NetSuite (N) Short; Price Target: $57.

00 (28% Downside)
June 2016 (Post Fiscal Q1 16)
Pree K. Yerramilli

RECOMMENDATION: SHORT
Summary: N is a compelling short given my work on the competitive landscape in ERP and e-commerce software that
suggests consensus is too high for FY 17 and beyond, and negative revisions are likely. I believe bulls are overestimating
Ns growth opportunities in the enterprise segment and SuiteCommerce while neglecting the level of spend necessary to
successfully compete and overlooking top-line headwinds from mid-market saturation and increasing competition. I have a
~$22mm miss to the Streets revenue estimate for FY 17 stemming from a slowing in billings, and I have significant misses
on profitability and FCF. The size of all misses compound significantly in FY 18, indicating Street estimates for the outyears could come down a lot, important for a company that many analysts try to project for five or more years to justify
valuation. Overall, I believe N is an above average SaaS business, but absent a takeout at a large premium (unlikely in my
view and which multiples already substantially reflect), the stock is priced for perfect execution. Shorting N now is
actionable given tough Q2 16 billings and subscription revenue comps from lapping the sizeable acquisition of Bronto from
Q2 LY and multiples that have re-rated on an admittedly decent Q1 print and the irrational view that virtually all mid-cap
SaaS companies are in play. I think this relief will be temporary for bulls, and the setup provides for a short to make
money. I believe my downside calculation is reasonable and reflects reality, as the market has not been kind to highmultiple software companies that have missed or guided below consensus (DATA, FEYE, PANW, RHT, etc.).
Risk/Reward: 2.2x on the short side based on FY 17 estimates
o Upside (Risk): $89.00 ($10 up, 13% upside; implies 5.8x consensus FY 17 EV/Sales, 70.9x EV/FCF)
o Downside (Reward): $57.00 ($22 down, 28% downside; implies 3.7x consensus FY 17 EV/Sales, 45.0x EV/FCF)
Timeframe: 12-18 months
Sizing: 150-200 bps (200 bps above $80)
Catalysts:
o Quarterly earnings (miss and/or guide below consensus)
o Reports of customer churn and competitive displacement

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Analyst: Pree K. Yerramilli

June 2016

THESIS
Mid-market Saturation: Cracks are showing in Ns growth algorithm. A closer look at the numbers shows a slowdown in
organic subscription revenue growth, which indicates saturation of Ns primary market of midsize business customers. A
structural downshift in Ns top-line growth is likely imminent.
Increasing Competition: N is misunderstood as a sustainable 20%+ recurring revenue compounder with a wide
competitive moat when, in reality, it is a largely single-product company in core ERP systems facing increasing threats from
large SaaS peers such as WDAY and legacy software companies like ORCL accelerating cloud product deployments. The
recent acquisition of DWRE by CRM will exacerbate this competitive environment and also challenge Ns incremental
revenue opportunity with SuiteCommerce.
Shift in Customer Base May Cause P&L Issues: As N endeavors to make a significant move into enterprise away from
mid-market, its sales cycle will elongate from the standard 1-6 months and upfront S&M spend will accelerate, with
management already highlighting that recent sales force additions have dragged on overall productivity. Meanwhile,
ramping professional services revenue at lower margins and pricing pressure from legacy enterprise vendors will also
constrain gross margins. This could result in a mismatch between any new enterprise billings and the associated
expenses and result in operating deleverage, a scenario the Street has not contemplated.
Aggressive Consensus and Valuation: The sell-sides estimates are too optimistic, with liberal assumptions on both
growth and operating leverage. Given expensive valuation, misses to consensus will result in multiple compression (the
stock trades in excess of 4x FY 18 sales).
Longer-term Concerns: My research suggests that while the near-term opportunity for a short is related more to sell-side
mismodeling and unreasonable market expectations, there is also a risk of bigger structural issues. Given an increasingly
price-competitive environment, N could see accelerated customer churn as competitors catch up on all sides (WDAY in
financials, CRM/DWRE in e-commerce, and ORCL in ERP). An acquisition of N is probably not likely at current multiples
given that the most logical acquirers are starting to compete in mid-market with their own SaaS/hybrid cloud solutions and
do not need to overpay for a customer base and third-party technology that would require significant integration expense.
BUSINESS
Company Description:
o Summary: Founded in 1998 in San Mateo, CA, N offers a business management software suite through a SaaS model
to primarily mid-market customers (100-1k employees; 116k companies globally), though it increasingly aims to further
penetrate the enterprise segment (> 1k employees; 9k companies globally). Its core product is horizontal ERP software
(built for all industry verticals), which serves as a system of record and coordinates the automation of critical processes
that are inherent in many businesses: order management, inventory, supply chain management, project accounting,
revenue recognition, etc. Much of Ns core strengths are suitable for customers that have very involved logistics and
back office components to their businesses, like those in the manufacturing, CPG, wholesale, retail, and e-commerce
industries. N offers additional functionality through customer relationship management, e-commerce solutions, and
professional services automation modules. The technological value-add of having these modules delivered in a SaaS
model, aside from the usual TCO advantages over client/server architecture, is that it enables a unified, real-time view
into an organization, with a live dashboard that allows managers to look at up-to-date, role-specific information to
ensure financial discipline and accountability more broadly. N states that it has over 10,000 unique customers globally.
o Key Products: Most customers subscribe to the core NetSuite or OneWorld offerings, with some also opting to
subscribe to NetSuite CRM+, SuiteCommerce, and PSA modules. The core NetSuite product is designed for midsize
customers and divisions of large companies, and the functionality of providing a single platform for all applications is
embedded in this product. OneWorld, which is increasingly important to Ns continued ability to grow, is targeted at
MNCs and segments of large companies operating across various geographies, as it provides functionality in multiple
languages and currencies and is designed in accordance with local market accounting and legal compliance.
SuiteCommerce is Ns product focused on the e-commerce market; it provides an end-to-end solution through which
customers can integrate order management into a web storefront, track orders through their lifecycle, and plug into
other NetSuite functionality like revenue recognition on the back-end.
o Contracts: Subscription and support agreements range from 12-36 months, with professional services contracts
lasting 12 months. Management has alluded to the fact that subscription contracts tend to see 90% renewal rates,
which is lower than some other SaaS companies but makes sense given a predominantly midsize customer base.
o Go-to-Market: N relies on both direct sales and value-added reseller (VAR) channel partners. Once a subscription and
support contract is secured, N relies on a variety of systems integrator (SI) partners like Deloitte and Capgemini to help
onboard customers.
o Geographic Exposure: ~25% of revenue is ex-US (15% of it is denominated in FX, with exposure to EUR, GBP, JPY,
AUD, and CAD).
o Competition: N principally competes with Oracle (ORCL), which offers its Fusion ERP product to mid-market
customers as well as enterprise, and SAP (which has been steadily losing share) on the legacy side. In the ecommerce segment, N counts CRM as a notable competitor after the DWRE acquisition, but also faces competition

