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Salesforce.com (NYSE:CRM)

F3Q10 Earnings Call

November 17, 2009 5:00 pm ET

Executives

David Havlek - Investor Relations

Marc Benioff - Chief Executive Officer

Graham V. Smith - Chief Financial Officer

Analysts

Mark Murphy - Piper Jaffray

Sarah Friar - Goldman Sachs

Analyst for Heather Bellini – ISI Group

Adam Holt – Morgan Stanley

Laura Lederman - William Blair & Company

Kash Rangan - Merrill Lynch

Analyst for Michael Nemeroff - Wedbush

Brent Thill - UBS

Robert Breza - RBC Capital Markets

Operator

Welcome everyone to the Salesforce.com Q3 fiscal 2010 financial results conference call. (Operator Instructions) Mr. David Havlek, Vice President of Investor Relations, you may begin your conference.

David Havlek

Thank you. I would like to personally welcome everyone to Salesforce.com’s third quarter financial results call. After a few opening comments to make today’s call official, I will turn things over to our Chairman and Chief Executive Officer, Marc Benioff, to review the highlights of the quarter. Graham Smith, our Chief Financial Officer, will then provide some detail on the financial performance of the quarter before we open things up to your questions.

Tomorrow is the kick off of Dream Force, our biggest user conference of the year. We will try to keep our call a bit more brief than past calls. In that context if we are unable to get to your question today please be advised that both Marc Benioff and Graham Smith will be hosting an in-person Q&A session at 1:00 PT tomorrow. If you are unable to attend that session in person it will be webcast.

With that let me quickly remind you that a full disclosure of our third quarter results can be found in a press release issued about an hour ago as well as in our Form 8-K filed with the SEC. Additional financial information, including historical financial detail beyond what is provided in the press release will also be made available on our website. Today's call is being live Web cast. A dial-in replay will be available shortly following the conclusion of the call until December 8, 2009, and a web cast replay will be made available for approximately 90 days. To access the press release, the additional financial detail, the Web cast replay, or any of our SEC disclosures, or simply to learn more about Salesforce.com, I encourage you to visit our Investor Relations Web site at Salesforce.com/Investor.

All of our financial commentary today will be in GAAP terms unless otherwise stated. In addition, at times in our prepared comments or in response to your questions, we may offer certain additional metrics to provide a greater understanding about our business or our quarterly results. Please be advised that we may or may not update these metrics on future calls.

The primary purpose of today’s call is to provide to you the information regarding our fiscal third quarter. However, some of our discussion or responses to your questions may contain certain forward-looking statements. These statements are subject to risks, uncertainties, and assumptions. Should any of these risks or uncertainties materialize or should our assumptions prove to be incorrect, actual company results could differ materially from these forward-looking statements. All of these risks, uncertainties, and assumptions, as well as other information on potential factors that could affect our financial results are included in our reports filed with the SEC, including our most recent Form 10-Q, particularly under the heading Risk Factors.

Please also be advised that any unreleased services or features referenced in today's discussion or in other public statements are not currently available and may not be delivered on time or at all. Customers who purchase our services should make the purchase decisions based on features that are currently available.

With that let me turn the call over to Marc.

Marc Benioff

Thank you David and welcome everyone to our call. We are very excited to share our results on the first fiscal third quarter and let me just begin with some of these exciting financial highlights. Revenue grew 20% from a year ago to approximately $331 million and this result was well above our outlook entering the quarter primarily as a result of improvement in new business demand and lower attrition.

At this level our annual revenue run rate is now more than $1.3 billion and we continue to be the fastest growing software company of our size in the world today. GAAP EPS of $0.16 as double the $0.08 we reported a year ago. Operating cash flow of $36 million was over 100%, actually it was 107% from a year ago and we now have nearly $1.1 billion in cash and marketable securities on our balance sheet.

By virtually every financial metric Q3 was an amazing quarter. Graham will have more to say about all of the financial details in just a moment.

Now while our financial results were outstanding, perhaps the most exciting part of our quarter was the improvement we saw in some of the key growth drivers of our business. On our second quarter call in August we discussed seeing signs of stabilization in our business, if you remember the call. However, based on our third quarter performance we now believe we are seeing some very early signs of improvement in some very key areas. That is really causing us to enter a growth stance in our company.

First, on a year-over-year basis new business performance was up in the third quarter and was our best growth quarter of the year. As a result we now expect new business for the full year to be flat to slightly up. Now, this is a big change from the first and second quarter when we thought new business for the full year would be flat to slightly down.

Next, and just as important, after seeing increases in attrition over the past several quarters, we saw a lower dollar attrition in the third quarter and finally customer demand for our services has never been greater. During the third quarter we added a record 4,700 net new customers. That is some 500 more than we have ever added in a single quarter and all our global customer community is now more than 68,000 customers despite this challenging economic environment. We are up 30 % from a year ago.

In light of our solid second quarter results and our improvement in the ones I just described in the third quarter we began to increase investment in key growth areas during the third quarter or enter as I commented this growth stance. This required more hiring and demand generation activities in preparation for next year.

