Given the numerous negative articles on Seeking Alpha concerning Salesforce.com (NYSE:CRM) and other SaaS companies, it is becoming obvious that many do not understand the recurring business model of an SaaS company and the impacts that growth has on operating margin. To accurately value these companies, it is necessary to dig deeper than just the revenue line and the profits it generates over the very near term.
The value of an SaaS company can simply be stated as the profit a customer generates over its life cycle times the number of customers. Too often, people look just at the first year of revenue and the costs that are included to acquire the customer and the costs to provide the service. What is missed in such an analysis is that the second year and going forward, the costs to acquire that same customer are not repeated and the costs to serve the customer are leveraged over more customers as many of the costs are fixed.
The lifetime value of a customer is a function of the price charged (annually), the life of the customer (based on the renewal rate), minus the cost to provide the service to the customer (COGS, R&D, and G&A) and the costs to acquire the customer (CAC). The sales and marketing line, which is very large for all SaaS companies, is predominantly CAC (though not all -- I completely understand that there is an ongoing expense in sales and marketing to retain customers, but for the sake of simplicity I will omit that from this discussion as the amount is dwarfed by the spend for acquisition). So, looking just at the last quarter reported for CRM, revenue was approximately $585 million (with expenses excluding S&M it was $262 million), generating a profit of $323 million in the quarter. We can use this to approximate an incremental margin, which could be used to arrive at a long-term operating margin (again, excluding the S&M costs that are required to retain customers, which I will readily admit is not an immaterial amount, but substantially less than the current period spend) of 55%.
So what makes up the delta between the 55% operating margin calculated above and the single digit reported? The vast majority is customer acquisition costs, which are expensed upfront even though the value of the customer and the profit they generate occurs over a number of years.
In the case of CRM, it has been witnessing a decline in its attrition rate (improving renewal rate) that is now in the very low double digits (let's assume that means 12%), which indicates a customer lifespan of over eight years. As has been demonstrated by numerous SaaS companies, the typical total S&M spend approximates the next year incremental revenue. This suggests that with incremental operating margins of at least 55% the cost to acquire a customer can be recouped in less than two years, leading to the next six years-plus achieving a high margin and return profile.
Given the high return potential of a customer, and the stickiness of the product, it makes sense to grow customer count as fast as possible. And given the accounting policies that drop all the acquisition expenses immediately and layer revenue over the next eight-plus years, the current operating metrics misstate the true value being created.
On a final note, it does need to be stated that not all SaaS companies and operating models are the same. Stickiness of the application, the cost to deliver the service, and the cost to acquire the customer are very important, and the rate of customer growth will drive the valuation of a company. Focusing on just the current operating profit, disregarding the business model and growth, will lead to a poor analysis of the long-term value.