Stocks

The Quest For a 6% Yield

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September 20, 2007 | Stocks | Author Asif

A subscriber wrote to me a couple of weeks ago asking my thoughts on Macquarie Infrastructure Co. Trust (MIC) as a potential dividend opportunity. Just days before I received this email, I was personally looking for a fund or REIT that invests in parking lots (especially in San Francisco) and was not very successful in my search. MIC caught my interest not only because it invests in parking structures but because it is the oldest and largest fund of Australia’s Macquarie Bank. A recent article in Fortune magazine titled Would you buy a bridge from this man? by Bethany McLean discusses Macquarie Bank and its infrastructure funds like MIC in great detail.

If the hedge fund manager in the article, Jim Chanos, is to be believed, some of their funds are set up like Ponzi schemes. I would personally stay away from MIC if there is even an iota of truth in that allegation. I can see why MIC caught this subscriber’s fancy as it pays a 6% dividend yield and has appreciated almost 40% over the last year. In a period of market volatility and pullbacks like the 366 point drop in the Dow we experienced on Friday, stocks and funds with high yields are indeed attractive. As an alternative to MIC, given below are a few potential investments that yield roughly 6%,

  1. If you are looking for high dividend payers check out Suburban Propane (SPH), a stock I last mentioned in May 2006 when it was sporting an 8.3% dividend yield. The company not only pays a 6.2% dividend yield but  with 33% gains over the last year, its returns have almost been on par with MIC. I found Suburban Propane by running a screen in 2005 that also brought up other SINLetter picks like Ambassadors Group (EPAX) and  Marcus (MCS). For a great place to start looking for other Suburban Propanes, check out this simple screen that brings up more than 20 stocks that yield at least 6%, with profit margins of at least 10%, Price/Sales of less than 5 and a PEG ratio of below 1.5.
  2. Financial stocks have taken a hard hit in recent months and even the large diversified banks like Citigroup (C), Bank of America (BAC) and Barclays (BCS) are sporting high dividend yields of 4.9%, 5.2% and 6.0% respectively. With most of these banks marking their mortgage portfolios to market, increasing loan reserves and taking large one time earnings hits, it may be a good time to move them to the top of your watchlist while the blood flows in the financial streets. I plan to hold off a little longer before I touch the financials.
  3. A third alternative would be the closed-end fund First Israel Fund (ISL) as mentioned by Gary of ETF Expert is his blog post Israel (ISL): Reducing Risk, Discovering the Rewards. ISL currently yields 5.8% and trades at a 2.69% premium to net asset value or NAV.
  4. While I still refuse to touch most REITs, rising apartment rents are going to be favorable for apartment REITS like AvalonBay Communities (AVB), Essex Property Trust (ESS), Colonial Property Trust (CLP) and Apartment Investment and Management Co (AIV), also known as AIMCO. AvalonBay and Essex have relatively low yields of 3% and 3.2% respectively while Colonial and AIMCO have much higher yields of 7.8% and 5.4% respectively. AvalonBay is an outstanding property management company and I have been watching this REIT since early 2006 but the low yield has kept me on the sidelines. For additional information about apartment REITs, check out this article.
  5. Canadian energy trusts like Penn West Energy Trust (PWE) and Pengrowth Energy Trust (PGH) were hit hard in the fourth quarter of 2006 when the Canadian government decided to start taxing the income of existing trusts in 2011 and increasing the dividend tax paid by institutional and foreign investors. Despite the high price of oil and gas, these trusts have not yet recovered and currently yield a very attractive 12.6% and 14.3% respectively. If you are not familiar with Canadian energy trusts or the risks associated with investing in them, check out this excellent introduction and this Forbes article.
  6. If you are not worried about illiquid investing opportunities (you should be unless you have large cash reserves and a highly diversified large portfolio) and love to support organic independent farmers, check out Organic Valley’s preferred stock yielding 6%. I was introduced to Organic Valley at a local organic grocer in Oregon a few years ago and while during some research on the company I was surprised to learn that in the early 90s, Organic Valley used to supply milk to Horizon Organic, currently a division of Dean Foods (DF).

Each of these investments are subject to their own unique risks and as most income investors are aware, sometimes it is best to stay away from stocks with very high yields as it can be a sign of trouble.

If you are aware of any infrastructure companies or funds that invest in parking structures and specifically in parking lots in San Francisco, please leave a comment on this blog or drop me an email. I would be happy to return the favor by elaborating on why I am interested in San Francisco parking lots.

P.S: The new stock contest is off to a great start and ironically almost everyone is beating me (literally) at my own game.

Voluntary Disclosure: Other than Marcus (MCS), I do not own any of the stocks or funds mentioned in this blog entry.

