Warning: Do You Own These 'Dot-Bombs'?

David Sterman's picture

Wednesday, April 9, 2014 - 11:45am

by David Sterman

When shares of Big Data firm Splunk (Nasdaq: SPLK) crossed the $100 mark at the end of February, the company had just delivered its first $100 million quarter. That was more than 50% higher than a year earlier, helping to seemingly justify the company's market value, which had just exceeded $10 billion. 

Analysts at FBN Securities noted that such a lofty valuation "shows that the stock is not for the faint of heart," but they saw another 15% upside to their $115 price target.

As it turns out, most have investors have lost heart. This stock has plunged 40% to around $60 over the past five weeks. What was once seen as an "own at any price" stock has quite suddenly become a "too hot to touch" stock. 

And Splunk has esteemed company: Many richly valued tech stocks have been falling at a rapid pace in recent weeks, even though forward sales and profit estimates have remained largely intact.

Make no mistake: If the market heads lower from here, these very same tech stocks have a lot more downside ahead. How do we know that? Many of them remain richly valued. 

Splunk, despite its sharp, plunge, is one of more than a dozen tech stocks that still trade for more than 10 times projected 2014 sales:

At this point, badly burned investors have a few pointed questions for these firms before they can again be considered safe buys. First, is there a clear path to strong revenue growth? Second, will that strong revenue growth lead to profits? And third, can current valuations be justified in the context of down-the-road profit potential? Let's take a closer look.

Of these firms, NetSuite (NYSE: N) and Veeva Systems (NYSE: VEEV) have a blended growth rate below 30%, which is a red flag for any stock trading for more than 10 times forward sales. Looking at these stocks in relation to their 2016 price-to-earnings (P/E) multiple doesn't really help either. Only Facebook (Nasdaq: FB) holds any sort of value by this metric. 

Some of these companies won't even be profitable by 2016, which is almost inexcusable for any company that has been in operation for a decade or more, as most of these have. 

Of course, just a few months ago, many investors believed that metrics such as P/E ratios simply didn't matter, and they presumed these kinds of companies would get a free pass for many years to come. That logic no longer holds water, and none of these stocks are likely to revisit their recent peaks any time soon. The folks who bought these stocks in recent years are the very ones that have been burned recently, so that buying pool is now much thinner.

To be sure, there are some great business models here. I recently noted that Yelp (NYSE: YELP) just received a boost from analysts at Oppenheimer after a pretty sharp pullback. And when these kinds of stocks fall back toward reasonable mutliples, clearer buying opportunities will emerge. 

For example, consider digital advertising firm Rocket Fuel (Nasdaq: FUEL).  After a well-received IPO in September 2013, shares soared higher. Yet they have fallen from $65 to $40 in the past few months, largely because investors grew concerned that the valuation couldn't square with growth rates. 

Yet the pullback has just led analysts at BMO Securities to upgrade shares to an "outperform" rating.  They see the company as a leader in the field of dynamic programmable ads, which are fast replacing static, serve-them-anywhere ads. They see shares rebounding to $58, which represents a 6.3 multiple of 2015 net revenues. Will Rocket Fuel ever deliver the kind of profits that justifies that $58 price target? Perhaps, but the long view is encouraged.  

Yet for every Facebook or Rocket Fuel, there are many more examples of companies that will likely never grow into their inflated market values. They operate with "me too" business models, and will face pricing and margin pressures on the road to maturity. 

Take Workday (NYSE: WDAY), which provides cloud-based human resources (HR) and finance software, as an example. Though the company's market value has slid from $21.5 billion in late February to a recent $15 billion, that's still quite rich for a company with less than $500 million in sales over the past 12 months.

Looking out to fiscal 2017, Goldman Sachs anticipates earnings before interest, taxes, depreciation, and amortization (EBITDA) of $200 million. That means shares trade for 75 times projected fiscal 2017 EBITDA. (Since profits aren't expected by then, P/E ratios don't apply.)

But Workday already has ample competition, and more competitors are coming public each year. How can you justify a market value that is larger than, say, a 100-year-old blue-chip firm like Alcoa (NYSE: AA)?  You can't.  

At this point, many investors are supporting this stock on the belief that it will make a fine acquisition target for a company like Oracle (Nasdaq: ORCL) or SAP (NYSE: SAP).  Acquiring a Workday rival such as Cornerstone OnDemand (Nasdaq: CSOD), which has a more reasonable $2.2 billion market value, may be the more obvious choice. 

Risks to Consider: These dot-coms are still richly valued and could head lower if the Nasdaq enters into correction territory.   

Action to Take --> As I noted in my look at the largest dot-coms of a few days ago, selective buys are starting to emerge. But it would be quite risky to randomly load up on some of these stocks for no other reason than that they've dropped 30% or 40% recently. You need to measure their current valuations in the context of market positioning and peak profit margin capability. In that context, it's crucial that you understand which fields are getting crowded (thanks to a robust IPO market that is capitalizing on many younger players), and avoid companies that will see massive competition. 

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.