Salesforce.com: Great Company, Exorbitant Valuation

Feb.26.09 | About: Salesforce.com, Inc. (CRM)

By any measure Salesforce.com's (NYSE:CRM) fourth quarter was an exceptional performance in the savage economic environment companies face today. Revenue grew by 34% yoy, earnings almost doubled, and cash flow rose impressively. There were also substantial new contract wins; gains from upstaging the giants (Oracle (NYSE:ORCL) and SAP) on their existing clients and outright wins on new tenders. Management was justifiably content with the quarter and their confidence reinforced about the future of Software as a Service within cloud computing. What’s there to complain about?

There is no problem with the company; it has demonstrated remarkable resilience and growth in a particularly stricken period. The problem is a significant moderation in the growth rate.

Although revenue grew 34% from last year, this only tells part of the success story - the bookings made and related to that specific quarter. The other part of the story is the change in deferred revenues, relating to contracts sold but due in future periods. So the overall customer success rate would be captured as an addition of quarterly revenue and the change in the deferred revenue over that quarter. This would give the true ‘customer traction’ over the quarter, and a year on year comparison would give a real growth rate without any seasonality, clearly a factor for the company.

The table below provides two series: the revenue growth and the customer traction rate over the recent history of CRM.

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Three key observations:

  • Jan. 2008 was a quarter where the force was truly with CRM and produced a 71% growth rate, along with a 30% share price lift in the following three months as investors digested the event. Naturally, this achievement set the bar for subsequent quarters.
  • Although revenue growth has moderated recently, it is still at a very robust percentage.
  • The customer traction depicts a markedly more somber picture, with a growth rate currently of 16%. Remember that figure: CRM is currently growing at 16%.

To reinforce the point, one needs to examine the cash flow. Cash rarely lies. This is relevant here as the deferred revenue would filter into cash but miss the income statement. The company’s cash flow for the year grew at 12%, remarkably similar to the 16% customer traction.

So my point is simply this: CRM is a great company with an exorbitant valuation. Would an investor pay a forward PE of 60 for a company that is growing its cash flow at 16%? Granted, any growth at all is a rare entity today, but after the major reset we have witnessed in share prices and company revenue forecasts, there are numerous companies that will grow earnings from the depressed 2009 base at a superior rate and sport a fraction of the PE multiple.

Combine this with the fact that this is the first quarter ever where management has not raised revenue guidance for the following year (they trimmed it marginally from $1.35bn to 1.33bn for FY10). They also forecast flat cash flow for the following year, due to higher cash taxes and capital expenditure, but let’s still say cash is growing at 16%.

The graph below depicts the same series. What happens to an exponential growth company whose growth isn’t so exponential anymore? No doubt, investors in FSLR or RIMM would prefer not to be reminded. May the force be with you.

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Disclosure: Short