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Salesforce.com's (CRM) lofty valuation (8x this year's revenue) is predicated on the idea that eventually it will generate high operating margins like the 30-40% seen at Oracle (ORCL), SAP (SAP), and Microsoft (MSFT). Is this a reasonable assumption? Let's use history as our guide. This is as much about Salesforce as it is about what I believe to be a bubble in the valuation of Software as a Service companies (note that we haven't seen a major takeout in this space since SAP bought Successfactors for $3.4 billion or 8x forward revs in early 2012). Without aggressive German takeouts, we are left with fundamentals..

First, let me give the common long investment case:

Salesforce.com has been wildly successful - look at the 10 year chart and the accompanying revenue growth which has made it the industry leader (14% share) from virtually nothing 10 years ago. It did $3 billion in revenue last year and will do $4 billion this year. When the company achieves scale we should see the 30-40% operating margins we see at Oracle /SAP. Software companies must spend a ton on marketing to generate 25-30% organic growth and can't generate operating profits while doing so. But looking forward to 2015-2016 we should have $6-7 billion in revenue and $2 billion in operating profit. Thus the $33-34 billion valuation (fully diluted), while expensive, isn't necessarily crazy. And we've got a lot of momentum.

But at what point does a company achieve scale? Is it impossible to generate profitability/necessary to lose money while growing the top line at 25-50%? To answer these questions, I looked back at old financial statements of other software companies - Oracle, Microsoft, SAP from the early 1990s when they were doing $2-5 billion in revenue and growing 30-50%.

Here is some Oracle history:

Year ended 5/31

1991

1992

1993

1994

1995

Revenue (in $ million)

1,027

1,178

1,502

2,001

2,997

Revenue growth

 

14.70%

27.50%

33.22%

49.78%

Operating Income

17.9

113.7

217

420

649.7

Operating Margin

1.7%

9.7%

14.4%

21.0%

21.7%

Equity

344.7

435

528

740.5

1211.4

Note the relatively low absolute revenue base, the high growth rate and…the strong operating margin.

Here is German Enterprise Resource Planning leader SAP:

Year ended 12/31

1993

1994

1995

1996

1997

Revenue (German Mark millions)

1102

1831

2696

3722

6017

Revenue growth

 

66.2%

47.2%

38.1%

61.7%

Operating Profit

228

449

652

944

1612

Operating Margin

21%

25%

24%

25%

27%

      

The German Mark/$ exchange rate was 1.8 so you can see that with a small revenue base (~$600 million starting point) the company grew at a very fast rate (compound annual growth rate here is 52+%) while generating a high and increasing operating margin.

Here is Microsoft:

Year end 6/30

1991

1992

1993

1994

1995

Revenue ($ million)

1843

2759

3753

4649

5937

Revenue growth

 

49.7%

36.0%

23.9%

27.7%

Operating Profit

640

990

1326

1726

2038

Operating Margin

34.7%

35.9%

35.3%

37.1%

34.3%

      

Ditto. Low absolute revenue base. High growth and strong operating margins.

For those who weren't keeping score, we are 3 for 3. When Oracle, SAP, and Microsoft were much smaller companies ($2-4 billion in sales) they were able to grow at a fast rate (25-60%) and generate 20-35% operating margins. I looked up Peoplesoft (which was acquired by Oracle) and the story was the same. Note that accounting rules did not require stock options to be expensed in the mid 1990s. Thus operating margins are overstated by 6-800 basis points (adjusted range is really 15-27% operating margins).

Salesforce doesn't have sufficient scale at $3-4 billion of revenue? Nonsense I say! The business isn't earning any money because either 1) its a bad business or (2) it is poorly run. There are a number of reasons to believe #1 - that Software as a service based Salesforce (with a large client base of small/midsized companies) will never be the type of software business that investors know and love/have loved (tough to argue that the market loves Oracle, SAP or Microsoft anymore but that's another discussion for another day). Reasons include: high structural churn (~15% vs. sub 5% for Oracle/SAP) because of 1) failure/acquisition in small/midsized company space (2) relatively low switching costs for Salesforce in general and software as a service specifically. While putting in an ORCL database/ERP system or SAP will take years (2-5 years) , cost tens if not hundreds of millions (not to mention organizational adaptation/training for system - interviews I've done w/ CEOs/CFOs suggest they'd almost never rip and replace an Enterprise Resource Planning system) this simply isn't the case with a Software as a service Customer Relationship Management system which can be deployed in a couple of months in some cases. High churn means Salesforce needs huge numbers of gross adds to grow. That is expensive. And if it's easy for customers to switch, it's easy for them to threaten to switch and haggle on price, thus depressing profitability.

When the rose color comes out of the glasses and people start thinking of a 10-15% operating margin business (at best, after a management change/restructuring) on a ~$5 billion base we are looking at maybe $750 million of projected 2015/2016 operating profit at a multiple of 10-12x. So my valuation target here is <$20/share.

Service Now (NOW), Netsuite (N), and Workday (WDAY) which are all trading at huge multiples (20x!) of revenue, and losing money at the operating line under the guise of 'we need to spend to grow'. We are in a software as a service bubble fueled by the lie that it isn't possible to generate profits while growing. This simply isn't true. These companies business models simply aren't high margin models. I suspect we will see significant valuation compression over the medium term. I'm short a basket and see even greater downside in some of the smaller players.

Disclosure:We/I am short CRM, NOW, WDAY, N and a few other SAAS companies.

Source: What Does Salesforce.com Have In Common With High-Margin Software Businesses? Not Much