Where is the Money? The Short Case for Netsuite
Netsuite is a company that produces an integrated suite of business applications for medium sized businesses. Within this core area they also produce industry-specific applications, and also a platform that allows for customer-driven development. The company was born in 1998 and seems to have brought some of that era’s valuation with it, as the company has a price/sales ratio of 8.75 and a price/free cash flow ratio of about 170. Revenue growth has been very impressive, increasing from $17.7 million in 2004 to $166.5 million in 2009. However, this growth has not yet produced any tangible benefit to the shareholders, and one wonders when the shareholders will run out of patience.
The company has an impressive rate of sales growth, but this revenue growth has not translated into increased earnings. To be precise, this revenue growth hasn’t translated into earnings, period. As James Montier noted in his excellent Value Investing, a low price/sales ratio doesn’t necessarily mean a cheap stock, as the metric does not take into account capital structure or profit margins.However, a high price/sales ratio is a sufficient indicator of an expensive stock, since no capital structure or realistic margins will produce the earnings necessary to justify the price. At 8.75, Netsuite’s price/sales ratio is one of the highest to be found in the U.S. market.
Turning to the earnings picture, it is normally helpful to use a proxy for free cash flow, which is earnings plus depreciation minus capital expenditures. Looking at this measure, we find that Netsuite actually isn’t producing any free cash flow. In 2007, Netsuite reported earnings of -$23.9 million, took $3.4 million in depreciation and amortization, and made $4.6 million in capital expenditures, resulting in free cash flow of -$25.1 million. In 2008, Netsuite reported earnings of -$15.9 million, took $6.9 million in depreciation and amortization, and made $7.3 million in capital expenditure, producing total free cash flow of –$15.5 million. In 2009, reported earnings were -$23.3 million, plus $10.7 million in amortization and depreciation and minus $6.1 million in capital expenditures, producing estimated free cash flow of -$18.7 million. Year to date 2010, the figures are no better despite the continuing trend of sales growth. Reported earnings for the first three quarters are -$21 million, plus $9.3 million in depreciation and amortization, minus $4.7 million in capital investments, total -$16.1 million, which would be -$21.4 million on an annualized basis.
Of course, it should be noted that much of the reported earnings losses spring from the fact that Netsuite is very good at handing out stock-based compensation. Given the high share price of Netsuite it is probably good for the company to hand out stock instead of cash, but from a shareholder’s perspective dilution is still dilution. If we set that aside, and add back in all the stock-based compensation, we find that in 2007 the company would still have earned -$7 million in 2007, -$4 million in 2008, $2 million in 2009, and $7 million year to date in 2010–equity-based compensation, at $23 million year to date, is more than 50% higher than it was last year at this time. It is not immediately clear to me what is the benefit to the shareholders from handing out stock-based compensation at a higher rate than the cash generation that the management is being compensated for, but that is the Board’s decision and they show no signs of changing it. At any rate, even if we neglect dilution, $7 million in cash flow is about $9.3 million on an annualized basis, and weighed against the company’s current market cap of $1.61 billion gives us a price/cash flow ratio of 173, a figure that strikes me as rather high.
I suppose that Netsuite’s sales growth may eventually produce better returns, and perhaps even positive earnings. Also, perhaps the last three years have been bad times for businesses to make major new investments (not that Netsuite’s 2005 and 2006 figures have shown positive earnings, either). But it seems to me that Netsuite’s current valuations can only be justified by wildly hopeful expectations.
And as to this rosy future, I will also note that in the 2009 10-K the company noted that “As a result of continuing losses, management has determined that it is more likely than not that the Company will not realize the benefits of its domestic deferred tax assets and therefore has recorded a valuation allowance to reduce the carrying value of these deferred tax assets to zero.” As the company discloses elsewhere in the same document, the operating loss carryforwards expire between 2018 and 2029. This means that, as they are fully written off, the company is saying that it cannot be more than 50% sure that it will achieve profitability under the Tax Code even by 2018 or later. Obviously, these projections are subject to revision, but this should be a sobering thought for those who are optimistic.
As a result, then, I can say with confidence that Netsuite is not presently generating anywhere near the results they need in order to justify their current market price, and I can recommend them for consideration as a short selling candidate.
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