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Cloud services' stock bubble gets pricked, despite defenders

Aaron Pressman
Daily Ticker

Stocks of cloud-services companies have been killed lately and, many investors say, with good reason. But some of the sector’s proponents are trying to push back.

Most of these companies were trading at sky-high levels when their sales or profits were measured against the rest of the stock market, bringing to mind memories of the Internet bubble.

Shares of Workday (WDAY), for example, hit $116 in February, giving the HR services company a value of over $21 billion. The company had total revenue last year of just $469 million and a net loss of $173 million. At 45 times sales, Workday was one of the most expensive large-cap stocks in the market. Google (GOOG) sells at just 6 times its sales, Facebook (FB) at less than 17. The ratio for the entire S&P 500 is under 2.

And in the recent move away from risky stocks, shares of Workday plummeted, closing at $71.76 on Friday (it is recovering a bit in Monday's trade, up close to 6% at $75.22). Even at its current price-to-sales ratio of 26, Workday ranks 25th out of almost 4,000 U.S. listed equities with market caps over $1 billion, according to Factset.

Smaller cloud-services companies have proven even more volatile. Castlight Health (CSLT), which helps companies manage healthcare costs, went public in March and more than doubled in its first day of trading. On that first day, the company was valued at over $3 billion on sales last year of $13 million. The stock dropped as low as $10.05 this month and has since recovered slightly to $16.25 in early trade Monday.

VCs pushing back

Dozens of other cloud service companies have suffered similar highs and lows. And the crash seemed to vindicate the analysts who warned of a bubble. The companies, however, have their champions.

Scott Kupor and Preethi Kasireddy, venture capitalists at Andreesen Horowitz, wrote last week defending the cloud players, arguing that so-called software-as-a-service providers are fundamentally different than other kinds companies. Don’t look at their revenue or profits or cash flow – the business is so different and so special, they say, that those standard kinds of metrics are too simple.

“So why do the pundits have it all wrong?" the pair write. "Because we love the simple income statement narrative that makes for great headlines, and we have trained the world to judge company performance based on revenue and earnings per share. Sure, it’s simple and, to be honest, it’s also accurate for a vast majority of publicly traded companies. When it comes to SaaS, however, such simplicity can lead to bad investment decisions.”

The pair run through various special metrics and stats, such as the average lifetime value of a customer compared to the cost to acquire a new customer, or LTV/CAC. They also emphasize that cloud companies’ current revenue understates their strength because it leaves out the recurring subscription fees customers have already agreed to pay in future years.

But all kinds of businesses, from mobile phone networks to publishers to online retailers, spend big money up-front to acquire customers they hope to profit from over time. And many fast-growing companies show rapid revenue growth that analysts project out over future years. Software companies such as Microsoft (MSFT) have long reported sales and development expenses up-front while deferring revenue for years based on assumptions about how long customers will use their products (the assumption a decade ago that customers would use Windows XP for three years ended up a bit low). In the end, the new numbers don’t prove cloud companies are unique, and they provide little help in evaluating whether any particular one has a stock price that is fair, excessive or insane.

Instead, simple valuation measures have proven a reliable way to compare companies across industries. In niche after niche, bubble after bubble, when stocks prices looked crazy on simple measures like price-to-earnings and price-to-sales, they usually were. There are dozens and dozens of academic studies of stock market bubbles, and they all use these same simple and reliable measures to illustrate bubbles forming and popping. Some 90% of Internet stocks ranked in the top quintile of price-to-sales ratios for the entire market in March 2000, just before the bubble burst, for example.

Further, the measures the VCs recommend aren’t directly discernible from companies’ public disclosures. One key variable in the special cloud metrics is the rate of customer churn but few companies disclose their actual churn rate. Trying to guess by looking at customer growth rates could be seriously misleading because a burst of new sign-ups could hide older customers quitting. Likewise, few companies reveal their average contract length or customer acquisition costs. The VCs make assumptions and guesstimates to calculate their cloud-specific ratios, making their precise-seeming business evaluations rather squishy.

Finally, the VCs may be fundamentally underestimating how difficult it will be for cloud services companies to turn a profit someday. In their theoretical model, a cloud company’s up-front investments today are setting the company up for big profits down the road, once enough customers have been acquired.

But the rosy scenario assumes a company’s customer acquisition costs diminish while the profitability of providing services remains steady or improves. It may be exactly the opposite, since acquiring customers becomes more difficult as a company grows larger, and those later customers can be more expensive to serve.

For example, Salesforce.com (CRM) has been in business for 15 years and not only hasn’t turned a profit for the past three years but has also seen its marketing expenses rising as a percentage of revenue, and its gross profit to deliver services falling. That results in a graph that looks just the opposite of the one in the VCs’ post, albeit less dramatic.

This time it's different? Probably not.