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One Stock, One Month, Three Prizes

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September 16, 2007 | Stocks | Author Asif

The Background:

When fellow blogger Vitaliy Katsenelson wrote to me last year about his plans to release a book he had been writing for the better part of 2 years, I told him that I would be happy to read his book and review it before launch. In case you are not familiar with Vitaliy’s work, he is a contributing author for some of the biggest financial websites including The Motley Fool, TheStreet.com, MarketWatch.com and Minyanville.com while maintaining his own blog over at Vitaliy’s Contrarian Edge. He is also the Vice President/Portfolio Manager of Investment Management Associates and teaches a class on equity analysis and portfolio management at the University of Colorado at Denver.

Given current market conditions, Vitaliy’s book Active Value Investing: Making Money in Range-Bound Markets which discusses investing in range-bound or trendless markets could not have been released at a better time. I started putting together a detailed review of his book but Geoff Gannon of Gannon on Investing beat me to the punch with this outstanding review of Vitaliy’s book.

The Prize:

I talked to Vitaliy about contributing a signed copy of his book to subscriber number 2,000 of my investment newsletter after subscriber number 1,000 proved to be elusive and he said he could do one better and instead give me four personally autographed books in case I wanted to give three of them away in a contest.

The Contest:

For some time now, I have wanted to launch a stock picking contest but have held off because of the amount of work required to set something like that up on an independent website like SINLetter. Vitaliy’s offer motivated me to go ahead with that project and we have now set up a simple stock picking contest that would reward the top three stock pickers with a copy of Vitaliy’s book. The rules of the contest are extremely simple as all you have to do is pick one stock and if your stock happens to be one of the top three performers by the end of regular trading on November 16th, you win. You can join anytime between now and November 15th and in case you are already a SINLetter subscriber you do not even have to login to participate. We decided to make things interesting by allowing participants to pick either long or short positions.

Since this is a beta version of our stock picking contest we would appreciate your feedback so that we can make the next one more robust. If there is sufficient interest in this contest and if I can find the moolah for it, we will probably launch another contest over the next few weeks with a bling toy like the Apple iPhone (AAPL) or a Nintendo Wii (NTDOY.PK) as the main prize. You can check out how you are doing from the stock contest rankings page, which would be automatically updated just like our model portfolio.

The Rules:

The three primary rules are,

  1. Only stocks that trade above $1 at the time of selection and that are listed either on the NYSE, Nasdaq or the American Stock Exchange will be accepted (sorry no pink sheet or bulletin board stocks at this time).
  2. Regular dividend payments will not be taken into account both on the long side and the short side.
  3. The stock contest price would be the highest price of the day for long stocks and lowest price of the day for short stocks if you pick the stock during a trading session. If you pick a stock after hours or over a weekend, the next trading session will be used to determine the highest price of the day for long stocks and lowest price of the day for short stocks. While this puts contestants at a slight disadvantage, it also helps stop people from gaming the contest.

Don’t forget to read the full list of rules and happy stock picking.

Click here to enter the contest.

Click here to view current rankings.

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Watch The Tape On Intertape Polymer Group (ITP)

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September 6, 2007 | Stocks | Author Asif

Intertape Polymer Group (ITP) is a company that makes packaging products like plastic films and tape and is headquartered in Montreal, Quebec and Sarasota/Bradenton, Florida. With over 2,000 employees and 2006 annual revenues of over $800 million, the company has a market cap of just $127 million and is currently selling at 0.17 times 2006 sales. This low valuation stems from the fact that the company is unprofitable and at the same time has a large debt burden of $310.73 million, giving it a debt to equity ratio of 1.096.

A couple of interesting events have transpired at Intertape over the last few months. The company received a buyout offer (pdf) at $4.76 per share in May from private equity firm Littlejohn, which represented a tiny premium of 5.5% over the average trading price of the last 30 trading sessions before the announcement. Over 70% of the company’s shareholders rejected this bid in late June and the stock took a deep dive. One of the reasons for this downward pressure is that a portion of the company’s long-term debt is due in 2009 and the company does not have enough liquidity to pay this debt.

When the buyout failed, the company decided to raise $88 million through equity financing and announced a rights offering (pdf) that allowed existing shareholders to buy additional shares at $3.44 per share. The stock immediately reacted with yet another sell-off bringing the price down to just $2.36 in early August. This reaction was a little surprising given the fact that three of the company’s largest shareholders had entered into a standby purchase agreement to commit $56.6 million in case the rights offering was not fully subscribed and Intertape’s senior officers had agreed to commit $6 million of their own money as standby capital. The company has also brought in its founder and former CEO to handle the turnaround. The stock has since rebounded to $3.10 as I write this blog entry.

