SaaS or software as a service has become the new hot water for salesforce (NYSE:CRM). The valuation of the share overestimates the innovative and game-changing nature of this trend. In the late nineties, the idea of "applications on demand" started as an alternative to the incumbent software providers. The enterprise software stack ran a company on its proprietary network in a closed ERP system or centralized relational database. In order to break the license and maintenance fee model, a new approach was in order. The market had to wait another 10 years before the idea really took off. The bottleneck was the cost and the reliability of the bandwidth that feeds the data from the external servers to the company.
Bandwidth was the catalyst
The exponential improvement in bandwidth to Gigabits per second led to a better utilization and scalability of IT power. This trend has many shapes and forms and the market is easily confused about the potential on each level. The benefits of "cloud" computing are now uncontested. However, the virtualization trend has already swept through the large enterprise landscape. The success of VMware (NYSE:VMW) and Citrix (NASDAQ:CTXS) is well documented. Many large enterprises have reaped the benefits of low bandwidth costs and outsourced their IT infrastructure. They have already rationalized their software stack. There is little incentive for these companies to switch from their virtual infrastructures to a complete SaaS solution. Most of the immediate cost benefits have been utilized. For strategic reason, companies still want to own the key application software or at least the database behind it. This article gives some more background on the cloud infrastructure flavors and explains some of the difficulties of running a SaaS shop. The appeal of salesforce.com is well illustrated with the Obama election team contract. For a fast and flexible solution without much going concern, there is probably no better alternative.
No party like 1999
The latest round of broker target hikes have compared salesforce.com growth with the growth track records of MSFT and ORCL. The weakness in this comparison is that MSFT and ORCL quickly became unique in their size and offering. They competed against one or two equal size players and a bunch of smaller competitors. They generated so much cash from the early days, they could swallow the competition in new verticals. Oracle bought Siebel in 2005 to add CRM capacity for $5.8bn. Peoplesoft was bought after a two-year battle in 2004 for $10 bln and launched Oracle in the core ERP stack. Salesforce.com is growing fast, but its cash generation is by no means sufficient to take out Microsoft, Oracle or SAP. The incumbent players also offer cloud services, but are reluctant to cannibalize their steady maintenance revenue. The "social network" image of CRM is neither proprietary or impossible to integrate for the large incumbents. They can spend more R&D or buy a start-up in social enterprise media if it becomes a critical factor for its large clients. That is the advantage of a cash-rich incumbent that can leave the first mover mistakes to the challengers.
CRM is an inflated M&A currency
Salesforce.com is acquiring companies as if it tries to soak up all new initiatives before the incumbents can get their hands on it. This is unlikely to succeed. There is too much innovation and most new media platforms like Twitter and Facebook are open platforms. All the cash that enters the company, including deferred sales, is invested in new growth acquisitions. This growth generates higher CRM share prices, because the stock is purely valued on growth. The company seems to avoid making profits in order not to get stuck on a PE multiple. It has been able to sustain an Enterprise Value to Sales of around 7 to 8 times. This was easy to explain when it was a nimble company with a couple of 100 million in sales and huge growth potential. It is a bit awkward with a company already pushing billions in sales. The high multiple is the currency that the company needs to keep the key people from the acquisitions on board with stock options. Since the IPO in 2002, 30 million new shares have been created or a salary equivalent of $4.8 bln. The company simply needs a high valuation to stay successful. It acquires left, right and center to add sales to the core business. The new people and functionality have done little for the profit line as EBIT losses have increased.
Show me the growth
The core CRM business does not generate anywhere close to the growth rates needed to sustain a 7x sales valuation. From sales automation, the CRM opportunity was an easy expansion for the company. Between 2005 and 2008 the company increased its market share in CRM from 3% to 9%. The CRM market itself grew from $9.0 bln to $10.5 bln. CRM grew its CRM sales from $270m to $945m, a 51% annual growth rate. The IDC overview now shows a 10% market share in a $11.9 bln market, a mere 7.4% annual growth rate. As the growth slows down, CRM is caught in a catch-22. It needs growth to support its share, so it can buy other companies and keep the people on board with stock options. This shares some characteristics with a pyramid game, but the model is not new in the technology sector.
CAPEX is spent before cash is earned
The subscription model of SaaS is more capital intensive than the traditional license-maintenance fee. Because it has to gain market share in a crowded market, there is no visibility on the long-term profitability of this model. CRM also needs to buy infrastructure with infrastructure providers that enable the service. How much profit it leaves on the table for companies like IBM Websphere is hard to estimate. It is clear that unlike CRM, IBM is a for-profit company that has been able to monetize part of the cloud trend. Also Oracle is not unfamiliar with running infrastructure.
What is the risk of shorting CRM
CRM is labeled a growth stock. Growth has become a scarce commodity in the current macro environment and can demand a premium. There is nothing wrong with that. The biggest growth stock in the universe, Apple, has lost its image as growth "perpetuum mobile." The sheer size of 600 bln of 'growth equity' mass has now been reduced to 500 bln. That is 4x the market cap of CRM. Growth funds that are running away from Apple have very few options. Amazon has a similar opaque business model as CRM and PE multiples are also meaningless. The short interest is relatively high with 15 million shares betting on a share price decrease. This might indicate common sense. It also constitutes a significant risk on a short squeeze. The top-20 institutional shareholders control 73% of the free float and are mostly buy and hold types. This is the ideal hedge fund pump and dump territory. Some brokers are front running the share price with higher targets. The two last quarter results were hardly exciting. The consensus has become immune to the losses. In 2008, the consensus expectation was calling for EBIT margins of 19% by 2011. That did explain the share price at the time, but now the market has ditched profitability as a valuation instrument.
The price a fool will pay
How long and how high the stock can go before rationality sets in, is the $25 bln question. The stock just got a technical boost from breaking the $160 level. Broker targets are edging now toward $200 and will have a hard time re-setting higher without positive news momentum. An acquisition by a competitor is unlikely. Even for Oracle, $30 bln is a lot of money, despite Bernanke's printing efforts. The recent strong market momentum has also benefited CRM with a beta of 1.40. A short position can be taken with a horizon beyond three months. A stop-loss is needed as the pump risk is quite large. I would keep some cash ready if a short squeeze materializes and an opportunity north of $180 arises.