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Analyst: Pree K. Yerramilli

June 2016

from more specialized omnichannel retail software vendors like Manhattan Associates (MANH) and JDA Software
(owned by private equity).
o Acquisitions: Ns acquisition of Bronto Software in Q2 15 is noteworthy as it signaled a further push into building out
e-commerce capabilities by layering on Brontos email marketing automation functionality. N paid approximately
$200mm in total for Bronto (cash and equity), a business that exited 2015 with $22mm in revenue (~9x forward
EV/Sales). Bronto contributed ~$32mm in billings during 2015.
o Significant Shareholder: Larry Ellison, software industry legend and CEO of ORCL, has remarked that he came up
with the idea for NetSuite by pushing Ns co-founder and CTO Evan Goldberg to develop an ERP solution that could be
deployed to customers on the web. Due to his early involvement in the business, today Ellison still beneficially owns
39.7% of the outstanding equity. While this is an important fact to point out, later I will detail why I think it is not the
signpost of a future sale of N that bulls may believe.
Growth Algorithm:
o Billings growth 20-30% y/y (implied by top-line growth guidance)
o Revenue growth 20-30% y/y (guided by management as sustainable run-rate growth for the next few years)
o Adj. EBIT margin LDD-mid-teens % (inferred from sell-side estimates)
o Adj. EPS growth 30%+ CAGR (inferred from sell-side estimates)
o FCF growth 30%+ CAGR (inferred from sell-side estimates)
Unit Economics: Looking at the lifetime value of a customer (LTV) versus customer acquisition cost (CAC) gives some
good insight on Ns subscriber unit economics. The math on LTV and CAC was adapted by me for simplicity based on
calculations developed by Bessemer Ventures. My takeaway broadly is that Ns unit economics are fundamentally just
okay and not great. The CAC ratio calculation is particularly helpful (change in period over period gross profit divided by
prior period S&M expense allocated to customer acquisition, usually assumed to be ~70% of total S&M for most companies
in the space). Many industry experts I spoke to have indicated that a solid SaaS business should have a CAC ratio well in
excess of 0.50x; from the below math, it appears N has generally straddled this threshold. This compares relatively poorly
to the average CAC ratio of other big TAM SaaS companies measured over the same period, like CRM (0.65x), NOW
(1.10x), and WDAY (1.20x). That said, I think any company that is recouping over 4x its CAC on a customer is probably not
a horrendous business, though this assumes that the average customer life is 10 years.

