NetSuites IPO Filing Reveals Vulnerabilities

Risks include a single data center located in a seismic area and a history of losses.

Earlier this month, after at least two years of rumors and speculation, NetSuite filed for its initial public offering. While the IPO is good news for the software as a service sector, where NetSuite is considered a strong contender, NetSuites S-1 filing reveals some troubling vulnerabilities.

Perhaps the biggest concern: NetSuite supports all of its 5,300 customers on one data center, and that data center sits atop a seismically-active area.

"We wonder how well that NetSuites customers feel that their interests—and their customers customers interests—are being served without any backup facility," writes Saugatuck Technology analysts Mike West and Bill McNee in a July 12 research note. "Remarkably, NetSuite discloses it currently intends to add a second data center in 2008, but for the purpose of increasing capacity, not providing backup redundancy."

NetSuites current situation is not without precedent., the current gold standard in the on-demand market, ran on one data center for a couple of years after its IPO. But two years ago the company spent $50 million to build additional data centers. When customers began experiencing hours-long outages last year, CEO Marc Benioff blamed the data center upgrades.

Another major issue raised by NetSuites S-1 Form: The company isnt profitable. While NetSuite has been in existence since 1998, much of its growth occurred over the past three years, when revenue went from $17.7 million in 2004 to $67.2 million in 2006. Even with that massive burst of capital, NetSuite reported a "history of losses" in its IPO filing. The company experienced a net loss of $23.4 million for 2006 and $3.7 million for the three months ended March 31, 2007. As of March 31, NetSuites accumulated deficit was $193 million.

As Saugatuck points out, NetSuites sales and marketing costs—the company is known for sending out cases of wine to journalists—ran 53 percent of total revenue last year alone.

"At issue for Saugatuck is whether the broader public markets, venture community and broader IT industry is prepared to repeat the 90s cycle of continually bringing emerging software companies to market before they are break-even, if not profitable," writes West and McNee.

There is some good news: In the past three years NetSuite nearly quadrupled its revenue.

"One thing NetSuite has going for it is its focus on verticals and customer service, and an incredibly focused sales and marketing organization led from the top," writes West and McNee.

"In addition, we especially like their dashboard-driven and role-based approach that is very appealing to SMB senior execs who must also appreciate the tight integration between various suite functions."

But as NetSuite points out in its S-1, the small and midsize business market it is currently pursuing "can be challenging to cost-effectively reach, acquire and retain…and we may become liable to our customers and lose customers if we have defects or disruptions in our service or if we provide poor service."

According to Saugatuck, despite NetSuites recent growth spurt it is worth noting that the company was founded a full year earlier than, which has grown seven times larger since. NetSuites slow pace can be attributed to the fact that non-core CRM (customer relationship management) is far outpacing suite adoption in the on-demand world. "At this point, we are not yet convinced that suites have gained serious traction in the market, nor the mind share that would suggest that its just around the corner," write West and McNee.

As with any company, established or emerging, there is the competitive angle to consider. In its S-1 NetSuite points to a burgeoning competitive landscape that includes software titans Microsoft and SAP, as well as smaller companies Epicor Software, Intuit, The Sage Group, and The filing doesnt mention Oracle, which has its own substantial hosting business coupled with the acquisition of Siebel CRM and its on-demand business.

/zimages/4/28571.gifClick here to read about how NetSuite has linked up with the iPhone.

Microsoft on July 10 announced a slate of initiatives around its Titan release, expected later this year, that offers on-demand, multi-tenant CRM; SAP is also expected to release its A1S on-demand suite geared to the midmarket later this year.

Finally NetSuites S-1 reveals that Oracle CEO Larry Ellison has increased his ownership of NetSuite substantially. Ellison now owns 61 percent of the company (compared to about 40 percent in NetSuites early days) while trust for family members account for an additional 13 percent. With Ellisons reputation—customers seem to either love him or hate him—his majority ownership in the company could be a boon or a bust.

Through its IPO, NetSuite hopes to raise about $75 million in cash (Salesforce, in comparison, raised about $115 million).

Saugatuck has some suggestions for spending once the company goes public.

"NetSuite will soon be in a position to make new investments and possibly acquisitions that may improve its attractiveness in the SAAS market. Saugatuck would certainly recommend that NetSuite contract for a backup production facility, open its emerging AppExchange-like platform in order to appeal to partner companies…and consider adding other functions to its suite such as HR/benefits/talent management."

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