NetSuite Beats Earnings, Stock Plunges After Hours

Correction (5/6/2008): As the Senior Director of Investor Relations from NetSuite correctly pointed out to me in an email yesterday, NetSuite beat analyst earnings expectations by a penny a share instead of missing earnings by a penny as I had originally mentioned in this blog entry. Earnings according to GAAP (Generally Accepted Accounting Principles) have included stock based compensation as an expense since the rule went into effect in 2005 and NetSuite reported a GAAP loss of 3 cents a share. The mistake I made was to compare the GAAP loss of 3 cents a share against analyst expectations of a 2 cent loss, which did not include stock based compensation. NetSuite’s earnings excluding stock based compensation was a loss of one cent a share, hence beating estimates by a penny.

On-demand software provider NetSuite (N) reported its first quarterly results as a public company yesterday with a 3 cents a share or $2 million loss, which came  in below above analyst expectations of a 2 cent loss. The stock registered a sharp drop in reaction to the results, falling $3.81 or 17.08% in after hours trading. It appears that my concerns about NetSuite’s valuation, as published in the April investment newsletter, were well founded. However it is always a good idea to go beyond the headlines (even mine) and take a deeper look.

Based on what I heard in the conference call, NetSuite had a strong quarter with $34.1 million in revenue that topped analyst estimates and $1.5 million in cash flow from operations. Management sounded confident on the call and they raised their 2008 revenue forecast to a range of $154 to $157 million.

The only logical explanation for the after hours sell off would be that investors were probably expecting NetSuite to meet or exceed earnings expectations and were not satisfied by the 47% growth in Q1 revenue. As mentioned in my last article about NetSuite, growth in the last four quarters was 71.64%, 64.28%, 56.35% and 57%. As the law of big numbers starts catching up (it is usually harder to grow from $100 million to $200 million than it is to grow from $10 million to $20 million, even though both scenarios represent 100% growth), it is not uncommon to see growth moderating.

Additional highlights from the conference call are given below,

• First quarter 2008 revenue grew 47% to $34.1 million when compared to Q1 2007 and increased 8% when compared to the previous quarter (Q4 2007).
• The company posted a net loss of $2 million or 3 cents per share. On a non-GAAP basis after excluding stock based compensation, the company posted a loss of $420,000 or 1 cent per share when compared to a non-GAAP loss of $842,000 in the previous quarter.
• NetSuite posted a smaller loss this quarter by reducing external professional services and because revenue growth outpaced expense growth. Gross margin came in at 71% (typically high for software companies) when compared to 70% in Q4 2007.
• As expected NetSuite’s investment in a data center (the company mentioned spending $10 to $15 million in its IPO filing) will impact gross margins throughout 2008.
• The company signed up 400 new customers in the first quarter, which is within the range of 300 to 500 customers they have historically signed up in previous quarters.
• International revenue grew faster than domestic sales with a 64% growth rate and international revenue now represents 19% of total revenue.
• NetSuite appears to be excited about its new OneWorld product with 30 companies like Six Apart (the makers of TypePad blogging software) live on this product and another 50 currently under implementation. NetSuite OneWorld has helped one of their customers manage 100 subsidiaries using the software.
• British Telecom, one of the resellers NetSuite is working with, will help introduce NetSuite products to 1.6 million small business customers in the United Kingdom and Europe.
• Subscription revenue renewal rate was 90% of revenue in Q1 2007. Upselling other products to current customers has usually offset churn and effectively helped NetSuite retain 100% revenue. It would have been interesting to see what the attrition rate was quarter-over-quarter instead of year-over-year and even a 10% rate of churn appears a little high.
• The company recently announced the NetSuite E-Commerce Company Edition product and the NetSuite Business Operating System or NS-BOS for developers. It estimates that nearly 1,000 developers are using NS-BOS to develop industry specific applications.
• The first quarter of 2008 represented the 34th straight quarter of revenue growth and 10th quarter of improving non-GAAP results.
• The company recognized $1.5 million in revenue from the distribution rights of their Japanese product. It expects to continue recognizing similar revenues for the rest of 2008.
• Product development expenses grew 2% quarter-over-quarter to $3.6 million. The company expects to spend 12 to 13% of total 2008 revenue on product development.
• Marketing and sales expenses grew 11% to $7.5 million primarily due to hiring in their new sales office. The company expects to significantly increase hiring in sales and marketing in 2008.
• NetSuite experienced a sharp 28% increase in general and administrative (G&A) expenses to $5 million. This increase when compared to Q4 2007 was on account of being a public company. G&A is typically high in the first quarter for NetSuite and the company expects G&A expenses to come in at 12 to 13% of revenue in 2008.
• 35% of Q1 2008 expenses were in currencies other than US dollars. This could be on account of their global support centers and may not bode well for the company in a strengthening dollar environment as it expects this percentage to grow.
• The company hired 99 new employees in Q1 and plans to hire a total of 350 employees in 2008, mostly in sales and marketing. The employee headcount stood at 765 at the end of the first quarter.
• The company recorded a $229,000 income tax provision in Q1 2008.
• Cash flow from operations was $1.5 million compared to $3.7 million in Q4 2007 and -$0.5 million in Q1 2007. Year end bonuses and commissions reduced cash flow in the first quarter.
• Capital used in investing activities such as hosting account capacity and equipment purchases was $1.1 million when compared to $1.4 million in Q4 2007 and $1.4 million in Q1 2007.
• Free cash flow was $379,000 in Q1 2008 when compared to negative $1.9 million in Q1 2007.
• The balance sheet currently had $170.2 million in cash. Accounts receivables dropped to $16.2 million from $18.7 million at the end of 2007. As a customer I can attest to NetSuite’s cash collection capabilities.
• Short-term deferred revenue (their pipeline, if you will) was $67.1 million, an increase of $1.3 million from the end of 2007. Long-term deferred revenue was $8.9 million, a decrease of $2.2 million from the prior quarter as the company shifts from multi-year contracts to annual contracts and some revenue from their Japanese product became current.
• Stock based compensation declined to $1.6 million when compared to $2.4 million in Q4 2007.
• NetSuite plans to reinvest most of its top line growth into the company and plans to add 2% to the bottom line every year.
• The company projects Q2 2008 revenue of $36 to $36.7 million and a loss of $1 million to $250,000.
• NetSuite increased its full year 2008 forecast to a range of $154 to $157 million and expects to post a non-GAAP loss of $2.4 million to $1 million. With an expected 61.3 million shares outstanding at the end of 2008, this should translate into EPS of -4 to -1 cents.
• If you get a chance to listen to the conference call, check out the comments about SAP in the Q&A section towards the end of the conference call.

Voluntary Disclosure: I currently hold no positions in NetSuite.