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Analyst: Pree K. Yerramilli

June 2016

WHY DOES THE OPPORTUNITY EXIST?

2H 15 saw N begin to report in-line billings and top-line numbers versus the usual magnitude of beats to the high end of guide
from prior years, resulting in the stock selling off. This came right after N closed the Bronto acquisition in Q2 15. Reporting inline numbers despite including the impact of Bronto suggests the law of large numbers has started kicking in on Ns growth
algorithm, and the organic growth of the business is decelerating. However, the sell-side has largely ignored this fact pattern
and management has been effective in distracting shareholders with promises of taking share in enterprise and accelerating
OneWorld and SuiteCommerce adoption. Meanwhile, the stock has rallied since the beginning of 2016 on the back of a Q1
print where management delivered a beat-and-raise, guiding to revenue, EPS, and CFFO ahead of expectations. When asked
for an explanation as to what drove the beat, management offered no granularity even when one of the more astute sell-side
analysts tried poking at the idea that some demand might have artificially been pulled forward. At the same time, multiples for
mid-cap software names have re-rated as a group, as a flurry of M&A activity has led to investors piling back in (CRM/DWRE,
MSFT/LNKD, MKTO take-private, CVT take-private, ORCL/OPWR, ORCL/TXTR, etc.). This dynamic has led to speculation
that all companies in the space are up for grabs, with the financial media reporting that N might be among the more attractive
targets. In reality, I think this backdrop has just raised the bar for expectations when Ns fundamentals suggest that slowing
growth is an increasingly serious problem.
WHY NOW?
N will lap the Bronto acquisition and a new customer addition of American Express, the largest deal in company history,
from Q2 15, resulting in tough y/y billings and revenue growth comps.
My work (detailed below) suggests that underlying subscription revenue growth from new customers has already slowed
when stripping out the impact of the Bronto acquisition.
ASP growth has flattened over the last several quarters, but bulls are banking on a reacceleration from going upmarket.
CRM recently acquired DWRE. DWRE has the distinction of not only being an ecosystem partner of SuiteCommerce in
some deployments, but also a head-to-head competitor in most others. In well-capitalized CRMs hands, this changes the
competitive landscape and suggests SuiteCommerce will face headwinds to increased adoption.
From a technical standpoint, zooming out from the recent M&A chatter, software investors have grown tired of growth at
any price top-line SaaS stories with meager FCF valuation support. If N posts weak numbers with heightened
expectations, I suspect bulls will shoot first and ask questions later.
BULL CASE
Bulls think N is still very early in penetrating its TAM, as average deal size will grow from penetrating enterprise and ASP
growth will continue due to continued adoption of OneWorld and SuiteCommerce. SuiteCommerce will expand Ns traditional
TAM, as it will add more customers outside of the major ERP verticals of manufacturing, distribution, wholesale, and retail.
These drivers will allow billings and revenue growth to easily compound at 20%+ for the next few years. Margins should be able
to hit at least the LDD % level, driven by the ASP lift and productivity gains from sales force maturation. The uber-bull case is a
takeout scenario, where N is acquired by a strategic that wants to gain a foothold in mid-market ERP.
VARIANT VIEW
1. Ns runway for growth is contracting as it saturates its primary market of midsize customers.

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Analyst: Pree K. Yerramilli

June 2016

Above is my billings and revenue build. Bulls think N has a very long runway of billings and top-line growth well in excess of
20%, but I think the company will decelerate much faster, hitting 20% growth by 2018. Management argues that N has 10k
unique customers today, and the TAM provides for 116k midsize customers and 9k enterprise customers with a total $30bn+
revenue opportunity, implying that N has only LSD % market share today. A closer look at subscription revenue growth
highlights why I am skeptical of all of this. In its filings, N discloses the amount of y/y dollar change in subscription revenue that
comes from new and existing customers, respectively. In FY 15, of $89.5mm of subscription revenue dollars that came from
new customers, management called out $20.0mm as stemming from Bronto. Stripping out Bronto indicates that the y/y rate of
change in Ns addition of subscription revenue dollars from new customers was flat. Though this rate of change accelerates to
10.8% in Q1 16, I note that the prior year had a comparatively much easier growth compare, so I think this acceleration is
actually more due to optics and is not indicative of a sustainable trend. At the same time, the rate of change in addition of
subscription revenue from existing customers went negative in Q1, implying an upsell rate of 4.9% versus significantly higher
percentages in prior periods. If SuiteCommerce and other add-on modules were really selling like hot cakes, I doubt the upsell
percentage would look so meager. However, for 2016, I assume that subscription revenue upsell rate sequentially gets better
throughout the year given that there is probably some low-hanging fruit on renewals where N can add on SuiteCommerce and
other modules. After fully lapping Bronto in Q2, I model the rate of change in new customer subscription revenue assuming the
general two-year stacked trend holds. N also guides that they will invest more in professional services given the new go-tomarket emphasis on enterprise (requiring more involved implementations), which should result in revenue from this source
contributing more to the total. Lets keep this fact in mind for argument #3 below.
All of these facts put together lead me to conclude that some combination of mid-market saturation and competitive pressures
are weighing on Ns ability to grow subscription revenue organically, and it would not surprise me if they decided to do another
acquisition to juice top-line growth. Overall, I have billings growth decelerating from 28% y/y in FY 16 to shy of 20% exiting FY
18. This should still allow for both subscription and total revenue growth of 20% in FY 18 (my total revenue growth trajectory is
below), but this is well below more bullish expectations in the mid-20%s.

