Any investor reviewing the financials of NetSuite (NYSE:N), the cloud-software based Enterprise Resource Planning (ERP) company, would probably derive a stock value below $30 rather quickly. Most investors would be shocked that the stock trades at nearly $110. The company is growing quickly as enterprises move toward cloud offerings, but NetSuite is only marginally profitable and revenue growth is slowing down to a more sustainable 25% long-term growth rate. Why then are investors willing to pay $8 billion for a stock only generating $400 million in revenue?
Operating margins are the key
NetSuite only generates operating margins of 6%, but the CFO made some interesting comments at the recent Deutsche Bank Technology Conference. The company actually provided some details that are not normally spelled out. According to the CFO, sales and marketing expenses are currently 45% of revenue yet the estimate is that 30% is spent to attract new customers. His estimate is that sales expenses of perhaps as little as 10% of revenues are required to keep the current installed base.
The claim goes that the operating margin would jump to an incredible 36%. The company competes against Oracle (NYSE:ORCL) in the ERP sector and brings up the general concern that the typical software company never reduces its sales expenses as proclaimed possible. The dilemma exists because investors fear that if a company stops spending heavily then its renewals will drop.
Speaking of Oracle and margins
Considering that Oracle is where NetSuite wants to end up in the ERP sector, lets see what margins it obtains now that it has achieved a market cap of over $150 billion. The company has reached the level of maturity where sales spending should be more focused on maintaining the customer base.
In the case of this multi-billion dollar quarterly revenue producer, sales and marketing spending only hits 20% of revenue. Its lower expenses allowed its operating income to reach 34% of revenue for the recent quarter ended in August. Considering that quarter is the weakest of the year, the fourth quarter 2013 report was even more telling with operating margins hitting an incredible 46%. One would have to conclude that these results back up NetSuite's claims.
One of the benefits of listening and even reading conference call transcripts is learning more about competitors. In this case, an analyst asked about Demandware (NYSE:DWRE) as a partner. Management countered that while it partners on many deals, it is increasingly seeing the company in a competitive light.
If investors like NetSuite, Demandware might be even more appealing. The provider of cloud-software e-commerce solutions only trades at 15 times its current-year revenue. Considering that the company is smaller than NetSuite and has a faster growth rate, the company might have a more compelling valuation proposition. Customers from Diageo to Ethan Allen currently use Demandware's services.
Cash flows tell the story
The major reason that these stocks trade at pricey valuation multiples is the attractiveness of positive cash flows. With clients prepaying annual subscription fees, these companies obtain cash upfront to match the sales spending. While NetSuite is mildly profitable, it generated strong operating cash flows of $59 million over the last 12 months.
Even Demandware generated $6.2 million of positive cash flows from operations during the first six months of 2013. This is impressive considering that the company has a non-GAAP loss of over $8 million. The primary reason for wiping out the loss was $10.6 million of additions to deferred revenue. Cash in the door can never be bad. Using that metric, though, Demandware trades at $1.5 billion while generating an annualized $12 million in operating cash flow.
Oracle's operating margin details solidify why investors are willing to pay premium valuations for a company such as NetSuite that only generates a small profit. Investors must decide if paying an extreme 20 times current-year revenues is worth the price. Smaller Demandware appears more attractive at only 15 times that multiple. Remember that if NetSuite dropped its sales expenses to 10% of revenue and generated operating margins of an impressive 30%, its operating income for 2013 would equal $120 million. Would that be worth paying $8 billion for?
The potential for strong operating margins are clearly driving NetSuite higher and higher, but the company's stock has lost touch with reality at this point.
Mark Holder and Stone Fox Capital have no positions in any stocks mentioned. The Motley Fool recommends NetSuite. The Motley Fool owns shares of Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.