comes to market, the probability of the price dropping is very substantial.  On the flip side of this coin is the fact that Larry Ellison - the founder of Oracle - has a large personal ownership in the company.  This should inspire confidence in the technology as Mr. Ellison certainly knows a good bit about software, but at the same time can cause concern as any decision to sell by this large shareholder would pressure the price.

The opportunity is large for Netsuite to expand both domestically and internationally.  The company received 82.3% of its revenue from the US this past year down from 86% in 2006.  International expansion, while expensive, will likely add a significant boost to revenues over the next several years.  At the same time, however, large competitors are entering the market with SAP likely to spend $1 billion on developing a product that competes with Netsuite’s offering.  Additional gorillas with deep pockets such as Microsoft and Seibel may also enter the market driving margins lower and creating a difficult environment for a younger less capitalized company to turn profits.

So with all the issues on the table, I have found it hard to get behind Netsuite on the buy side. The company announced earnings Thursday night that were above expectations, but the good news failed to ignite a rally in the stock.  Despite the enthusiasm of analysts and investors alike, the risk appears to outweigh the potential returns at this time, so until there is more visibility into the profitability of the firm, I will be content to sit on the bench and watch this show from the sidelines.

N Notes

FD: Author does not have a position in N

Additional Reading:

Zachstocks weighs in on Salesforce.com

Joe Panettieri on Why Sofware as a Service Isn’t Perfect

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