The company is restructuring its operations by closing facilities with the goal of becoming profitable and as you can see from the second quarter results (pdf), it narrowed its net loss from $18.2 million in June 2006 to $8.1 million in June 2007. The company actually achieved $14 million in EBITDA in the last two quarters and after excluding restructuring costs, adjusted EBITDA came in at $18.4 million in Q2.

As expected sales have declined 13% on account of this restructuring. Unlike my other turnaround pick Blockbuster (BBI), there is too much uncertainty surrounding Intertape for it to be considered a long-term play at this point but I am looking for a short-term bounce of anywhere from 10% to 30% in the stock over the next few months based on the price of the rights offering, the Littlejohn bid that was rejected and management’s efforts to make the company profitable once again.

Investing in turnaround situations is extremely risky and if I decide to act upon Intertape, I plan to allocate no more than 1 to 2% of my capital to this position.

Voluntary Disclosure: I currently do not hold a position in Intertape Polymer Group.

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NetSuite: Another Hot Tech IPO?

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August 22, 2007 | Stocks | Author Asif

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).

Software-as-a-Service (SaaS):

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).

Company Information:

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.

  • NetSuite takes longer to customize than you would expect from a SaaS product. In defense of the company, customers can also buy a scaled down “out of the box” product but the sales team at NetSuite is quite obviously going to steer potential customers towards the customizable full-fledged product.
  • NetSuite’s target market is small and medium size businesses (SMB). The sales cycle to convert these businesses to NetSuite is not likely to be a whole lot less than that required to convert large businesses but SMBs are much more likely to go out of business in an economic downturn when compared to Fortune 500 companies. This could be one of the reasons NetSuite would consider moving upstream and targeting larger businesses. However that segment of the market is highly competitive with well entrenched companies like SAP and Oracle. Moving upstream will also create a conflict of interest with Larry Ellison who along with related parties happens to own a 74.1% stake in NetSuite. Such a large stake also limits the influence of other investors and may not be conducive to an acquisition of NetSuite by third parties other than Oracle.
  • From a geek’s perspective, the ability to only use Javascript to write custom applications that integrate with NetSuite could be a big turn off for some developers. Other providers like Salesforce.com allow clients to write custom components in full fledged platforms/languages like Java and ASP.NET. Thankfully NetSuite provides support for web services which allow customers to access raw data in a structured format and build custom applications around this data.
  • As Jason mentioned in his blog entry, NetSuite only operates one data center and does not have a backup data center (not to be confused with backups for the data). NetSuite plans to add another data center in 2008 but this would only help increase capacity and would not serve as a backup data center.

Competitors:

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:

  • It appears that NetSuite probably exceeded its internal 2006 sales targets based on the bonus of $209,621 paid to Dean Mansfield, the head of worldwide sales and distribution at NetSuite. The bonus amounted to 104.8% of Mr. Mansfield’s annual salary of $200,000.
  • I was a little surprised to see that the company is already expanding internationally and 17% of their first quarter 2007 revenue came from outside North America. The company is spending money to localize its products for different countries and has formed a subsidiary called NetSuite Kabushiki Kaisha or NetSuite KK to market its products in Japan.
  • Another surprise was that product development expenses were $8.0 million in 2004, $13.1 million in 2005 and $14.4 million in 2006. As a percentage of revenue, product development expenses actually dropped in 2006. While this is music to investor’s ears it is also surprising given the highly competitive nature of the industry.
  • On June 27, 2007, just before the company filed its intension to go public, NetSuite issued 25.816 million (yes million) options to its employees. These options are excisable at $0.62 per share and 18.878 million of these options were fully vested upon grant.

Conclusion:

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.

NetSuite: Another Hot Tech IPO?
8/22/2007 | Stocks

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).

Software-as-a-Service (SaaS):

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).
Company Information:

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. NetSuite ERP Diagram
Source: NetSuite

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.

