What happens to a software company that, after 15 years in business, has never seen a net profit?
Here’s one answer: its market capitalization swells to 15 times its annual revenue as, over a three-year period, its stock price grows at more than twice the rate of any other software company in the land (according to a Morgan Stanley analysis).
That’s no fiction. It describes NetSuite, the publicly traded, San Mateo, California-based provider of enterprise resource planning (ERP) software. Now, admittedly, its revenue, $308 million in 2012, is not earthshaking, considering that ERP-market titans Oracle and SAP raked in $37 billion and $21 billion, respectively.
But do NetSuite’s investors care? Obviously not. Does its CFO, Ron Gill, care? Not in the slightest. The company grew by about 30% last year and Gill expects it to do the same in 2013. To NetSuite, it’s not even a case of growth trumping profitability. Rather, growth is all that counts. At least for now.
Gill is a longtime veteran of the enterprise software space. He’s worked for both SAP and Hyperion, an ERP vendor later bought by Oracle. Those companies did and still do provide large-scale physical installations of their ERP software and have a perpetual-license revenue model. NetSuite has made its way as a provider of software-as-a-service (SaaS), where the software is in the cloud and it’s a pay-as-you-go subscription model.
CFO recently spoke with Gill about NetSuite’s growth, 2012 financials, and business strategies. Following is an edited version of the conversation.
Is the role of CFO at a company that sells stuff to CFOs different from those elsewhere?
I think it’s more fun. You get to have a more holistic experience as a CFO. You spend a lot of time talking to customers and prospects, because you get them and they get you. You spend a lot of time with the product team, because you’ve got some insights about what’s in the product, what’s missing, and what should be prioritized on the development road map. I like that. The job isn’t just in the back office.
How else does the business you’re in inform what you do day-to-day as a CFO?
We spend a lot of time thinking about the metrics to measure a SaaS business. They’re very different from the metrics you use to measure a perpetual-license software business. There, the sales you do in a quarter are the revenue. It’s right there to see. But at a SaaS company, when you sell something it doesn’t go into revenue. It goes into deferred revenue.
Actually, the industry is starting to mature now. There was a time when SaaS CFOs spent a lot of time on the phone with each other. “How do you compensate your sales reps? Oh, we tried that and they all did this or that.” Things have settled down.
NetSuite listed $150 million in deferred revenue on its 2012 income statement. That was almost half as much as the revenue you did recognize.
Yes, it’s a very slow-moving model. It creates a specific onus on the CFO. If the sales department misses its number, it’s probably the CFO’s fault, because all the quarterly revenue is really coming out of a modeling exercise that’s an accumulation of everything you’ve done in the past and how it flows through this quarter.
You can’t be two weeks from the end of the quarter and say, “Gee, what can we do to make the revenue number just a little higher?” There is nothing you can do at that point. If you want to grow revenue next year, you better have hired sales reps in the first quarter of this year.
Eventually, almost all software will probably be in the cloud. But right now, companies that don’t buy cloud software think they have good reasons, having to do with performance degradation, downtime, and security. How do you address those issues in the sales process?
What a lot of people don’t think about, with regard to running a good SaaS company, is how important the data-center operations component is. Those things are key parts of the offering. We’re professionals at delivering them and have a bunch of guys dedicated to that.
You can have some funny conversations with CIOs. They’ll say, “I’m concerned about uptime.” And I’ll say, “Well, I can show you on our website what our uptime is. For the last seven days, we’ve had six days at 100% and one day at 99.99%. For the last year, we’ve had 99.98% What’s your uptime?” And he doesn’t know. But it’s not that!
And then he’ll ask about security. I’ll say, “I’ve got a chief security architect and a team of people who are trying to break the system constantly. What are you guys doing for security?” And it’s one guy and a contractor who maintain their systems in a closet down the hall.
For you as the CFO, what is your current top priority?
The biggest issue we face right now is scale. We were about $200 million revenue in 2011, $300 million in 2012, and will be $400 million this year. We’re always trying to identify processes we have that work for a $200 million company but would break a half-billion-dollar company. We want to replace those with scaling processes. I’m spending a lot of time on that these days. That and hiring people.
