Shares of Salesforce.com (CRM) have returned 49.2% over the past 12 months. At $170.42 per share, the stock is trading very close to its 52-week high of $176.96 attained just recently. Will the solid price uptrend continue? In this article, I will elaborate on my valuation analysis which may assist you in formulating the investment decision.
From a relative valuation perspective, CRM's valuation appears to be stretched based on the company's financial performance relative to its peers (see comparable analysis chart below). Sell-side analysts on average predict the firm's revenue and EBITDA to grow at CAGRs of 24.6% and 28.2%, respectively, over the next 2 fiscal years. The consensus growth estimates are markedly above the averages of 16.4% and 19.4%, respectively, for a group consisting of CRM's primary peers. However, the firm's EBITDA margin is forecasted to expand by just 1.0% over the same period, compared to the peer average of 1.4%. On the profit side, most of CRM's profitability and capital return metrics are substantially below par. The company carries a relatively higher level of debt as reflected by its above-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, CRM's free cash flow margin is only slightly higher than the peer average. Both the company's current and quick ratios are below par, reflecting a mediocre balance sheet performance.
To summarize the financial comparisons, CRM's superior revenue and EBITDA growth potential would be the primary support to the stock's valuation. However, given the firm's weak profitability, I believe the stock's fair value should not trade at a substantial premium over the peer-average level. Nevertheless, the stock's various valuation multiples are trading at an average premium of 67.9% over the peer-average trading multiples (see chart above), suggesting that CRM's strong growth prospects have been fully priced in and the stock valuation may be stretched.
Moreover, CRM also appears to be expensive from a historical valuation standpoint. The stock's current trailing EV/Revenue multiple of 8.5x is now trading at 11.0% premium over its historical 5-year average at 7.7x (see chart below). I believe the trading multiple premium cannot be substantiated by the firm's fundamentals provided that 1) CRM's capital return measures including ROE, ROA, and ROIC have declined gradually over the past 5 years and are currently in a negative territory; 2) the firm's profitability margins have also been trending down over the same period; and 3) despite a recovery in the top-line growth since fiscal 2009, the current revenue growth rate is still considerably below the level 5 years ago (see charts below).
I also performed a DCF analysis to support my view (see DCF chart). The model incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2018. The purpose of this analysis is aimed to gauge the assumptions that are embedded in the current share price and thus to test the investment's margin of safety. The terminal revenue growth rate is set to be 5.0% and the terminal EBITDA margin is assumed to be the same as the market's estimated margin for fiscal 2018. Other free cash flow related items including depreciation, tax expense, capital expenditure, and net working capital investment are projected based on their historical ratios relative to the total revenue.
Based on a WACC of 10.3%, a terminal growth rate of 5.0%, and an implied EV/EBITDA multiple of 15.8x, the model yields a stock value of $170.92, which is fairly close to the current share price at $170.42. From my view, some of the assumptions used in the model appear to be somewhat aggressive. The 10.3% WACC appears to be low for a high-growth stock like CRM that has a 5-year beta of 1.41. Since both revenue and EBITDA are projected to grow at 5.0% in the terminal year, the model's implied terminal year EV/EBITDA multiple of 15.8x is relatively high given that CRM's peers whose revenue and EBITDA growth rates are fairly close to the 5.0% level are currently trading at a much lower valuation in terms of the EV/EBITDA metric (see comparable analysis chart above). Moreover, the model assumes the capital expenditure/revenue ratio to be constant at 5.0%, which is notably below the historical average at 6.7%. Hence, the DCF analysis suggests a limited margin of safety on CRM's valuation.
Morningstar's research analyst, Rick Summer, had the following view in a recent research note which I tend to agree (sourced from Thomson One, Equity Research):
"Salesforce.com has been a pioneer in developing and selling on-demand software, leading it to a top position as the largest public cloud application vendor. Although the Sales Cloud drives the bulk of today's revenue, the firm also sells a services solution, a marketing solution, and a platform for third parties to develop and sell cloud applications. We are encouraged that the company continues to pursue billion-dollar revenue opportunities outside of its legacy Sales Cloud. Still, its acquisition strategy and pursuit of social marketing strategies should come into focus over the next year, and any disappointment may reverse the market's optimism for the stock."
The market's current sentiment on CRM remains very optimistic. According to Thomson One, of the total 42 analyst ratings, there are 13 strong buys and 22 buys. The chart shown below indicates that the market's consensus revenue estimates for CRM from fiscal 2013 to fiscal 2015 have been steadily trending up over the past 18 months.
Bottom line, despite CRM's robust growth potential and the market's optimistic sentiment, the stock's elevated valuation level and limited margin of safety suggest a very unfavorable risk/reward profile. From a contrarian perspective, I would assign a sell rating to CRM.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts are sourced from Capital IQ unless otherwise specified.