After the highly successful VMware (VMW) IPO last week, which saw the price of the stock nearly double in just two trading sessions, it appears that tech IPOs are hot once again and there are some interesting ones that are currently in the pipeline. Located close to each other in San Mateo, California, NetSuite and Success Factors are two such companies that have filed to go public in the near future. Apart from their location these companies also have one more thing in common. Both of them are Software-as-a- Service (SaaS) providers or in the outdated pre-2000 jargon, Application Service Providers (ASP).
SaaS is a concept where you do not purchase a piece of software and try to customize it for your needs but instead license the use of it from a company that hosts and maintains the software for you. Something similar to leasing a car instead of buying one with the added advantage of having the dealer take care of oil changes and other maintenance for you (at a cost of course unless you drive a BMW). The only thing the client needs on their end is an internet connection and a web browser. SaaS offerings are platform independent making them suitable for companies that use multiple operating systems and they are also available universally (no more having to VPN into a corporate server).
Salesforce.com (CRM), one of the well recognized players in the SaaS arena, has seen tremendous growth over the last few years and as implied by its clever ticker symbol provides customer relationship management (CRM) software. The biggest gap with Salesforce.com’s offering is that it does not provide enterprise resource planning (ERP) components such as accounting, inventory management, fulfillment and payroll, unless you attempt to bolt on third party solutions provided through their AppExchange platform. NetSuite has a product that is not only broad enough to incorporate ERP components but also extends to include CRM and E-commerce capabilities. This allows companies to have a single solution to cover all their needs without purchasing or building separate pieces of software that have to talk to each other.
I have in the past migrated data from legacy applications and antiquated databases. When I was asked to look into integrating the accounting software MAS 90 with a client’s home grown sales application, I came to the conclusion that the time required to achieve this complex integration made the project prohibitively expensive for my client. NetSuite’s key strength lies in its ability to provide seamless integration between departments while providing executives with various dashboards to measure vital statistics across the entire enterprise. Functionality like this used to be the domain of large companies that had the money and IT staff to implement solutions provided by Oracle (ORCL) or SAP (SAP).
Google has a history of releasing various tools and applications with varying levels of success. It is said that the Google applications that have been most successful are the ones that are heavily used inside Google. Like any good chef, NetSuite must enjoy its own cooking as the company runs its business on its own suite of applications giving it in-depth real world experience with its own product. NetSuite also allows its customers to share parts of its application with partners (customers, vendors and selling partners) often at no additional charge. This not only allows businesses to streamline interaction with partners much like EDI does, it also happens to be brilliant marketing as NetSuite gets “virtual face time” with dozens (if not hundreds) of potential customers.
NetSuite customers subscribe to their service by paying the company for the number of “seats” used each month. Subscription models usually start paying off as the company gains traction and looking at the increase in sales over the last two years, it appears that NetSuite is indeed gaining a lot of traction. Moreover an ERP solution is integral to the functioning of a company and it is not as easy to cancel a NetSuite subscription after implementation as it would be to cancel a NetFlix (NFLX) subscription and switch to BlockBuster’s (BBI) Total Access plan.
The market for ERP, CRM and supply chain management software was approximately $12.7 billion in 2006 according to Gartner. Small and medium sized businesses accounted for 31% of this market and their spending is expected to grow 11.3% annually from 2005 to 2010 when compared to a 5.8% annual rate of growth for large companies. Some key customers of NetSuite include LCD monitor maker ViewSonic and Linden Lab, the creator of the virtual world Second Life. Evan M. Goldberg who co-founded the company with Oracle’s Larry Ellison is also the Chief Technology Officer and interestingly enough can be sometime found on the user forums at NetSuite.
The 124 page S-1 filing takes a while to read and I was planning on summarizing the key points from the filing, but Jason Wood has already done an excellent job on his blog The Ponderings of Woodrow giving me no reason to reinvent the wheel. As an investor and a consultant who recently picked NetSuite for a client after analyzing multiple ERP solutions, there are a few thoughts I would like to add to Jason’s analysis in the areas of valuation and disadvantages.
