Even as the broader stock market shows signs of a clear
pullback, some of the hottest stocks in the market remain near
their 52-week highs -- and they still carry very high valuations to
boot. But if history is any guide, then these are now among the
most vulnerable stocks in the market. Any further big drops in the
broader market could prove especially painful for these highflyers.
Richly-valued stocks can stay aloft at the beginning of a big
market pullback, but as we saw in 2001 and again in 2008, they
eventually can suffer massive corrections as investors shift to
defense and start to focus on value instead of growth. If you own
highflying names like
, for example, then you need to seriously reconsider just how
vulnerable stocks like these can be.
As theeconomy emerged from therecession of 2008, this provider of
customer-management software became a key focus area for investment
technology (IT) managers. Sales grew 21% in fiscal (January) 2010
and another 27% in fiscal 2011. Look for similar results in the
now that many IT spending plans for the rest of this year are in
But signs are also emerging that results in the coming years may
not be good enough to justify the stock's triple-digit
) ratio. First, operating margins may have already peaked. They hit
16% in fiscal 2010, slipped to 14% in fiscal 2011 and were just 11%
in the first quarter of fiscal 2012. Fast-growing sales should
gains, and this is a sign the company is working harder to secure
new sales wins. The fact that marketing expenses remain so high (at
more than 40% of sales) tells you this is not an easy sell.
Free cash flow
, which had risen for eight straight years, fell more than 50% in
Second, the company now has a target on its back. It occupies one
of the few bright spots of the technology sector. Companies
are taking the customer relationship software niche more seriously,
and those firms have a tendency to compete very aggressively on
Lastly, an economic slowdown typically leads to a pullback in
corporate IT spending. Expectations of 30% year-over-year sales
growth are built on expectations that IT managers will spend all of
their allotted resources by year-end, in what's known as a budget
flush. But they can just as easily hold off spending their full
allotted budgets until conditions improve.
Make no mistake, Salesforce.com has built an excellent track
record, but itsshares , at nearly 10 times projected (January) 2012
sales and more than 100 times projected 2012 profits, and more than
200 times trailing free cash flow, are simply too rich for these
sober economic times.
Perhaps the hottest area of high-tech is "cloud computing." An
increasing number of companies are moving their enterprise data off
of their corporate campuses and into data centers so key
information can be even more readily accessible. Consumers are
expected to follow the same trend, storing their songs and other
media " in the cloud" on Internet servers.
VMWare has established a pole position in the field. Its software
can handle massive amounts of cloud-based data in a very efficient
manner. The company boosted sales 41% in 2010, growth could hit 30%
in 2011 and another 20% in 2012, according to consensus forecasts.
Are you spotting a trend? Sales growth is starting to cool as the
company's revenue base grows larger and competition heats up.
Part of the company's impressive growth was due to a first-mover
advantage in large data environments. To keep growth at high rates,
VMWare is aiming at the desktop market, focusing on smaller data
volumes that can be managed from simple terminals. Trouble is, that
field is already dominated by firms like
Citrix Systems (Nasdaq:
RedHat Software (NYSE:
. Citrix in particular represents a major challenge. The company is
increasingly aligning itself with
Cisco Systems (Nasdaq:
, which had historically been a key partner for VMWare.
As those firms and others start to develop their own cloud-based
technologies, VMWare should start to lose its impressive pricing
power. Even as the customer base keeps growing at a solid clip,
revenue growth may become more muted.
In addition to concerns about rising competition and tougher
pricing, investors need to account for the impact of a slowing
. It's getting harder to see how IT spending levels will continue
to keep growing as more companies see a toughening economic
environment. And that makes it harder to justify a stock that
trades for around 50 times projected 2011 profits and more than 10
times projected 2011 sales.
Action to Take -->
The stock market is now back down to levels seen in late March.
Many stocks have already corrected by a significant amount. It may
just be a matter of time before these richly-valued highflyers also
feel the impact of a tough economic environment. If you hold one of
these stocks, you should seriously think about selling.
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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