NetSuite IPO: why now?

Having been hinted at, promised and much discussed for the past two to three years, what made NetSuite decide to pick this week to submit its IPO paperwork to the SEC?

One delaying factor was outside of the company's control (although it ought to have seen it coming). It had to replace its auditor at the beginning of this year when Deloitte & Touche realized there might be some conflict in being NetSuite's auditor at the same time as doing Oracle's accounts, particularly since Oracle boss Larry Ellison is a majority owner of NetSuite. NetSuite had previously suggested the IPO might come early this year, but it wouldn't have been prudent to go ahead while in the middle of getting new auditors on board.

Then there's the question of picking the most favorable month to stage the IPO. The old stock market adage, "sell in May and go away", may have less force in these days of year-round 24x7 trading, but starting the IPO registration process now will allow NetSuite to issue its stock in September, just when the markets start picking up again after the summer break.

Yet having said all that, I think there's another reason why the IPO has waited until now. Some people have wondered why the company has chosen to issue its S-1 in a quiet holiday week, but perhaps they are overlooking that this is also the first week of a new quarter. I believe NetSuite was waiting to make sure that it had met certain financial milestones in its second quarter. Having done so, it was ready to press the button on the IPO. That decision in turn triggered an options bonanza for staff, who on June 27th were granted options on more than 25 million shares, with a total book value of $6.7 million.

The Q2 financials of course are not in the current draft of the S-1 but will be updated in later versions of the document between now and the September public offering date. I think we can expect to see them showing an extra surge in sales along with a much lower rise in costs — sufficient in combination to project NetSuite turning the corner into profitability within a few quarters.

Such metrics will be important because an examination of the S-1 underlines how difficult it is to make money in the early years of an on-demand venture like NetSuite. NetSuite needs to be able to demonstrate that it can make money; otherwise it won't be much of an investment prospect. Its 2006 financials don't inspire much confidence on that score: sales and marketing alone swallowed up 65% of revenues, while the raw cost of providing its services swallowed up the rest. Adding in product development and general administration costs produced a loss of $23 million, against revenues of $67 million.

In Q1 of 2007, NetSuite's sales and marketing costs have fallen to 54% of revenues. That's below the 57% that Salesforce.com reported in fiscal 2004, immediately before its IPO. I suspect NetSuite will want to get the figure down to around 50%, which is the level Salesforce.com runs at currently.

A bigger problem for NetSuite though is its cost of revenues, which is what it spends on running its hosting operations and on professional services. When Salesforce.com had its IPO, it was reporting costs of around 18% of revenues (it has since risen to 24%). NetSuite's costs were 34% of revenues in 2006, falling to just below 30% in Q1 2007. Unlike Salesforce.com, NetSuite doesn't break out the professional services element of that figure, but that is likely to be the larger component and it's difficult to see it reducing significantly in the near future since NetSuite has been targeting larger customers with more complex implementation requirements. Meanwhile, NetSuite faces higher hosting costs in 2008 as it plans to add a second hosting center — something that Salesforce.com already did a year ago.

So given this surprisingly high cost of revenues, I think we're going to see NetSuite doing as much as it can to squeeze down its general running costs in other areas — perhaps even the decision to launch its latest edition last month in London was as much to do with bringing down its expenses as with other factors.

The good news is that NetSuite is delivering high-velocity growth, rising from sales of just $3.1 million in 2002 (in retrospect, an astonishingly small figure considering the attention the company was getting even then) to $67.2 million in 2006, when sales were 90% up on the previous year. That compares favorably to Salesforce.com, which in the run-up to its IPO had recorded a growth rate of 80% in fiscal 2004, although with higher revenues of $96 million.

It's important to remember that Salesforce.com is still barely profitable, deliberately choosing to plow its revenues back into sales in order to keep growing. NetSuite makes the point in its S-1 that renewals and upgrades incur lower sales and marketing costs and fewer professional services, the effect of which is to increase the profitability of its more mature accounts. So long as it's acquiring new customers at a rapid clip, those effects are muted, but in theory it ought to be able to look forward to higher margins once growth starts to top out.

In the scheme of things, NetSuite at present is still relatively small. At March 31st, according to the S-1, it had 5300 customers, which is a drop in the ocean of its stated target market of companies with 1000 employees or less. If it can sustain the same growth rates post-IPO as Salesforce.com has maintained, then it too can aspire to a half-billion dollar turnover in a few years' time. The question investors will be pondering is whether it can do that while keeping its costs under control — which is why those Q2 financials are going to be a crucial factor in persuading Wall St to put its faith in NetSuite.