Should You Be Invested in Enterprise Cloud Software Companies?

In the early earnings season, we've seen a trend: Companies are mostly beating estimates but issuing very conservative guidance. For most industries, this rule applies, but enterprise cloud software companies like ServiceNow (NYSE: NOW  ) and Aspen Technology (NASDAQ: AZPN  ) have provided reason to be bullish in this one particular space. And coupled with the weakness from on-premise IT juggernaut International Business Machines (NYSE: IBM  ) , investors might want to take a closer look at the space and upcoming reports from the likes of Salesforce.com (NYSE: CRM  ) and Workday (NYSE: WDAY  )

First indication comes with noted declines
Last year, hedge fund manager Stanley Druckenmiller called IBM a great short, saying that every dollar earned by cloud services takes (multiple) dollars from on-premise IT companies like IBM.

The reason for Druckenmiller's thesis is that cloud services are cheaper than on-premise IT and allow customers to perform many functions under one-single platform. Thus, anything that saves customers money is positive, but in this case, it has been a nightmare for IBM.

For the last year IBM has been showing signs that Druckenmiller's outlook is correct via year-over-year revenue losses. In the company's last quarter, total sales declined 5.5%, while its global technology-services revenue declined 4% year over year.

Hence, IBM is losing business rapidly, and given the growth of these cloud services, there are many reasons to believe that IBM's fundamental woes could continue...and that many cloud services are thriving.

Second indication lies in recent reports
IBM's fundamental woes serve as a first indication that enterprise cloud software companies are thriving, but a second indication comes from those companies that have already reported earnings.

Last week shares of ServiceNow soared 15% after earnings exceeded expectations and guidance called for continued performance.

The company may directly benefit from IBM's demise as it strives to maximize the efficiency of IT operations through the cloud. Therefore, investors should be pleased with its 66.6% revenue growth, but more important is the company's 59% rise in deferred revenue and its backlog balance to $875.1 million, signaling long-term growth.

Then, the following day, peer Aspen Technology -- makes training, presenting, and software integration easier in complicated industries such as energy, chemicals, and engineering via the cloud -- reported very strong earnings.

While Aspen's revenue growth of 27.8% might seem irrelevant compared to peers ServiceNow, Workday, and NetSuite, its performance is made impressive when you consider its profit doubled and that it carries the highest operating margin among cloud-only companies.

For potential investors, Aspen and ServiceNow's earnings serve as a great indication of industry strength and what may come from other companies to report earnings in the next two weeks.

Valuations remain a problem
Clearly, we are seeing a noticeable trend: Growth in enterprise-software companies is accelerating while on-premise loses its appeal. Ultimately, this is a trend that most expected but perhaps not at the rate we are currently seeing.

However, the Achilles' heel of this industry might be its valuation and the expectations that are already in place.

With that exception of Aspen, none of these companies are profitable, including the largest pure cloud-enterprise company Salesforce.com and the most hyped company Workday, which sells HR and payroll-related cloud services.

Yet, one thing this entire space shares, aside from growth, is a pricey premium-to-12-month-sales ratio.

You can see below:

Company

Price/Sales Ratio

ServiceNow

24.3

Aspen Technology

11.2

Salesforce.com

9.8

Workday

38.4

NetSuite

22.0

As previously said, all of these stocks are pricey, meaning if you want to invest in the industry, then you are going to pay for it. However, given the impressive growth we are seeing throughout the space, a good assessment of the space, and a selection of the best value, the space might be lucrative for investors long term.

Final thoughts
It's worth noting that despite ServiceNow and Aspen's double-digit price/sales ratios, both saw large intra-day gains following earnings. This implies that despite lofty valuations, it is still likely or possible that such companies as Salesforce.com and Workday trade higher if the trend of strong fundamental performance continues.

With that said, if you're looking to invest long term, then valuation must be considered in order to put you in the best possible situation to produce consistent gains without great downside risks. Currently, even the largest of these companies, Salesforce.com, is unprofitable, with an operating margin of negative 5.4%. Yet, considering the negative 33.3% operating margin from Workday, I suppose many in this space would be happy with Salesforce.com.

However, Aspen Technology, a company with an operating margin of 26.5% and coming off a quarter where its profits doubled, presents investors with a rare combination of growth and efficiency. At 11.2 times sales, it is one of the cheapest stocks in this space, and with near 30% growth, investors might find that long term, Aspen stands a good shot to outperform this very exciting and fast-growing space.

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9/16/2014 3:59 PM
AZPN $39.44 Up +0.13 +0.33%
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IBM $192.96 Up +1.15 +0.60%
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NOW $59.91 Up +0.93 +1.58%
Service Now CAPS Rating: *
WDAY $86.17 Up +0.56 +0.65%
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