The First Quarter Was Business as Usual for Cloud Companies -- and That's a Bad Thing

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Cloud companies are growing, and they're losing money. If that's all you know about them, it's enough. Those two facts define the industry more than any hyperbole coming out of Silicon Valley. Much as their predecessors did 15 years ago, today's tech companies are selling an exciting new technology; and like the dot-coms, they've embraced a business model that will self-destruct at the first sign of trouble.

With few exceptions, and regardless of size or sector, these businesses are running losses. Many are funding themselves through the issuance of new stock, either directly or through stock compensation - a strategy that works well during the good times, and only then. Investors prize growth, so there's little incentive for these companies to sacrifice it by raising prices. On the other hand, costs have become worse rather than better, with SG&A (sales, general, administrative) expenses eating up ever-greater portions of revenue.

At the moment, these companies are simply growing and hoping - a plan perfectly suited to springtime, though a little uncomfortable as summer closes in. With earnings season now behind us, we can see whether this strategy is paying off.

I'll begin with the enterprise cloud, a relatively mature group of businesses with high valuations. Four of the largest are Salesforce.com ( CRM ), Concur ( CNQR ), Workday ( WDAY ) and Netsuite ( N ), each of which offers Web products that address basic business functions, like marketing and payroll. All of them lost money in the first quarter, with operating margins ranging from -2% at Concur to -36% at Workday. More surprising, each company saw its margins deteriorate versus a year ago. This, coupled with fast growth (though slower than in previous years) led to a doubling of pre-tax losses. A Bernstein analyst said of Salesforce , the largest of the four, that "they're moving from organic to inorganic growth. And inorganic is very expensive."

Together, these firms are worth $46 billion in market capitalization. They made $1.2 billion in sales, and lost nearly $100 million before taxes. At the same time, a total of 15 million new shares found their way to market, representing roughly $800 million in value - a remarkable amount when compared to business operations, but in line with past quarters. While this was mostly the result of stock valuations - 8% annual dilution being high but not extraordinary - it nevertheless provides a tangible benefit to these companies, by skewing payroll towards stock compensation. Earnings reports then emphasize non-GAAP earnings, which paint a rosy picture by ignoring stock compensation; but this understates real expenses, and ignores the risk that, should shares fall, employees will demand cash. Then there is always the danger that companies which depend so heavily on their stock valuation, will find ways to lead investors by the nose.

Other cloud firms logged similar performances. Palo Alto Networks ( PANW ), which operates a security platform, lost $6 million pre-tax on $101 million in revenue, versus a negligible loss one year ago. Share count rose nearly two million in the quarter, or more than $100 million at current value. The company's press release focused on the bright side: revenue grew 54% .

Athenahealth (ATHN) sells Web-based services to health-care professionals, and until recently it was a shining beacon of cloud profitability, with operating margins of 8% in 2012; but last quarter it bled $12 million before taxes, on $126 million in revenue. The loss was due in part to the acquisition of Epocrates , a mobile app developer and perennial money-loser. Nevertheless, the purchase allowed Athenahealth to maintain a 30% growth rate - a detail that received top billing in its earnings release .

Meanwhile, more grounded enterprise companies like Oracle (ORCL), SAP (SAP), and Cisco ( NASDAQ:CSCO) continue to earn big bucks. Growth was low but generally positive year-over-year, and margins steady. They may be dinosaurs awaiting the meteorite but, so far, these old men of enterprise don't seem all that endangered. We can say that, at least, it probably won't be a recession that kills them.

When it comes to the consumer cloud, we have fewer public companies to look at. Netflix (NASDAQ:NLFX) did turn a profit, earning $7 million ($3 million after taxes) on revenues of a little over $1 billion - a modest improvement over last year's awful Q1. Stock growth amounted to a relatively modest $150 million. Pandora Media (P), on the other hand, lost $28 million on sales of $126 million, with improved margins accompanying a larger loss. The value of new shares was $24 million.

I would characterize these results as ugly; others might not. In many ways, though, the first quarter was business as usual. The market devoured two new IPOs - Marketo (MKTO) and Tableau Software (DATA) - while the rest of the industry soared with market indices. Infrastructure providers like Rackspace (RAX) and Equinix (EQIX) were, once again, more profitable than many of their clients. As in other gold rushes, this one has favored the brothels rather than the prospectors.

It seems cloud companies are still growing, and they're still losing money. Maybe next quarter will be different.

Also see:

Why Microsoft Need Not Worry About Windows 8

Xbox One, PlayStation 4 -- and Apple? -- in the Age of Convergence

Why I've Given Up Hope for Apple, Google, Microsoft to Deliver Better TV



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks , Technology

Referenced Stocks: CNQR , CRM , N , PANW , WDAY

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