  • NetSuite takes longer to customize than you would expect from a SaaS product. In defense of the company, customers can also buy a scaled down “out of the box” product but the sales team at NetSuite is quite obviously going to steer potential customers towards the customizable full-fledged product.
  • NetSuite’s target market is small and medium size businesses (SMB). The sales cycle to convert these businesses to NetSuite is not likely to be a whole lot less than that required to convert large businesses but SMBs are much more likely to go out of business in an economic downturn when compared to Fortune 500 companies. This could be one of the reasons NetSuite would consider moving upstream and targeting larger businesses. However that segment of the market is highly competitive with well entrenched companies like SAP and Oracle. Moving upstream will also create a conflict of interest with Larry Ellison who along with related parties happens to own a 74.1% stake in NetSuite. Such a large stake also limits the influence of other investors and may not be conducive to an acquisition of NetSuite by third parties other than Oracle.
  • From a geek’s perspective, the ability to only use Javascript to write custom applications that integrate with NetSuite could be a big turn off for some developers. Other providers like Salesforce.com allow clients to write custom components in full fledged platforms/languages like Java and ASP.NET. Thankfully NetSuite provides support for web services which allow customers to access raw data in a structured format and build custom applications around this data.
  • As Jason mentioned in his blog entry, NetSuite only operates one data center and does not have a backup data center (not to be confused with backups for the data). NetSuite plans to add another data center in 2008 but this would only help increase capacity and would not serve as a backup data center.

Competitors:

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:

  • It appears that NetSuite probably exceeded its internal 2006 sales targets based on the bonus of $209,621 paid to Dean Mansfield, the head of worldwide sales and distribution at NetSuite. The bonus amounted to 104.8% of Mr. Mansfield’s annual salary of $200,000.
  • I was a little surprised to see that the company is already expanding internationally and 17% of their first quarter 2007 revenue came from outside North America. The company is spending money to localize its products for different countries and has formed a subsidiary called NetSuite Kabushiki Kaisha or NetSuite KK to market its products in Japan.
  • Another surprise was that product development expenses were $8.0 million in 2004, $13.1 million in 2005 and $14.4 million in 2006. As a percentage of revenue, product development expenses actually dropped in 2006. While this is music to investor’s ears it is also surprising given the highly competitive nature of the industry.
  • On June 27, 2007, just before the company filed its intension to go public, NetSuite issued 25.816 million (yes million) options to its employees. These options are excisable at $0.62 per share and 18.878 million of these options were fully vested upon grant.

Conclusion:

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.

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Adopting A Cautious Approach

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August 11, 2007 | Stocks | Author Asif

Looking back at the gyrations of Mr. Market last week, it is amazing that the major indices ended in positive territory for the week. Huge injections of liquidity by central banks on both sides of the Atlantic certainly helped prop up the markets and this was repeated once again on Monday. There have been rumors about the potential of a large hedge fund blowing up and Goldman Sachs (GS) had to pump $3 billion into one of its hedge funds to keep it afloat. In addition to the two failed Bear Stearns (BSC) hedge funds, three funds from French bank BNP Paribas (BNPQY.PK) were suspended last week. It appears that the Europeans had an equally (un)healthy appetite for John Doe’s exotic mortgage.

I was very surprised to see ABN Amro (ABN) drop last week based on speculation that the takeover of this Dutch bank may fall apart. Potential suitor Barclays (BCS) took a harder hit and I am glad I liquidated our position in Barclays as discussed in the portfolio readjustment section of the August investment newsletter. A lot of investors are getting interested in the battered financial sector and indeed some of the large banks have attractive valuations while paying a sizable dividend. However the headwinds against the large commercial banks are strong with slowing mortgage originations, low interest spreads and a consumer that may finally be scaling back as seen by declining retail sales in July. Unlike Quant Investor who prefers Bank of America (BAC), the only large bank that I find mildly interesting is Citigroup (C) based on its international diversification, a 4.6% dividend yield and a 17.82% Return on Equity (ROE).

However it may be prudent to stay on the sidelines (update: I meant for new positions and not liquidating an entire portfolio) until the magnitude of this subprime mortgage mess becomes clear. The failure of a large fund or bank would put a lot of pressure on the capital markets and there is a lot of fear out there but not enough to make investors capitulate in despair. Capitulation is seen near the bottom of a bear market and it is not even clear if we are experiencing a correction or the start of a new bear market following the bursting of the real estate bubble. In the words of James Stack of Stack Financial Management “if it looks like a bear and growls like a bear, you treat it like one”.

On the flip side, I am very excited about the VMware IPO, which will raise $957 million at $29 per share and was priced at the high end of its forecast just like Chipotle Mexican Grill (CMG) last year.  VMware should begin trading on Tuesday under the ticker symbol VMW. Assuming VMware earns $160 million in 2007 (profits were $75.3 million in the first half of 2007), the valuation with a P/E of roughly 66 is quite rich even at its IPO price. If the stock shoots up like it is expected to, the company will earn membership amongst the rare group of growth companies sporting a triple digit P/E. However if VMware can continue its red hot rate of growth, the IPO price will begin to look like a bargain in a couple of years.

This spin-off has helped our April 2007 pick EMC corp post a gain of 37.55% in the model portfolio and based on how well the IPO does, EMC could head even higher as it will retain an 87% stake in VMware post IPO.

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