Jim Cramer recently followed up his FANG acronym with the Cloud King stocks. Cramer has identified 7 stocks which are at the heart of the cloud revolution, a position which he thinks will make them long term winners.
But not all of those Cloud King stocks are destined for huge returns in the long run.
I agree that some of the Cloud King stock will remain kings in their respective area of the cloud. Those stocks will roar higher over the next several years. Big growth, mitigated competition and huge margin drivers will power those stocks to big gains.
But there are 3 stocks in the Cloud Kings group which I don’t think will fare so well in the long-term. The growth narratives aren’t as robust. Competition will erode growth and margins. And the valuations don’t seem to account for these risks.
Which Cloud King stocks would I avoid? Let’s take a look.
Cloud King Stocks to Avoid #1: Red Hat Inc (RHT)
Red Hat Inc (NYSE:RHT) provides cloud-hosted solutions which help companies digitize and modernize their business.
This is certainly a big growth engine, but growth really started to pick up after the company pivoted into helping corporations build out their own private clouds. After all, the future of the cloud is hybrid (part public, part private). Pivoting into private has allowed Red Hat to dominate a market that was largely untapped before.
Despite that big-growth talk, the numbers aren’t that good for Red Hat. Revenue growth is up roughly 200-300 basis points from last year, but it’s still only 20%. And it’s been stuck at 20% for the whole year.
While that is in-line with peer cloud companies, Red Hat isn’t benefiting from strong margin drivers like its cloud peers. Other cloud giants are pivoting their business models to high-margin subscription models, and consequently, margins are zooming higher. But Red Hat has already largely made that transition. And its subscription business is only growing at 20% per year. That isn’t that great in the cloud subscription world.
Moreover, because the subscription business isn’t really driving margins higher, margins as a whole aren’t zooming higher with the same velocity as other cloud players. Indeed, gross margins have been relatively flat over the past 12 months, while operating margins are up just 60 basis points.
Minimal margin expansion potential on 20% and slowing revenue growth doesn’t lead to explosive earnings growth. Indeed, over the 5 years, analysts are modeling for just 18% earnings growth per year.
That wouldn’t be a problem if RHT stock was trading at 20- or 25-times forward earnings. But RHT stock is trading at more than 46-times forward earnings. That multiple seems out of whack with less than 20% earnings growth.
As such, I think valuation puts a cap on RHT stock over the next several years.
Cloud King Stocks to Avoid #2: Workday Inc (WDAY)
Another one of the supposed Cloud King stocks which I’m avoiding is Workday Inc (NASDAQ:WDAY). Workday provides cloud solutions for enterprises looking to digitize their finance and HR departments. This puts the company at the heart of the automation trend, but with a fairly narrow focus. Automation will surely help grow Workday’s up-sell opportunities, but a limited focus on finance and HR somewhat limits the company’s total addressable market.
The numbers speak to this.
Much like Red Hat, Workday is victim to a slowing growth narrative at a time when the growth narrative should be ramping.
Just look at revenue growth. Workday started the year with 43% subscription revenue growth and 38% total revenue growth. The company ended the year with 34% subscription revenue growth and 33% total revenue growth. Next year, subscription revenue growth is expected to slow to 27.5% while total revenue growth is expected to slow to 25.5%.
Automation tailwinds should keep revenue growth big, but again, limited exposure to different aspects of automation implies that revenue growth deceleration will continue into the foreseeable future.
Meanwhile, margins are marching higher, but the pace at which they are growing is rapidly decelerating. Operating margins grew by nearly 900 basis points in the first quarter of last year. By the final quarter, operating margin growth had slowed to less than 400 basis points. Next year, operating margins are expected to grow just 200 basis points.
Why? Slowing revenue growth allows for less expense leveraging and less margin expansion. It’s all connected. Therefore, so long as revenue growth continues to slow, margin expansion rates will also slow.
Meanwhile, WDAY stock is trading at over 100-times forward earnings, making it one of the most expensive cloud stocks. Earnings growth over the next 5 years is expected to be between 40-45%, and that isn’t anything too special in the cloud space.
That will inevitably keep a lid on long-term upside in this name.
Cloud King Stocks to Avoid #3: Splunk Inc (SPLK)
Although Workday is the most richly valued Cloud King stock, Splunk Inc (NASDAQ:SPLK) isn’t too far behind. Also like Workday, Splunk is victim to slowing growth both in revenues and margin expansion.
Slowing growth on a big valuation isn’t a great combination, even for a Cloud King stock.
Splunk essentially operates in the world of turning data into actionable insights. This is a good place to be. The world is currently exploding with data thanks to the mainstream emergence of the Internet-of-Things (IoT). As businesses are flooded with more and more data, they will increasingly look to cloud solutions to turn that data into business insights.
As such, Splunk is looking at big revenue growth potential over the next several years.
This is also true because Splunk has already established itself as a trusted name (85 of the Fortune 100 companies are customers) across a broad spectrum of applications, from IT to business to IoT to security, the sum of which constitutes Splunk’s $55 billion addressable market. Revenues currently sit at under $1.3 billion, so there is clearly a long runway for big growth.
Despite all that, there is a ton of competition in this “turning data into insights” market. And that competition will only grow more fierce as the amount of data globally explodes.
This is why SPLK’s revenue growth is consistently slowing. Over the past several years, it has come down from 48% in fiscal 2016 to 42% in fiscal 2017 to 34% in fiscal 2018 to 28% expected in fiscal 2019. Meanwhile, the margin expansion rate is also slowing. Operating margins jumped 300 basis points higher last year. This year, that expansion is expected to be just 230 basis points.
Granted, 30% revenue growth and 200 basis points of margin expansion still leads to huge earnings growth. But as both of those numbers come down over the next several years (following current trends), then overall earnings growth will likewise come down. I largely agree with analysts that 30% and slowing revenue growth plus 200 basis points and slowing of margin expansion could lead to roughly 45% earnings growth.
But at over 100-times forward earnings, SPLK stock is more than priced for that 45% earnings growth. Such a big multiple relative to growth means that any hiccups in the growth narrative could lead to massive weakness in the stock. Considering the huge level of competition, such hiccups are inevitable going forward.
As such, I think this is a name to avoid. It could march higher as the amount of data continues to explode globally, but the upside is limited by the currently stretched valuation. Meanwhile, the same big valuation makes the downside risk look enormous.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.