2. Competition is intensifying from all angles.

The mid-market segment of ERP is Ns stronghold, but bulls think N can use the same bag of tricks to take share against
legacy software vendors in enterprise. My industry checks (the takeaways are detailed below) suggest that competition in
enterprise ERP is exacerbating due to the legacy vendors aggressively cutting prices on their cloud products, and that these
players, particularly ORCL, are actually also selling to mid-market successfully. N states they offer more than just cloud
architecture, but that SaaS also allows for deeper functionality and faster execution. In fairness, management is technically
correct as legacy products (for instance, SAP S/4 Hana and Oracle Fusion) are executed in hybrid architectures, a cross
between client/server and the cloud, and not pure SaaS. Yet SIs, VARs, and other industry participants indicate that in many
cases, legacy vendors cloud products are perceived as good enough by customers, particularly if they are offered with steep
price concessions. Using these data points and some common logic, I conclude that N, with relatively weaker financial
wherewithal versus a company like ORCL, is disadvantaged in a price-competitive market and would therefore not be able to
sell NetSuite with much success to enterprise. Bulls have subscription gross margins going up across a multi-year period. I
concede that some of this is likely due to leverage from spreading out costs like datacenter investments over more revenue, but
I believe the offset is that ASP growth will not be as aggressive as bulls think. Management has guided to flattish subscription
gross margin in FY 16 versus last year, around 85%, given investments in three new datacenters.
On the e-commerce side of the business, CRMs acquisition of DWRE should raise some eyebrows (apart from just the > 7.0x
forward sales price paid). I believe the significance of this transaction as it relates to the competitive environment is not

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Analyst: Pree K. Yerramilli

June 2016

understood well and has not been incorporated into Ns valuation. DWRE was already a notable competitor to SuiteCommerce
prior to being acquired, but I think CRMs control of this asset now makes the N bull argument of selling to bigger customers
more difficult to believe. SuiteCommerce is regarded as one of the drivers for ASP growth to reaccelerate going forward. My
checks indicate that while SuiteCommerce can likely be upsold to midsize customers, the enterprise is better served by
Demandware, and this dynamic should continue given CRMs focus on large customers. Combine this fact with other
developments like WDAY accelerating their entry into financials/ERP, and I believe assuming bull case subscription gross
margin improvement in the high 80%s over time is dangerous, particularly for a company that has seen this number bounce
around in the 85% range for years on end, as I show below. For conservatism, I assume some expansion in the next two years
but basically just rebounding to the high end of the historical range. I believe the level of GM expansion I model would hardly be
a reason to get excited on the stock.

