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How High is Too High? Overvalued Cloud Software Set to Report Earnings

Over the next 1-2 weeks, a string of cloud software companies report earnings. Investors buying at the top of a growth market are, in essence, hoping another investor comes along and pays a more exorbitant price. If you are buying cloud software right now, which is the focus of the growth market we are in, your exit will require sniper-like timing. Even as the trade war has put pressure on Apple, and the semiconductor space, software valuations are higher than during the dot-com bubble as investors show a relentless appetite to invest at record price-to-sales ratios. 

The dangers of overvaluation are quite apparent, and while each company is fundamentally different, they are operating in the same environment, and are exposed to the same market forces. In other words, Zoom’s overstretched valuation at a 50 price-to-sales is a problem for every investor in the tech sector, as this company, and others in cloud software, cannot return money to investors at this price. Eventually, cloud software will have to come back down to earth and the tech sector will feel the pain when it does. 

Here is a quote from the CEO of Sun Microsystems following the dot-com boom, when his company had a 10 price-to-sales ratio: 

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

- Scott McNeely, who was the CEO of Sun Microsystems 

To put this into perspective, if Zoom were to pay out 100% of its revenue to investors, it would take 50 years to break even. 

In February, I identified five, pure play tech stocks that benefit from the continuous growth of Cloud IaaS. These include Zscaler, Okta, Twilio, Slack, and Veeva. The purpose of this article is to caution that a few of these stocks have hit dangerous levels (minus Slack which is not public yet).  We have reached the point where great companies have become bad stocks as the fundamentals cannot keep up with the unrealistic prices.

1. Zoom:

Zoom’s financials outperform many successful software-as-a-service companies on the public markets today, such as Workday and Okta. The S-1 Filing shows $60M in revenue in 2017, $151M in revenue in 2018 and $330M in revenue in 2019. The company has been posting 100%+ revenue growth for three years with gross profit margins in the high 70% to low 80% range compared to more mature SaaS companies currently on the public market posting increasing net losses (Okta and Workday). Zoom’s technology is simple, marketable, and the company prides itself in using the “viral adoption model” to get ahead of the competition. 

As of late April, Zoom has become the most highly (and over) valued tech stock, and Zoom’s CEO Eric Yuan says that he is “comfortable” when the overvaluation as Zoom’s value skyrocketed to a market cap of $14.4 billion after just one day of trading. 

Yuan says that the market valuation does not bother him at all, because he is focused on getting people to switch to Zoom. The CEO holds a 21.1% stake on the company, which is equivalent to roughly $3.6 billion, which is a good sign as to Yuan’s motivation. 

With that said, the valuation today does bother me. You can access my previous analysis on Zoom here, where I stated it would be a buy at the $9 billion valuation. The market cap is now $20 billion, and with a strong earnings report, could test new highs. Eventually, however, this stock will have to take the elevator down. 

2. Okta

Okta’s parabolic trend is appealing, but there’s reasons to be cautious. Okta is a leading brand in the cloud security sector with a 67% year-to-date lead, and this is well known to the market creating a 349% return in the stock. Based on RSI indicators, Okta is nearing overbought levels. After closing at almost $110 recently after jumping from $88, there may be limited upside to this stock for now.


3. Zscaler 

With 65% growth in the second quarter, Zscaler held the title of richest-valued stock on the market with a price-to-sales ratio of 38 and EV/revenue ratio of 38 until Zoom bumped it out of place. Expectations for this earnings report are high at $0.01 per share in the upcoming report, representing a year-over-year change of 150%. Revenue is expected to be about $75 million, up 51% from the year-ago quarter. 

ConclusionOvervalued cloud stocks are priced too high – and basic investor common sense warns us that overvaluation can result in quick and rapid losses when the time comes. When overvaluation occurs, you will eventually reach a ceiling when it is no longer feasible to discuss the fundamentals of the company in question. These are solid companies; however, they’ve now broken the record on price-to-sales ratios from the dot-com era. Zoom has an ambitious, successful CEO, but the old adage states “hindsight is 20/20” -- which is why I’m going with Scott McNealy of Sun Microsystems on this one.

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