The Fork In The Road

Why The Cloud Doesn't Always Rain Money

So much time is being spent speculating if we are in a bubble or not, that what’s really important is being overlooked: evaluating companies for the long term. It’s time to change the focus of the discussion to business models. We all know that when companies fail, it always comes down to not enough revenue and/or too many losses.  This is a fundamental of business, as well as a pretty obvious statement. Whether it is optimism or misjudgment this is something businesses still fail to grasp. 

Planning for future revenue as the savior of a company is not new. In 2000, I had a client who told me once the add-on technology was offered to the public in two or three years, they would be profitable. In the meantime, if they kept a customer for a year, they only lost $10 on that customer. Two additional facts: (1) they had multiple millions of customers, and (2) in hindsight, we can see the technology for which they were planning only started to hit the market in 2007.

Today, some cloud computing companies are embracing business models that are only successfully in their overly optimistic dreams. The problem with this is they are taking their investors, customers and employees along for the ride and turn ugly when anyone questions their assumptions.

Cloud computing executives should invest in two things:

1)      an analyst whose job it will be to consistently assess the marketplace and the company. This person is likely to straddle finance and sales/marketing.

2)      an honest opinion. You would think this should be the role of everyone on the management team, but too often groupthink, fear or frustration stifles what is sure to be an unpopular question. Ideally, someone on the team will be given this role. If the company cannot do this on their own, a trusted advisor or consultant is essential. Otherwise, you are in danger of engaging in groupthink, which never turns out well.

There are a few versions of cloud computing business models that need to be assessed more closely:

1)      trying to make an enterprise software-style sale via cloud computing. There is a class of SaaS company which isn’t truly SaaS. If your company must do tons of custom work for each installation and you only close a handful of deals a year, your company is not a SaaS company. It only happens to be delivered via the cloud. As more true cloud-based offerings are available in your space, it will become more difficult to sell solutions that take months to implement, require significant investment of customers’ IT resources and cost more than other cloud-based offerings.

2)      Freemium models that don’t have either a path to Premium or an additional revenue source, such as advertising. High-volume user plays are a good sales plan as long as the “free” users don’t become a drain on the company. Having a model that includes“free” users must at least pay for itself. Companies must also take into account the cost of supporting these users. Free trials or limited functionality are two ways to increase the conversion rate to paid customers.

3)      Ridiculously thin margins are the death of many restaurants and will eventually be the death of many cloud companies. This coupled with a “do anything to get the deal done” attitude occasionally results in negative revenue by the time the solution is fully deployed. This goes back to having ongoing analysis of revenue and the cost of sales.

As investors look for what can go wrong in the marketplace, they need to first look to see what could go wrong in each individual company. Only then will there be sound companies that can blossom in sunny times and weather any storm.

Bubble – No; Bubble Companies - Yes

As things improve in the business and investment world, speculation has begun about whether we are experiencing true growth or a bubble. From 50,000 miles away it might look like a bubble the likes of 1999, but when you take more than a cursory view, it is clear that we are not in an investment bubble, but there are bubble companies among us.

Saying there is an investment bubble implies there is too much investment happening and most, if not all, investors are getting carried away. We are a long way from that. Although the number of IPOs has slowly begun to climb, they aren’t nearly what they were before they fell off a cliff in 2008. The chances of achieving the same momentum of IPOs during the Internet bubble are less than slim, not just because of market factors. In the past 12 years, investors have learned there is serious money to be made through M&A as well. An IPO isn’t always the best option, and smart, mature boards now assess which step is best for their companies.

There is a clear difference between a company that has received a lot of investment money and large valuation and one that has solid revenue or at least a defendable business model.

For example, Facebook is currently valued at $50 billion and although most people think of it as a social networking company, its real value is the large amounts of personal data to which it has access. To date, the company has not produced revenue comparable to its valuation. It seems hard to image that in its present format it could produce comparable revenue without leveraging its accountholders data. Given the company’s repeated disregard for its users privacy, it could happen, but so far it has not.

On March 27, NYTimes.com ran a great piece that illustrated the difference between 1999, when the valuation of 24 companies equaled $71 billion. Today, the valuation of 4 companies equal $71.3 billion. Among the 1999 were Juniper Networks, which currently has a market cap of $21.59 billion, and Agilent Technologies, which has a current market cap of $15.72 billion. These are more than respectable numbers. The NYTimes.com piece is worth a read and at least worth a look to view the illustrations of 1999 compared to 2011.

Clearly, a bubble does not means the companies involved are actually worthless; it just means someone thinks they are worth more than they should be. It is likely that just as in 1999, not all the companies that comprise today’s bubble will be around years down the road. Of course, the difference is there are fewer companies this time around.

No one can accurately predict a bubble. If they could, it would be easy to navigate around them. For now, there is a handful or so of companies with valuations that seems hard to maintain.