3. Penetrating the enterprise segment is expensive and has P&L implications that the Street has not considered.
While some bulls think that Street billings and revenue estimates currently bake in minimal contribution from enterprise wins, I
disagree based on the fact that I have already shown that the rate of new subscription revenue from existing customers
(virtually all midsize) is slowing. Assuming some incremental growth obviously comes from existing midsize customer renewals
and upsell/cross-sell, I have to believe with the sell-side forecasting 20%+ growth for multiple years that at least some of that is
also driven by the embedded assumption of new enterprise customer wins. This brings me to my argument on what happens to
software companies that do successfully sell to enterprise. The Street is modeling a lot of top-line growth but is conveniently
ignoring two things that are true of enterprise: 1) enterprise billings are lumpier, as the sales cycle can generally range from 618 months (versus 1-6 months in mid-market), and 2) the heightened level of investments required in Ns SI network and S&M
line. On the first point, I believe the longer sales cycle shows up in numbers with regard to how deferred revenue gets released
from the balance sheet and recognized as subscription revenue in the out-years. Off of a bigger base of deferred revenue, less
subscription revenue will be recognized in-period on the P&L, which should add some natural deceleration to the saturation and
competition headwinds I have noted. On the second point, which is even more important than the first, I find the long-term LDDmid-teens % non-GAAP EBIT margin that bulls are playing for to be a pipe dream, which will ultimately compromise FCF
generation.
As I pointed out earlier, management has guided that going upmarket will require heavier investments into SI relationships
(higher contribution from professional services revenue). N began making these investments in Q2 15 (which is why PS
margins compressed to 6.9% at that point), so it will lap this on the Q2 16 print. However, management has confirmed that
given PS revenue will see elevated growth over the next few years, PS margins have to structurally come down over the next
few years, which is what I am modeling (model above in argument #2). This leads me to believe that total GM is constrained at
shy of 70% over the next few years. Further, I believe that S&M will require heavier investments, as management has already
hinted at going on a hiring spree for seasoned enterprise salespeople. The issue is that management has also noted in the last
few quarters that overall sales productivity has declined as these salespeople are onboarded, requiring a year or more to hit full
productivity. Half of the total sales force was hired in the last two years, which has been noted as a headwind to operating
margin expansion. Though bulls expect that this headwind will turn into a tailwind later this year, if I am correct in assuming that
the enterprise business to be won is limited, then N will have spent a lot of money on what is ultimately a poor ROI sales force.
Further, on Ns Q1 16 earnings call, management says they have a lot of work to do on the demand generation side in
enterprise, suggesting that marketing expenses will also have to ratchet up from current levels. Putting all of this together,
below is what I believe the non-GAAP EBIT margin progression of the business looks like over the next few years. I believe that
the path to getting to even LDD % EBIT margin will take far longer than what bulls believe, and that the pacing will be at a more
moderate slope.

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Analyst: Pree K. Yerramilli

June 2016

4. An acquisition of N is unlikely right now.

Despite market noise, I do not view N as being an actionable buyout target for several reasons. First is the obvious point on
multiples. Based on consensus numbers, N trades in excess of 5x and 4x FY 17 and FY 18 EV/Sales, respectively. This
implies an EV/FCF multiple north of 50x in FY 18, which is absurd in my view and indicates Ns valuation is likely already
contemplating a takeout scenario. Even if one believes there is upside to Street estimates, the magnitude of upward revisions
needed to make multiples look reasonable to any rational acquirer would be hefty. MSFT and CRM set unreasonable
expectations with their recent acquisitions, but I believe given they were involved in fairly competitive bidding for those assets
and the targets serve as significant TAM expansions, the premium multiples can be justified. Putting aside valuation, I think the
most logical buyers for N actually do not view the acquisition as sensible. While ORCL or SAP could technically bid for the
company with operating cash flow, I do not think either is likely, at least in the near term. As I mentioned earlier, Larry Ellison
owns nearly 40% of Ns outstanding equity. Unless he sold out of a large chunk of his position without any public record of the
transaction, I think corporate governance red flags would immediately go up on the self-dealing nature of a transaction with
ORCL. My checks suggesting that particularly ORCL is successfully selling its own products to the mid-market also imply that
acquiring N for its customer base would not make sense. With regard to SAP, Ns management team despises the company
(Ns CEO openly delights in SAPs market share losses in company presentations) and would view a sale to them as an
admission of defeat.
Further, the software space has also shown a recent drift in terms of attitude towards M&A, which is much more geared
towards deals that are accretive to expansion into new verticals or to open up new TAMs. An acquisition of a horizontal ERP
business frankly does neither. ORCL recently bought TXTR (to expand its engineering and construction vertical) and OPWR
(software facing the public utilities industry). Both acquisitions were sub-$1bn and were valued at an estimated 6x and 3x
forward EV/Sales, with OPWR being acquired at less than half of its IPO price. These deals were tuck-ins with clear strategic
motives to expand particular verticals and likely offer real synergies. Finally, from a technology perspective, my conversations
with industry experts suggest that integrating Ns architecture would be an expensive undertaking for an on-premise vendor
given it is a horizontal business. The required integration expense would likely offset any synergies from a deal, thus likely
making little financial sense at current multiples.
DUE DILIGENCE SUMMARY
My primary research generally corroborates my directional views. Some takeaways from my conversations that are directly
relevant to the thesis are presented below. In the spirit of intellectual honesty, I should divulge that most existing customers I
spoke with seemed to like NetSuites products from ease-of-use and aesthetic standpoints, but many of the same also sounded
uncertain as to whether they were convinced yet that it was worth the sticker price.

