Photo Credit: Frank Farm (Flickr) 

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and Marketwatch.com

Some of our most successful Danger Zone warnings have been on overvalued cloud software companies, i.e. Demandware (DWRE) and Splunk (SPLK). This week we’ve identified another highflying cloud company that exhibits many of the problematic traits we saw in DWRE and SPLK. Revenue growth can only support a stock for so long and this week’s Danger Zone stock, Marketo (MKTO: $29/share) has plenty of room to fall.

Look Past Impressive Revenue Growth

Like many cloud companies, Marketo has used excellent revenue growth to woo investors into buying its “growth story.” The problem with this revenue growth is that is has not resulted in profit growth. Since 2012, Marketo’s after-tax profit (NOPAT) has fallen from -$34 million to -$65 million on a trailing twelve-month (TTM) basis.

Figure 1: Don’t Be Fooled By Revenue Growth 

Sources: New Constructs, LLC and company filings

The reason for the divergence between revenues and profits has been the cost of acquiring new customers. Since 2012, revenue has grown by 60% compounded annually but sales & marketing costs have grown by 62% compounded annually. General & administrative costs have grown by 50% compounded annually as well.

In an effort to keep investors’ hopes high for the future, Marketo’s growth at all costs strategy has come at the expense of the bottom line. NOPAT margins remain an alarming -36% on a TTM basis. Not exactly a value creating business model.

With negative profits and an increasing invested capital base, it should come as no surprise that Marketo earns a bottom quintile return on invested capital (ROIC) of -48%.

Marketo Faces Deep Pocketed Competition

By operating in the online marketing market, Marketo faces competition from multiple firms, many of which are much larger and possess a significantly larger resource pool from which to expand business operations. Making the landscape tougher for Marketo, its largest competitors have many other profitable business lines, which allow them to subsidize losses in other segments. Not surprisingly, Figure 2 highlights how much higher the ROIC is for Marketo’s competitors. Even Salesforce, a company we’ve previously been critical of is able to generate a positive return while Marketo’s ROIC remains well below zero.

Figure 2: Marketo Faces Steep Competition

Sources: New Constructs, LLC and company filings