So what about your market cap being 15 times revenue? I talked to a software-industry analyst the other day who said she’s never seen that. Even though you’re still not profitable, the market seems to be supporting your efforts very well.
Yes, both we and our shareholders are focused all on growth. The world is shifting very much in our favor, with the growing acceptance of SaaS. Profitability is not the focus.
But there are other indicators. We’re cash-flow positive, and last year our cash flow was up 50%. And we’re paying attention to our non-GAAP revenue, which takes out the stock-compensation expense. Our non-GAAP income was up 77% in 2012.
Your R&D expense was about 16% of revenue. Are you comfortable with that level?
It’s not that unusual for a SaaS company. On the one hand, we make ERP software, which is really broad and complex and has a lot of different aspects to it. It takes quite a bit of investment to keep adding features and functions all the time.
On the other hand, something else we’re doing has made a huge difference. Until about two years ago, all of our software developers were here in Silicon Valley, which is probably the most expensive place in the world to develop software. A couple years ago, we opened a development center in the Czech Republic. Since then we’ve opened another one in Uruguay and are now putting developers in The Philippines as well. That’s allowed us to scale the number of people developing our product at a much faster rate than we’ve scaled the expense.
Of course, the big-ticket item is sales and marketing. That was about half of revenue in 2012, and even higher in 2010 and 2011.
It is fundamental to the business model. You’re always investing ahead of growth. You hire a sales guy, a couple months later he makes a sale, which you then defer over the subsequent 12 months.
An odd phenomenon that happened to a lot of SaaS companies in 2008 and 2009 was that profitability actually improved during those tough years, because they slowed down their hiring.
In your case, whenever you finally do start to make a profit, will that be a matter of the software being mature enough now that you can ramp down the sales and marketing and R&D expense? Or will it be a matter of gaining a critical-mass customer base?
The leverage in the P&L is primarily in that sales-and-marketing number. On the R&D side, building an ERP is like painting the Golden Gate Bridge. You’ll never finish it. But if your rate of growth slows, then you’ll see a bunch of margin fall out of that sales-and-marketing number. If we weren’t planning to grow aggressively next year, and I kept the same-size sales force, profitability would come out pretty quickly.
You had $186 million in cash at year-end 2012. That seems a lot for a $300 million company.
We’ve been cash-flow positive for a while, and we have not been particularly acquisitive.
You’ve cast your net into the small-and-medium business (SMB) space, largely. Is it a goal to expand more into the large-company market?
We started at the S end of SMB. Then we grew to the low end of the midmarket and proceeded up through the midmarket. An exciting, newer phenomenon is that some very large enterprise companies that traditionally run an SAP or an Oracle have implemented NetSuite in their subsidiaries or divisions. They sometimes have a one-system strategy but a 27-system reality.
In 2011 the average size of a new business deal was up 45% year-over-year. At the beginning of 2012 I said, that’s not going to repeat. It’s going to go flat and revert back to the historical trend. I was right for one quarter. For the full year, it was up about 21%. Our deal size is getting bigger at a rapid rate.
Would those large enterprise companies you mentioned also perhaps buy individual modules from you to use for the company proper?
We’re big believers in the suite concept, with everything integrated and running together. But we do see some of that, especially with our professional-services offering, which is for managing projects and all the time reporting and billing professional-services firms do around that. For some of the very large ones, we’re not at this point aspiring to be their core ERP system, but they’ve bought NetSuite to handle those specific aspects of their business.
How about that healthy stock price of yours? How important is that, in the context of everything you have to think about?
It’s not a day-to-day key success factor for us. We’re more focused inwardly on what we’re achieving and our business metrics. I can’t say it’s not important at all. We want to keep shareholders happy, and we have a lot of employees who are shareholders. But it doesn’t come up in daily meetings or operating reviews or anything like that.
I’ve heard it said that NetSuite is a good company but that its suite is not yet an ERP in the same way that Oracle’s and SAP’s systems are.
I fervently disagree with that. The accounting and finance system of record is there. Around that, think of all the things that flow into accounting: order processing, inventory management, e-commerce, payroll, customer-relationship management. It’s all there. Accounts receivable, accounts payable, billing, tax, and all the other aspects of tracking the business are all there. Whether that’s taking orders over the web, managing inventory, shipping: all of that is inside NetSuite. It’s ERP.