Value-added Resellers:
o I spoke to four different VARs, two of which were top 10 partners.
o All four VARs suggested that selling to enterprise in significant numbers would be very difficult for N. The only business
that they have high expectations to be heavily involved in via the channel going forward would still be midsize.
o The competitive environment in ERP broadly was noted as promotional, with legacy vendors offering sizeable volume
discounts for bigger customers, especially those with upcoming renewals. One VAR stated that he believes ORCL is
actually the real share winner from SAP, as he has contacts in sales there who say the mid-market for their Fusion
product has been a particular standout recently. He went on to say that he does not think it would be wise for N to
participate in a pissing match on cutting prices, but that it may have to happen if they want to compete for bigger
accounts.
o One VAR said he has noticed a slowdown in demand for NetSuite since the beginning of this year, as he thinks most of
the low-hanging fruit has been picked already. He was not alarmed by this right now but indicated it could be an issue if
it continues. He believes N will still take share but that there was definitely a lull while they figure out which market to
attack next.
o The VARs I spoke with were not heavily involved in as many deployments containing SuiteCommerce as I would have
expected, though I believe this is because much of that business is handled by the direct sales team. One VAR said he

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Analyst: Pree K. Yerramilli

June 2016

knows customers who have added on SuiteCommerce and liked the product. However, in the very next sentence, he
offered the thought that e-commerce is a tough market to really crack, as a lot of good software is coming out to
address those needs, especially in the low end and middle market, and Demandware is still best-in-class for enterprise.
Systems Integrators:
o I was able to speak with three global SIs and one that has a more regional footprint.
o One global SI said outright he believes Ns existing SI network would be insufficient to build a big book of business in
enterprise. He noted that software is a relationship business as much as it is a technology business and to have a real
shot at competing in enterprise, N would have to scale up its SI partnerships and sales force well ahead of getting
much traction. He believes the whole process would cost a big boatload of money (no more specific quantification),
and he does not think N really has that kind of a budget, as it involves brand marketing, awareness, training
salespeople, and getting more SIs educated on the product. He also noted the competitive environment is getting more
difficult, as ORCL is seeing some success in the cloud and though SAP is losing share, they are getting irrational on
price to entice large customers to renew. He believes N will take a few points of market share in enterprise over the
next few years, but not all of a sudden.
o Another global SI says he has been approached for his thoughts on N entering enterprise more than a few times, and
that as time passes, he has been incrementally more skeptical. He said he has one of the larger NetSuite practices in
the industry, but mostly all of the new business they have been onboarding is still mid-market. He believes horizontal
ERP is still a good business in that it will not be disintermediated by rationalization of IT budgets, but he thinks that
makes it all the more likely that only larger vendors will ultimately be able to keep pricing attractive enough for larger
customers. He also thinks that most large customers are still happy to go with the good enough product in ERP, as
long as it fulfills basic needs and is not overly expensive.
Competitors:
o I spoke to senior sales executives at both SAP and ORCL and have followed public commentary from both
management teams, though I have not yet met or spoken with either myself. I take these comments with a grain of salt,
as clearly software is a hypercompetitive industry, but I believe they are still directionally helpful.
o SAPs sales team believes that N has saturated the mid-market opportunity. The contact I spoke with thinks Ns bread
and butter will always be smaller customers, and he actually thinks that they do not currently have the bandwidth to
serve the largest customers. He also noted that the hiring environment for software salespeople is extremely
competitive right now and that he imagines N would have to continue making very heavy S&M investments. He thinks
SAP and ORCL ultimately control industry pricing based on their read of the competitive environment, and they could
actually absorb the impact of cutting prices. He believes NetSuite is not a cheap solution, so for them to compete for
volume, they would have to do deep discounting.
o The ORCL contact I spoke with believes that there is a lot of unjustified chatter in the market about Fusion being a
worse product than NetSuite just because the latter is SaaS and Fusion runs on hybrid architecture. He characterized
this as silly and that ORCL would not be growing cloud revenues in ERP if customers felt that they were better served
by another vendor. He thinks Wall Street likes to exaggerate stories about on-prem guys who suck in the cloud and
are going the way of the dinosaur, but were not seeing it. He noted the mission-critical nature of ERP and said doing a
rip-and-replace is something that can cause large customers a significant headache, so they have to be sure that
theyre doing it if it really makes sense with regard to their TCO and balance that with the level of functionality theyre
getting. He echoed the sentiment that a lot of large ERP clients find hybrid cloud solutions offered by legacy to be
sufficient for their needs, as he believes something like NetSuite is probably nice to have for an enterprise at this
point, but not really a must have. Customers arent irrational on pricing, especially since a lot of IT spending is coming
under review.
Customers:
o I spoke to CIO-level contacts with ERP buying responsibilities at 12 NetSuite clients, most of whom were on the larger
end of the midmarket. Two were enterprise customers.
o Customers of all sizes noted that NetSuite software is generally easy to use and aesthetically an improvement over
legacy solutions. Most of these clients replaced SAP a few years ago.
o Customers understandably did not reveal details of their subscription contracts with N, but nine out of 12 suggested
that they thought it was an expensive solution. One customer offered that his organization received a quote we thought
was already pushing our limits during the RFP, but then we ended up with an even bigger invoice while we were
implementing it. I am not sure that the same dynamic exists across the entire customer base, but it sounded broadly
from other discussions as well that N is very aggressive on pricing.
o The enterprise customers I spoke with, both OneWorld subscribers, stated that they had been with SAP for a number of
years and finally decided to switch over to a cloud-based solution as their supply chain became more complex globally.
Both said that at the time they signed the RFP, it was not really a competitive bidding situation. They had no opinion on
Oracle Fusion, as they did not demo the product but said they are always mindful of good technical solutions that are
also cost-effective that may come to market, so it is not guaranteed that they would renew NetSuite indefinitely. One of
these customers, a retailer who entered into a contract with N in the last year, uses SuiteCommerce. This contact noted
that while the software is sleek, it was pushed on him aggressively and he is not sure that it is really offering that

