Enterprise Software: Growth at a Cost

The enterprise software space is one beloved by Wall Street, awarded hefty premiums due to explosive growth. While this growth is fueled by new customers, large market opportunities, and long-term subscription services, only one of the most watched companies has achieved growth minus an extreme cost. This one company might serve as a far better option than those most preferred, such as Workday (NYSE: WDAY  )

Growth at a particularly high cost
Workday offers cloud-based applications for human capital management, payroll, time tracking, and other work-related products. In 2013, it is expected to grow total sales by 70% over 2012, and analysts expect growth of another 51% in 2014.

In the company's last quarter, it saw sales growth of 76.1%, accounting for $127.87 million. Examining the company's last four quarters, it has produced total sales of $408.59 million. However, Workday may be growing fast, but what many investors aren't considering is the amount of money the company is spending in order to achieve that growth.

In the last 12 months, Workday had total operating expenses of approximately $544.58 million. In other words, the company spent $1.33 for every $1 of revenue it earned in the last 12 months. Some might suggest that Workday's growth is only attainable because of its spending rate, and that 70% growth this year would not be possible without such excessive spending. Moreover, the company has shown no real reason to believe that profitability is anywhere in sight.

With that said, investors are willing to pay a whopping 35 times trailing 12 month sales to invest in Workday. This number, combined with its spending, is mind-boggling, as it would likely be considered a huge risk in any other industry and a reason to short the stock, rather than buy.

Costly revenue-generating machines
Unfortunately, it's not just Workday that's spending big bucks to convince Wall Street that it's a revenue-generating machine. Salesforce.com (NYSE: CRM  ) , the leader in the enterprise software industry, had sales of $3.76 billion on expected growth of 33% for the full-year.

Given the fact that Salesforce.com is the largest, it should, theoretically, be among the most efficient, having a well-established business. Yet, its operating expenses of more than $3.96 billion means it spends $1.05 per every dollar earned.

With that said, $1.05 is better than $1.33, and Salesforce.com's price-to-sales ratio of 8.8 is far better than Workday's trading premium. In many ways, Salesforce.com's lack of operational profits shows the nature of this business, making it even more difficult to fathom the reason behind such hefty valuations.

Cornerstone onDemand (NASDAQ: CSOD  ) is another company showing strong growth, but also another one that's paying a high price to earn that growth. The company provides talent management through the cloud via recruiting, performance measures, and outreach programs, and is expected to grow 55% this year.

In the last 12 months it's had revenue of $166.7 million and spent $1.20 per dollar earned. While Workday is growing faster, Cornerstone is spending slightly less, and trades at half the multiple with a price-to-sales ratio of 16.5.

A single bright spot
Clearly, neither Salesforce.com nor Cornerstone are profitable. Both have slightly slower growth than Workday, and both are significantly cheaper. This fact creates serious questions regarding Workday's valuation.

Furthermore, examining the three companies side-by-side, noting each company's growth and the money spent to achieve that growth, it's clear that growth is greatest where the most money is spent. Therefore, Workday doesn't have any real niche or advantage over its peers, but rather the willingness to spend at a more irresponsible rate.

There is one bright spot in the industry, a company that exhibits impressive growth while keeping costs in check: Aspen Technology (NASDAQ: AZPN  ) .

Aspen makes training, presenting, and software integration easier in complicated industries such as energy, chemicals, and engineering. In 2013, the company is expected to grow 17%, and sales are expected to rise another 17% to 428 million in 2014.

Despite this growth, and an obvious spending trend among its peers, Aspen has spent just $0.78 per dollar earned over the last 12 months, and continues to improve its operating expenses every quarter.

Final thoughts
While Aspen is a bit pricey at 12 times sales, this might suggest that its operating efficiencies warrant a premium, versus a higher multiple being given to companies that simply blow through the most cash.

This rather ludicrous fact really illustrates how overvalued Workday is priced. As an investor, buying good companies that will return long-term gains is the goal. But at this point, it appears that (with the exception of Aspen), this is a space that's hardly built to earn profits.

Therefore, while all four companies have impressive growth, investors might find the best option is the one that's separated from the pack, not by top-line performance, but rather by margins and efficiency, and that company is Aspen.

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  • Report this Comment On December 30, 2013, at 6:39 PM, canucknobuck wrote:

    I agree that Workday is priced richly but for their space if they can succeed as an alternative to the old, monolithic ERPs they will earn this valuation. None of the other companies you mention are plausible alternatives to Oracle, SAP, or PeopleSoft as an ERP. Maybe if you'd included NetSuite.

    Workday has strong mgmt and they've already embraced mobile. I've used some of the other ERPs and they are big, costly, clunky, unfriendly and unwieldy - a far cry from what people expect in today's web-enabled world. Workday is on to something big in my opinion.

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