How to Get Into Cloud Computing at a Reasonable Price

The cloud index rose by 107%, while the NASDAQ only went up by 58% in the last year. This trend is evidence that the general public believes potential in this type of technology.

Mar 17, 2014 at 1:32PM

Today, businesses are looking for ways to gather information quickly while keeping expenses low, and cloud computing offers just what companies need. Within the past year, investors have been snapping up shares of cloud computing companies, and the problem has become finding them at reasonable valuations. To put it in perspective, the cloud index rose by 107%, while the NASDAQ only went up by 58% in the last year. This trend is evidence that the general public sees potential in this type of technology.

Great company, but extremely expensive
Given the potential of the technology, valuations are through the roof. Ultimate Software Group (NASDAQ:ULTI), a provider of SaaS payroll solutions, has a forward P/E of 62.8 and an EV/EBITDA of 75. This isn't an EBITDA problem -- the EV is just huge. Applications stored on Ultimate Software's server are delivered to clients over the Internet on-demand. The remote storage enables cost cutting, application updates, international accessibility, and security. Costs are reduced because clients no longer need to buy and maintain physical servers in the office. Another important feature this company provides is the UltiPro Mobile. This mobile app enables teams to stay connected with each other globally, managers to view subordinates' profiles, and employees to update retirement contributions. Users can see each other's profiles, similar to Facebook. Ultimate Software has been recognized as leader of cloud-based payroll software because the services it provides continue to enhance the daily operations of clients. As a result, its financial performance has been excellent over the last few years. Cash flow from operations was $42 million in 2012 and $74 million in 2013. Investors quickly recognized the value of this company, leading to a 217.13% share price increase in just a few years.

Another great cloud computing company with an astronomical valuation is Athenahealth (NASDAQ:ATHN), which provides cloud computing services for electronic health records, practice management, and care coordination. One product, AthenaClinicals, manages health records electronically, allowing family doctors to conveniently access a patient's results. AthenaCollector helps doctors manage their practices through integrating operations such as scheduling, reminder calls, and accounting. AthenaCommunicator connects patients to doctors outside of the office, so both patients and doctors can view medical information, appointments, and payments. AthenaCoordinator assists caregivers, facilities, and patients by managing the flow of orders, such as tests and surgeries, between all parties. The company has operational cash flow of $70 million and $93 million in 2012 and 2013, respectively. Just like Ultimate Software, its valuation multiples are huge. It has a forward P/E of 135 and an EV/EBITDA of 129. This company also has no problem making money, and the valuation is massive due to the hype.

Larger companies such as Salesforce, Workday, and NetSuite have not been profitable, but have large valuations due to their potential.

Cloud computing at a good price
To move away from lofty valuations, look at companies that don't appear to be cloud computing companies on the surface. Recall (ASX:REC), an information management company that recently spun off a division of Brambles, makes most of its sales from physical storage, but is quickly growing its cloud-computing business to capture opportunities in upcoming market trends. It helps customers convert information to digital format and allows clients to access documents on various devices, including mobile phones. The cloud-based management system stores converted images and allows quick access for members of all departments.

Since its spin off, based on EV/EBITDA and forward P/E, it is currently undervalued compared to Iron Mountain and similar companies. Iron Mountain has significantly more debt than Recall, which boosts its EV. Recall has an advantage in the international markets, which will be a large source of growth for data storage. The company already has infrastructure set up and is ahead of the game. Transitioning from traditional physical storage to digital services could yield tremendous value for investors. Valuation multiples of cloud computing companies are, on average, two times more than those of Recall.

In conclusion, cloud computing is only getting bigger but investors need to avoid cloud computing companies with these massive valuations.  Look for the companies moving in the cloud computing direction. Recall has upside potential based on its current business in physical storage and on its future growth opportunities when it diverts more resources to cloud-computing. Now may be a good opportunity to buy this stock while it still priced at low multiples.

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Mike Thiessen is long Recall Holdings. The Motley Fool recommends Athenahealth and Ultimate Software Group. 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.

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