Cloud Stocks: Upside Value or Downside Risk?

Companies that sell software-as-a-service, or operate through the cloud, have been some of the market's biggest highfliers during the last two years. However, these same companies have been the hardest hit during the last six weeks. Therefore, in breaking the cloud industry down into three segments that cover all companies, including , Workday , ServiceNow , The Ultimate Software Group , and Aspen Technology , do any of these segments or companies present upside value?

The big dominant and problematic
In talking about cloud stocks, should always be the first company that comes to mind; it is the quintessential pure cloud play with a diversified offering of products and services.

In 2013, posted revenue of $4.07 billion, representing growth of 33% relative to the year prior. Not to mention, its deferred revenue -- a closely watched metric for future growth in cloud companies -- grew 38% to $2.47 billion at the end of the year. 

The problem for is that its margins have declined in each of the last five years, and competition has intensified, thus putting pressure on pricing power. With all things considered, continues to grow, but much of that growth is acquired. And with operating margins of negative 7%, the company is nowhere near profitable. Hence, the biggest and most dominant name in the space might not be the best.

Small companies with big caps
The second market segment within the cloud space involves those that are fundamentally small, but have large market capitalizations because of lavish expectations. ServiceNow, which provides IT-related cloud services, and Workday, HR and payroll-related products, are the two most significant names in this segment.

Workday and ServiceNow have lost 30% and 27% of their valuation, respectively, in the last six weeks. Thus, many consider them to be presenting an opportunity. The problem is that these two companies have a combined market cap of $22 billion, yet less than a billion dollars of annual revenue.

Both companies are expected to achieve top-line growth in excess of 50% this year, but with such large valuation multiples, both companies need several years of such growth to support their current valuation.

Not to mention, Workday and ServiceNow have achieved their growth rates in large part because of spending. Thus, neither company is profitable: Workday has an operating margin of negative 32.6% while ServiceNow's is negative 15.6%.

In retrospect, it's easy to grow when spending is so aggressive. Yet, the question remains whether either company can produce solid growth without excessive spending, and eventually become profitable while growing into their valuations? These are very important questions with no answer, and with such a high multiple, both stocks are still too expensive, meaning both could fall significantly further.

Balanced growth, fair value, and profitable
Lastly, there is a smaller group of cloud companies that have been able to maintain attractive growth rates, remain fairly valued, and all-the-while staying profitable. It is in this group where value can be found, especially following large six-week losses. Two companies in particular are Ultimate Software Group and Aspen Technology, who've seen stock declines of 25% and 18%, respectively.

The Ultimate Software Group trades at 8.7 times sales with a market cap of $3.6 billion, thus it's not cheap by any means. However, in this industry, the ability to produce consistent growth with profitability is rarely seen. Hence, the company's 21% three-year annualized growth rate and 10.5% operating margin are very impressive, as is its expected 23% growth rate for the next two years. 

Also, it's worth noting that Ultimate operates in the HR/payroll segment of the market, making it a competitor with Workday. The most significant difference is that Ultimate spent just $0.89 to earn each dollar of revenue last year, while Workday spent $1.32. So, which company's growth is more impressive? Personally, I'll take 20%-plus growth with lower expectations and more responsible spending as a better long-term investment.

Aspen Technology is a bit different than other cloud names: It operates with little competition in providing software technology in the energy, chemicals, and engineering sectors to make operational integration and day-to-day activities simpler. Therefore, it has pricing power, creating operating margins of 26.5% last year.

In addition to large profits, Aspen has consistently produced 20% growth. This is a smaller under-the-radar company with a market cap of only $3.7 billion, trading at 10 times sales, but for investors, its profits and valuation bodes well in comparison to those that are valued according to five-year expectations.

Final thoughts
Some investors might feel confident investing in a stock trading at 30 times sales, or a company with five years of continuous margin declines. However, in a market where momentum stocks are feeling pressure, fundamental analysis must be used to separate opportunities from value traps.

With that said, none of these companies are bad, but rather too expensive. Aspen and Ultimate are the only companies that provide investors with profits and growth while also being the cheapest as well. It is this fact that makes both good long-term investments following large stock losses.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends and 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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