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much incremental value to make it a good ROI. He said his peers mostly all use Demandware, and he believes they
are happy with the solution. He was goaded into buying SuiteCommerce, however, as part of replacing the total ERP
system from SAP and was given what he believes was an attractive price for an add-on.
VALUATION
Estimates:
o Management provides explicit guide on revenue, non-GAAP EPS, and CFFO. My full model can be found below as
Exhibit A, and my variance to key metrics are given in the table at the beginning of this write-up. Investors care most
about billings and revenue but are increasingly paying attention to adjusted EBIT and FCF.
o Putting together all of my conclusions above, I am mostly in-line to slightly ahead of consensus on all key metrics for
FY 16 but would note that the magnitudes of my beats are pretty consistent with Ns historical performance. I would
point out that excluding the expected contribution from Bronto after the deal closed in Q2 15, management actually did
not raise guidance for the core business throughout the year. Therefore, my 2016 numbers already give N credit for
being able to deliver a beat to the high end of guide articulated post Q1 16, so to hold current multiples, I think the buyside is likely expecting numbers consistent with my estimates (if not higher).
o For 2017 and 2018, I begin to get meaningful downside variance to consensus based on all of the work I have detailed.
For high-growth SaaS companies, even slight misses to billings or revenue tend to cause total blow-ups. For FY 17, I
am about $5mm short of consensus on billings and over $20mm light on revenue. The misses I model on EBIT, EPS,
and FCF are all fairly large, which then flow through and compound in FY 18. The result is that the growth in FCF
between 2016 and 2017 is minimal.
Entry Point:
o N has consistently traded in the range of 4.5-5.0x FY 17 EV/Sales in recent quarters, heading towards the lower end in
2H 15 when the stock tanked. This is in the general neighborhood that most software companies guiding to 20-30%
consistent top-line growth have traded at on a one-year forward basis (CSOD and ULTI are among those that come to
mind). In the high $70s, I think the entry point looks compelling to short N, as this implies > 5x FY 17 EV/Sales, > 60x
EV/FCF, and > 100x P/E based on consensus. On my below-consensus FY 17 numbers, the stock is even more
expensive.
o On a technical basis, the stock is well off its all-time highs above $100 per share, but I could argue it never should have
been valued so egregiously. Above $80, the stock is at the same level as two years ago, when there was clearly more
growth ahead of the business. Therefore, in the $80s would represent an attractive risk/reward to size a short position.
Exit Valuation:
o Methodology: I primarily use EV/Sales to determine what N is worth and triangulate with the implied P/E and EV/FCF
multiples. The table at the beginning of the write-up shows an EV/Sales framework which suggests that if I assume that
someday N hits 10.0% non-GAAP EBIT margin, pays 35.0% cash taxes (today it pays zero, but when it achieves
mature profitability, that should end), and I am willing to pay up to 50.0x P/E today for the growth trajectory that gives
me that earnings power, then the stock is worth 3.3x EV/Sales. I use this as an anchor for a floor valuation if I still
believe N will one day hit at least LDD % EBIT margins, but clearly the market is currently willing to pay well above 50x
P/E.
o Base Case: The valuation matrix shows how I arrive at my base case valuation. If N misses billings or revenue per my
model, I believe it will see multiple compression. For conservatism, I assume one turn of compression but note that
high-growth software companies that miss numbers usually see much sharper de-rating. Assuming a 4.0x EV/Sales on
my FY 17 revenue estimate gives me a $61 stock (still 53x EV/FCF and 95x P/E). If I roll forward one more turn of
multiple compression and use 3.0x on my FY 18 sales estimate, I get a $56 stock. These valuations give the company
full credit for a net cash balance that I project as $274mm in 2017 and $401mm in 2018. 3.0x in FY 18 is slightly below
the 3.3x that the stock would be worth in my EV/Sales framework, but I believe it would be justified as the market
should reevaluate what it is willing to pay for a company that is missing numbers and might not ever hit LDD % EBIT
margins.
o Downside Case: I assume that if N gets totally torched for a miss and does my sales numbers, then the FY 17
multiple further compresses to 3.5x. My price target of $57 is triangulated based on my base and downside case
calculations and suggests that there is nearly 30% downside to be realized in shorting N.
o Upside Case: I believe that an upside case would likely yield no more than a 5% beat to the high end of current Street
revenue estimates for both FY 17 and FY 18 (obviously assuming no acquisitions). If I assume a premium to the
current 5.0x FY 17 EV/Sales multiple at 5.5x (the market might pay slightly more for a company that returns to a beatand-raise story), I get an $89 stock. Bulls will argue that N could be acquired for more than 5.5x EV/Sales, but I do not
share this view. As discussed elsewhere in this write-up, I believe the buyer universe is limited and far more rational
than implied by recent acquisition multiples offered by other companies in different software verticals.

