Wall Street's ongoing struggle to make sense of the cloud

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Wall Street has become quite familiar by now with cloud computing.

The model of delivering services over the Web has gained so much momentum that public market investors, who traditionally parked their tech dollars with Microsoft, IBM, Oracle and Cisco, have dozens of new stocks to choose from if they want growth.

But despite the hype surrounding cloud and the rapid influx of capital from money managers, Wall Street is still puzzled when it comes to valuing cloud vendors.

That's because, of the 26 index members to go public most recently, 21 are losing money on a GAAP (generally accepted accounting principles) basis. And not just a little dough. Those unprofitable companies were a combined $388.7 million in the red in the last quarter.

Wall Street doesn't seem to care. Right now, some 28 publicly traded cloud computing companies are worth at least $1 billion, according to the BVP Cloud Computing Index, an index created in 2013 by Bessemer Venture Partners. Of the 42 companies the index tracks, worth a combined $173 billion, 26 have gone public in the past three years. Others like Eloqua and ExactTarget went public before getting acquired.

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For that matter, as of Feb. 7, the BVP index was up 146 percent since the beginning of 2011, which is as far back as the data goes, compared with the 63 percent gain in the S&P 500 and 79 percent jump in the Nasdaq.

Which means that, for cloud companies, the trusty price-to-earnings ratio should be tossed out the window. Even Salesforce.com, which went public in 2004, lost almost $40 million in the latest period. Workday, the developer of human resources and financial software, racked up a $59.9 million quarterly deficit.

Investors have grown comfortable with losses, because in the case of cloud companies they rarely reflect the health of the business. In a subscription model, companies pour money into landing customers, particularly when facing off against a big incumbent. Once they get a deal, revenue trickles in by the month, while the bulk of the costs get recognized upfront. Expenses are immediate, but revenue is amortized.

Beyond the financials, investors are betting on a massive paradigm shift in technology. Old packaged and desktop software is being tossed aside as businesses shift to simpler services that run in browsers and on mobile phones while spanning across many machines and performing sophisticated data analysis.

"This is the future of software and a core driver of technology today," said Bessemer partner Byron Deeter, who helped create the BVP index.

The companies that can combine the best user experience and pricing options with efficiency in sales and marketing are in pole position. Software as a service, or SaaS, is the software subscription model that's winning the day.

In SaaS, price-to-sales ratios are only marginally better than price-to-earnings metrics, because they're backward looking and don't reflect new contracts. Investors care more about the pipeline of deals, the likelihood that existing customers will spend more in the future and the costs that go into landing new clients. With that, analysts can gauge growth prospects and future profitability.

"You're spending money to acquire recurring revenue, so you don't have to spend money to renew it every year," said Tien Tzuo, founder and CEO of Zuora and former marketing chief at Salesforce.

Tzuo follows SaaS economics as closely as anyone, because in addition to having spent nine years at Salesforce, his current Silicon Valley start-up sells subscription software that helps subscription-based businesses manage billing and finance. Customers include software developers Box and Marketo, Australian telecommunications service provider Telstra and media companies like Reed Business Information.

Tzuo talks publicly about the need for standards and blogs for Business Insider explaining how to evaluate subscription businesses. For example, he poured over New Relic's recent IPO prospectus to show that the company is "crushing it," because it had about $110 million of annual recurring revenue, or the amount that will come in the door every year without additional spending, along with near 80 percent growth.

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Good luck finding recurring revenue rules in GAAP. You won't. Companies get to choose how they report those metrics to the Securities and Exchange Commission as long as they reconcile them with GAAP requirements surrounding revenue and profit.

To date, investors have given cloud companies the benefit of the doubt based on the performance of the stocks. Eventually, when there's a pullback and skepticism creeps in, shareholders will likely demand more clarity, said Gordon Ritter, a partner at Emergence Capital Partners, a Silicon Valley venture firm that's been investing in SaaS since backing Salesforce in 2003.

"It will take a change in the current market environment for those conversations to be realistic," said Ritter, whose firm announced on Wednesday the close of a $335 million fund, the biggest in its 12-year history. "Those standardizations come from times when the balance of power shifts a little bit."

An SEC spokesperson declined to comment.

Even within the BVP Index, valuations vary pretty widely. It includes metrics like enterprise value (EV) to revenue and EV to earnings before interest, taxes, depreciation and amortization (EBITDA). For EV to 2015 revenue, multiples range from 0.8 for E2open all the way up to 15 for Workday. And for EV to EBITDA, about half the companies have multiples in excess of 75, which Bessemer labels as NM for "not meaningful."

"It's really hard just looking at companies at this moment to get a snapshot, because everyone is at a different level of maturity," said Richard Davis, an analyst at Canaccord Genuity, who's been covering software companies for over 20 years and focuses on SaaS businesses. "A company early in its life cycle is virtually certain to be losing money, because they haven't reached scale, whereas larger companies should be getting to profitability."

Davis manages a team that writes reports on 30 to 35 public companies and tracks about 100 of them as well as another 500 private cloud companies.

Perhaps the biggest difference between software companies now and those of previous cycles is the maniacal focus today on customer satisfaction. In the legacy model, big clients would pay for licenses upfront and lock themselves into multiyear contracts that carried with them pricey maintenance fees.

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The dominant vendors worried little about competition, because the costs of challenging them were prohibitive. With cloud, distribution is less of a barrier and popular products spread by word of mouth. Unhappy customers have choices.

Therefore, no analysis of a cloud company is complete without a thorough understanding of churn and retention. Think of it like this: For every 100 customers, what percentage of them bail out after 12 months? It typically takes at least a year for a customer to become profitable, because of the costs of sales and marketing, so renewal rates are critical.

"It's not where you are, it's where you're going," Davis said. "You have to assess management's abilities and talents, and are the products going to sell—all the hard stuff."

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In Box's roadshow, the company said it has a retention rate of about 130 percent, meaning that even without adding a single new customer it would grow 30 percent. MobileIron, a provider of mobile management systems, reports a metric called recurring billings, which increased 68 percent in the latest quarter. Zendesk reports on the percentage of revenue growth generated from customers that signed on in the past year (65 percent), versus sales from accounts that existed before that (35 percent).

"We're still far away from having a set of metrics or practices that make us very comparable," said Mikkel Svane, founder and CEO of San Francisco-based Zendesk, which provides software that automates customer service.

Whether accounting standards change or investors just figure it out through trial and error, there's little doubt that subscription economics are here to stay.

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The global cloud computing market is forecast to grow 30 percent a year and reach $270 billion by 2020, according to Market Research Media. And subscriptions are becoming more a way of life in the consumer world. Look at Netflix's streaming service, Spotify's music offering or Dollar Shave Club's razors.

Ritter of Emergence says that subscriptions are just a better way to sell and will become more prominent across all industries. In addition to providing a more user-friendly experience and mobile compatibility, cloud vendors can collect and analyze much more data than older technologies because they have greater visibility into the business.

"The value of being in this relationship with your customer is the data you can grab and aggregate for customers to help them do their jobs better," Ritter said.