Is Cloudera a Buy?

Cloud computing -- the use of software and other services hosted off-site at a data center and accessed via the internet -- has been one of the best-performing businesses in the past few years. As the cloud industry has boomed, merger deals and other consolidation have also been on the rise.

Enter Cloudera (CLDR) and Hortonworks (HDP), two cloud-based big-data management and analytics companies that recently announced a merger of equals. Some Wall Street analysts were upbeat regarding the deal, but investors who like software stocks should be aware of some glaringly optimistic assumptions before buying in.

Why the story is compelling

Cloudera developed a commercial open-source version of Hadoop -- a system for efficiently storing and making sense of big data. The data a big business generates can be diverse, from website logs to connected-equipment feeds, and Cloudera helps companies warehouse and analyze that otherwise messy-looking information.

Hortonworks plays in the same sandbox, offering big-data management and services to make life easier for enterprises sitting on loads of information. In combination, the top teams at both companies are optimistic that their new leading data platform will be better able to handle customer needs. They also think that working together will help them accelerate the development of new services. That could be necessary considering that the competition includes monster tech names like Alphabet's Google, Microsoft, and Amazon, all of which have extensive lists of services with which to woo clients.

Cloudera and Hortonworks aren't just under pressure from huge rivals. The cloud boom has spawned lots of other companies growing just as fast, and the smaller upstarts are starting to bump into each other as well. Companies like Atlassian and the always aggressively expanding Salesforce are finding the industry is getting crowded, and mergers, acquisitions, and partnerships are becoming increasingly more common.

Cloudera consolidating with its peer Hortonworks just makes sense, then, allowing the two to work in a way that is mutually beneficial rather than vying with each other.

Image source: Getty Images.

Why the numbers aren't as compelling

Cloudera and Hortonworks in their current state will be generating about $720 million in annual revenue. Since both operate at a loss, investors will be happy to hear that the management teams see $125 million in annual synergies, which is jargon for cost-cutting. In calendar year 2020, positive free cash flow of $150 million is the expected profitability figure. That's a big difference from the current numbers.

Data source: Cloudera quarterly results and YCharts. YOY = year-over-year. 

Data source: Hortonworks quarterly results and YCharts. YOY = year-over-year.

Cloudera and Hortonworks are converting higher revenues into rising gross profits, and operating losses are inching closer to breakeven. But free cash flow for the two -- money left over after basic operations and capital expenditures are paid for -- is at negative $50 million over the past year. That means that, post-synergies, the new Cloudera should be solidly in the black on the free cash flow side. 

However, the companies seem to be assuming that top-line growth will continue at a double-digit rate and even then that equates to a forward price-to-free-cash-flow ratio of at least 40 (using Cloudera's information that the new company will be valued at $5.2 billion post-merger, and backing out Cloudera's and Hortonwork's current capital expenditures of roughly $23 million).

Before the combination, though, sales at both outfits were already starting to decelerate. Cloudera has forecast 21% revenue growth for the current fiscal year, and Hortonworks as much as 31%. Both figures represent a slowdown from results year to date, and are far lower than the respective 41% and 42% Cloudera and Hortonworks reported last year. Paying for over 40 years worth of free cash generation seems like a steep price to be paying given the uncertain growth rates from the new Cloudera going forward. 

The big-data cloud company will soon be turning a new page in its story -- assuming investors and regulators give the OK -- and the proposed combination should go a long way toward insuring a healthy future for operations. (If all goes well, the deal should be complete by the first quarter of 2019.) But with stiff competition in the big-data space and sales slowing down, I'm not so eager to buy the optimism yet. I'd like to see some positive financial results, including proof of profits, from the new Cloudera before I make a purchase.