Numbers and Valuation:
NetSuite expects to go public in September and raise $75 million in the process by selling roughly 10% of the company. This values the entire company at $750 million, well below the roughly $2 billion market cap that was afforded to Salesforce.com when its stock closed its first day of trading back in June 2004. The $750 million valuation seems about right as it would be roughly 6.5 times 2007 sales based on estimated revenue of $115.35 million for 2007. Salesforce.com’s currently trades for 8.26 times sales and another SaaS provider RightNow Technologies (RNOW) trades for 4.17 times sales.
The estimated revenue for 2007 was calculated by taking into account first quarter 2007 revenues of $23.229 million, which grew 71.64% when compared to first quarter 2006 revenue of $13.533 million and applying this rate of growth to full year 2006 revenues of $67.202 million. The rate of revenue growth for NetSuite in the first quarter of 2007 exceeded the revenue growth at Salesforce.com (quarter ended April 2007) and RightNow Technologies by a wide margin.
Losses for the first quarter of 2007 narrowed to $3.71 million, which is a decrease of 45.2% when compared to a loss of $6.78 million in the first quarter of 2006. This reduction was achieved not only through revenue growth but also by gross margin improvement, which increased 600 basis points (another way of saying 6% that bond investors and people watching margin changes prefer). Revenue growth has been close to 100% over the last two years but slowed down to 71.64% in the first quarter of 2007 as discussed above.
SG&A expenses are likely to increase in the near future as the company has to spend resources on SarBox compliance and starts filing quarterly reports as a public company. The company explicitly mentions this in the “risk factors” section of its S-1 filing where it states “In addition, as a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company.”
The Dutch Auction IPO Process:
Unlike most companies that decide to go public by using Wall Street underwriters to price their stock and then allocate the shares to a select few individuals and institutions as outlined in this article, NetSuite has decided to use the dutch auction IPO process that will provide an opportunity for all investors to participate in the IPO. Google adopted this approach with it went public in 2004 and I am still kicking myself for having completed 7 pages of the 8 page application and then deciding not to apply. For an excellent introduction to the dutch auction IPO process, check out this article titled Going Dutch With Google.
The dutch IPO process as it applies to NetSuite is laid out quite well in pages 25 through 31 of the S-1 filing. A couple of key points to note about the NetSuite dutch auction. You would require an account with Credit Suisse, W.R. Hambrecht + Co. or E*TRADE to participate and the minimum bid size is 100 shares. Check out the website www.netsuiteipo.com for additional information about the auction process as it becomes available.
Risk Factors and Disadvantages:
The risk factors of investing in NetSuite have been covered in great detail in the filing but I wanted to highlight some of them and add a few of my own looking at the company through the lens of a customer and software engineer.
Some direct competitors of NetSuite are RightNow Technologies (RNOW), Salesforce.com (CRM) and to a lesser extent Visual Sciences (VSCN), which merged with WebSideStory in February 2006. Other competitors include Intuit’s (INTU) QuickBook suite of products, The Sage Group’s MAS 90/200/400 and Peachtree line of products and Microsoft Dynamics (formerly Great Plains). If NetSuite decides to swim upstream and target large companies, it is going to face a strong current in the form of Oracle and SAP.
Some other interesting tidbits of information from the S-1 filing:
While Larry Ellison took a chance almost 10 years ago by investing in an ex-Oracle executive’s unproven idea, we are currently getting a chance to invest in a company that appears to be executing well, is very well positioned in its market segment and seems to have just entered the sweet spot of rising revenue with narrowing losses. Based on my personal experience with their product, I am as excited about this IPO as I was with Chipotle Mexican Grill’s (CMG) IPO last year and VMware’s IPO last week and plan to participate in this offering for my personal portfolio.
Voluntary Disclosure: I personally hold a long position in BlockBuster and featured it in the July 2007 investment newsletter.