Three companies in one of the hottest tech sectors just released earnings. And all three stocks are on the rise this morning. But the surprising thing is that analysts and investors continue to be bullish on these stocks despite growing losses.
These companies operate in a sector known as “enterprise software.” Enterprise software stocks including Salesforce (NASDAQ: CRM), Splunk (NASDAQ: SPLK), and Workday (NASDAQ:WDAY) are some of the most loved growth stocks, and enjoy remarkably rich valuations.
The bullish case on these stocks seems to be completely reliant on rapid revenue growth, which investors assume will translate into future profits.
But skeptics point to one big issue: these profits aren’t materializing.
While each of these companies continues to see their stock soar to new highs, losses continue to grow at an astonishingly similar rate.
3 of the Most Expensive Stocks Today
Let’s examine the three biggest stocks in the sector: Salesforce, Splunk, and Workday. These players undoubtedly get the bulk of the attention from the media and investors.
Theoretically a lot of this attention is deserved. The disruptive potential of these cloud-based enterprise software players is huge, and the revenue growth is real. Demand for these services is there. But thus far, these companies aren’t turning a profit.
A lot of stockholders will point to the unique nature of the Subscription as a Service (SaaS) business model, as a reason for the discrepancy in valuation. With enterprise software contracts typically spanning one to three years, revenue is recognized linearly on a quarterly basis. This gives the appearance of steady sustained growth over the long term.
As these businesses have matured, it’s surprises me to see growing losses. And what’s surprised me even more is that no on seems to care at all.
Let’s take a quick look at each companies revenue and losses.
|FY14 Operating Profit Growth|
The following table shows just how expensive these stocks are on a price-to-sales (P/S) and price-to-earnings (P/E) basis.
|Stock||FY14 GAAP P/S||FY14 GAAP P/E|
Despite rapidly growing top-lines, every company managed to increase its losses by a significant amount year over year. This seems particularly worrisome given that all these companies are enjoying ludicrous P/S valuations.
Many tech companies – including these three – like to report earnings on a non-GAAP basis. This allows them to selectively remove pesky expenses including stock options, write-offs, and taxes. On a non-GAAP basis, the income statements look far more favorable. Yet these numbers doesn’t provide a true view of the profitability.
As we saw this week, yet another quarter of growing losses was reported from each of these three companies. And you guessed it right! All three stocks are trading within 5% of their all-time highs.
Sooner or later investors are going to have to start demanding profits, or some sort of tangible value. Very rarely has there been a growth company that was unprofitable during its boom years and subsequently enjoyed long-term success.
Apple, Google, IBM, Microsoft, and Oracle are all great examples of tech companies that were profitable during the period where they experienced the most rapid growth. No – it doesn’t seem as though these enterprise software stocks are “the next Microsoft.”
So why are investors giving a free pass to the most expensive stocks like Salesforce, Splunk and Workday?
The simple answer is due to their “software as a Service” or SaaS business model. But this is nothing more than an argument of “this time it’s different because….” And anybody investing in shares of these companies now better hope that’s right. With stratospheric valuations and no assets to fall back on, these stocks will have a long way to tumble when the growth finally slows down.
If you own shares of these high flying enterprise software stocks, now may be a good time to be locking in your gains. If profits never materialize, there is no question these stocks will be trading at significantly lower prices sometime soon.
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