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Analyst: Pree K. Yerramilli

June 2016

MANAGEMENT
Impressions: I have met with management a few times through sell-side conferences. I view this as a decent management
team with strong tenure in the enterprise software space. However, I do also think they are quick to dismiss real business
issues; for instance, my questions on the slowdown in organic subscription revenue dollars were dodged, and the few
thoughtful sell-side questions on earnings calls are met with commentary about how great Ns software is and no real
substance. Further, I am accustomed to promotional management teams in SaaS, but CEO Zach Nelson is on another
level with the hyperbole. From his keynotes at the annual SuiteWorld customer conferences and the prepared remarks to
earnings calls, you would assume he singlehandedly invented cloud computing. While this is not smoking gun evidence of
any wrongdoing (which I am not accusing anyway), I would find these issues worrisome if I were a bull.
Incentives: The financial performance component of executive compensation (75% of total compensation, with individual
performance being the remaining 25%) is determined by a weighted formula considering three financial metrics: revenue,
non-GAAP EBIT, and non-GAAP CFFO. Of these buckets, revenue is weighted at 70% of total financial performance, with
non-GAAP EBIT and CFFO at 15% each. Again, taken alone, this may not mean much in an industry where top-line growth
is of paramount importance, but when combined with slowing organic growth, it is more concerning. Clearly, executives are
incentivized to drive revenue growth at all costs, and I believe the 9.0x forward EV/Sales multiple paid for Bronto is
illustrative of managements attitude towards hitting top-line numbers.
RISKS/PUSHBACKS
M&A: The biggest risk in shorting N is M&A optionality. N is clearly not afraid to buy growth. While making another
acquisition would further highlight decelerating bookings growth, it could still lead to upward revisions and multiples could
still hold, and a short would lose money. Despite my earlier arguments around why an acquisition of N may not make
sense, I could have misread the setup. Maybe Larry Ellison can do some kind of complicated share swap deal to sell out so
he can have ORCL buy the company. If an activist investor believes N is undervalued at some juncture, that could also
change things.
OneWorld: I could also be wrong if I have incorrectly handicapped the ability of N to take share in enterprise by
aggressively selling OneWorld, which structurally has a larger TAM given it focuses on MNCs (including divisions of larger
companies overseas). As common sense suggests, it is usually easy to grow off of a small base. Management does not
disclose how much total revenue comes from OneWorld today, but if the base is small enough, perhaps there could be
some low-hanging fruit to be picked in enterprise through pushing OneWorld and reaccelerating ASP growth.
Customer Satisfaction: As I note in my due diligence, most existing customers actually like the NetSuite product. This
would indicate that renewal rates could continue to be strong, and the large retail customer I spoke with was successfully
cross-sold SuiteCommerce. However, the aggressive pricing behavior I note also indicates that N may have over-earned
historically, so the ability to keep pushing price and add-on modules (key to the bull case numbers working) may be limited.
Timing: Sentiment is more mixed/negative today than I normally would advocate for a short, with short interest hovering
near 15% (keeping in mind Ellisons ownership at 40%), so an incremental borrower of shares may not find the setup as
compelling. Admittedly, I am only publishing this write-up after having initiated my position for some time so as not to overdistribute the idea and work against myself. From a timing perspective, I personally believe in being just a little earlier on
the short side, which may be difficult to stomach especially since I have upside to Street numbers for FY 16. However, this
is a growth business and is valued off of multi-year forward estimates; I believe that absent a series of events that lead to
the Street taking numbers up meaningfully for FY 17 and beyond, the stock is currently priced for perfection.

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EXHIBIT A: N FINANCIAL MODEL

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