Should You Chase Future Gains in This Pricey Industry?

Should You Chase Future Gains in This Pricey Industry?

Paylocity is prepping for an initial public offering after hiring Bank of America, Deutsche Bank, and William Blair to assist in the process. The company is part of the exciting cloud-based human resources/payroll software space, an industry that has performed exceptionally well over the last year. As a result, there is reason to believe that this company will be highly anticipated on the day of its IPO; that is unless the bubble bursts.

An IPO to produce gains?
According to a report in Reuters, Paylocity has $55.1 million in annual revenue with 10,000 customers, and is growing rapidly. With that known, one has to assume that the market will be willing to pay a huge premium for the company's growth and current revenue, as peers Workday , Ultimate Software Group , and Cornerstone onDemand have already paved the way with massive gains

To no surprise, Paylocity is already talking about a $100 million IPO (market cap of roughly $1 billion), and it's only in the early stages -- not even planning to go public until next year. Therefore, sales will continue to rise and it's very possible that the size of the IPO could rise considerably.

The valuations are insane!
The reason that Paylocity might have a very successful -- and expensive -- IPO is because of the market's three growth leaders in the space, those already noted.

Cornerstone is likely the most similar, having trailing-12 month revenue of $149 million with year-over-year growth of more than 60%. In 2013 alone, Cornerstone's valuation has climbed 76% to a whopping $2.7 billion. This valuation supports a price/sales ratio of 17.6.

Ultimate Software has the most annual revenue, with $370 million, but has growth of just 23%. It, like Cornerstone, is also a cloud-based HR/payroll company but also offers other products and services. Also, like Cornerstone, Ultimate Software trades with a large premium to fundamentals at 11 times sales.

However, Ultimate Software is by no means the largest market capitalization. That particular honor belongs to Workday, a company that trades at a whopping 40 times its last 12 months of sales. In 2013 alone, Workday has surged 50%. Despite sales of only $353 million in the last year, it trades with a market cap of $14 billion!

Valuation must eventually align with fundamentals
Clearly, HR/payroll cloud-based companies carry much larger valuations compared to the rest of the market. The reason is because HR and payroll is a large space that all businesses must utilize, yet companies of all sizes are finding it to be economical and simpler to utilize the cloud to provide this particular service.

Therefore, while the outlook for this space remains strong, the question is whether or not any of these companies can ever grow to a level that supports such lofty valuations. In theory, valuations and fundamentals must eventually align. This means that while companies may carry massive premiums today, once a company grows too large or sees slowed growth, the market has always corrected valuations to reflect fundamentals.

Right now, the S&P 500 index trades at 1.5 times sales, while the technology sector trades at a higher ratio of 3.0 times sales. The reason is because technology traditionally carries higher margins compared to other industries of the market, such as energy or consumer stables. But in the case of cloud-based companies, most are not profitable.

Workday has an operating margin of negative 35% and Cornerstone's is negative 22%. Ultimate Software has an operating margin of 10.5% but such a profit is rare, as even the largest cloud-based company Salesforce has an operating margin of negative 4.5%. Therefore, the massive pricing premiums related to these companies are not due to higher margins but rather growth.

Moreover, despite a seasonally strong growth period in the second quarter, Workday, Cornerstone, and Ultimate Software have all begun to see declined revenue growth over the last five-to-six quarters. If in fact these companies are valued excessively on sales growth alone, then this could be a sign that the bubble is preparing to bust.

The makings of a bubble?
Former Vice President Al Gore recently defined a bubble as involving "a lot of asset owners and investors who don't see what in retrospect becomes blindingly obvious."

Obviously, these cloud-based HR/payroll stocks are expensive, are not profitable, and eventually these stocks will trade at a level that is consistent with the rest of the market. In the case of Workday, this is especially true, as it cannot maintain 40 times sales for the duration of its existence.

Thus, one of three things will happen: Either growth will exceed stock performance for several years; stock performance will be flat for an extended period of time while growth continues; or stock performance will produce excessive losses while fundamentals continue to grow. This then occurs until valuation and fundamentals align, or are at a level that is consistent with the rest of the market.

What about Paylocity?
Unfortunately, there is no way to know when the bubble will burst; these stocks may all double again before it occurs. However, there is little doubt that a bubble is forming, if not already present.

Over the weekend, Art Cashin suggested that we are in another tech bubble, saying that today's cloud and mobile valuations are reminiscent of the dot-com era. I'd say he's right, but like I said, we don't know when the bubble bursts.

Until then, HR/payroll stocks continue to outperform the market, defying what's logical. In the end, this fact makes the IPO of Paylocity very appealing, as it might very well see Workday-like performance. However, with all things considered, be aware of the valuations in which you buy stock, and if you're lucky enough to return large gains, you might be equally rewarded by shorting in anticipation of this bubble bursting.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Ultimate Software Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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