Now let me take a moment to review some of the key wins in the third quarter. Our two marquis transactions this quarter were both in Japan where we continue to see just remarkable momentum. First, I am thrilled to announce that AIG Edison signed an ELA with Salesforce.com during the third quarter. In addition to the roughly 5,000 sales people that will be sales cloud we offer, AIG is also using the service cloud to build a customer portal that is expected to serve more than one million users and AIG Edison also plans to use the Force.com development platform to build applications demanding new contracts and insurance payments. In all of these applications, as well as their data, will be available in real time to employ via their smart phones in Japan.

AIG Edison is an excellent example of how our multi-cloud strategy, the sales cloud, the service cloud and the custom cloud is allowing us to grow beyond sales. It is just now about sales anymore because a Force.com platform is allowing us to create success in other great new areas like contract management or in the case of AIG Edison we are able to expand our footprint inside of our customer’s themselves. As a result, every employee at every business of every size is seriously a prospect for Salesforce.com.

Also in Japan the flagship implementation with Japan Post continues to grow very nicely. In order to expand their use of the Force.com platform, Japan Post decided to upgrade to unlimited edition, in addition to the applications they have already built for areas like product sales reporting on the platform, and ad space management on the platform, audit management and claims and access management in the platform, they are now expanding to build new things like sales information and commission management, IT asset management and a post office master application.

Japan Post is one of the most impressive customers we deal with, managing over 100 million savings accounts in Japan, working with over 400,000 employees in over 25,000 locations and managing 6.8 billion transactions in a year. They have a lot of data to manage. More of that data than ever before is moving to Force.com.

In addition to these great new wins we also won other major transactions at a long list of new and existing customers including Akamai, ING Australia, Net One Systems, the US Census Bureau, [Avaya and EMC]. Now according to AMR Research the growth of cloud computing is expected to outpace the growth of on-premise by double digit percentages over the next five years. Now nothing speaks more to this shift than our list of wins against the big, on-premise companies. Let’s start with Oracle.

Against Oracle we won deals at ING, American Express, Centex, PR Newswire, Phonographic Performance, and even more exciting another one of Oracle CRM on-demand’s very top and premier customers in the technology industry has made the decision to convert to Salesforce.com. Through that customer’s request we are not giving their name but they are one of a growing list of former Oracle CRM on-demand customers who have made a decision to convert to Saleforce.com including Success Factors, Motorola and Axion.

Although we are competitors, I do want to offer my very personal thanks and my kind regards to Oracle for graciously including us in their Oracle Open World Conference this year. On a serious note this meant a great deal to us and we commend Oracle for their openness in the environment and their ability for customers to see solutions of all types. Certainly when I was at Oracle this was our value system and I am delighted to see that continue. We had an outstanding experience at Oracle Open World and I couldn’t be more grateful to the Oracle executives who allowed us to attend the conference. We are very honored.

Roughly 5,000 Oracle Open World attendees visited our booth during the vent. We believe that was the number one booth visited during the conference and more than 750 people braved the weather to join us for a full presentation at [inaudible] center, on our presentation on Service Cloud II.

It was a fabulous event and evidence that even the most diehard on-premise software companies like Oracle are looking for ways to integrate cloud computing into their IT environments and I just want to again take my hat off to the executives at Oracle Corporation for including us in the event.

We also had success against Microsoft in the quarter at MCSI, Needham & Co., Denmat, Vital Images, [inaudible] College in Nevada and finally while license deals report a long list of wins against SAP, once again as I mentioned in last quarter’s script I don’t know whether it is through their own operational performance or their position to not participate in the Salesforce automation or customer service markets, they remain largely invisible on our market space.

However, we are pleased to see our largest SAP installed base accounts add to their sales force deployments including companies like Thomas Cook, Lenovo, Kellogg’s and Schwan’s. Add on an upgrade activity at industry leading companies like these and others it is another key of our growth formula.

In addition to our competitive wins, I am also pleased to report that our team continues its diversification in our business. That really includes our sales cloud, service cloud and our platform cloud (our custom cloud if you will), and our service and custom cloud business both reported record sales quarters in the third quarter both grew more than twice the rate of our overall sales cloud, really speaking to our customer’s adoption of these exciting new technologies as well as us entering new markets.

Together our non-sales cloud businesses were responsible for roughly 25-30% of new orders in the third quarter and when we talk about our new business being now flat to slightly up for the year you can really look to the exciting growth in these new products as a key reason why we are growing new business while those traditional enterprise software companies continue to see dramatic double digit declines.

Now our Service Cloud II is really connecting with our customers. Customers love our vision for customer service call centers and self-service portals. In the age of the Internet, in Q3 we made several key announcements in the launch of Service Cloud II. Many of you participated in those worldwide events that happened in Japan and San Francisco, New York, London and other places including Salesforce Knowledge, the world’s first multi-tenant, multi-channel knowledge as a service. We were the first to deliver. Bam, you can have knowledge as a service. Knowledge is a huge market. Knowledge management is a huge market and critical in the customer service market.

It is 100% Force.com product, written natively in our platform, leveraging all of our security, reliability, scalability and powerful customization technology as well by visual course and Apex. If you have attended any of those demos I am sure you have seen that. If you didn’t attend those demo’s you should go onto You Tube and type Service Cloud II or Service Cloud Knowledge and you will see me or others giving these demonstrations of these new technologies. You Tube is a tremendous vehicle for you to see all of Salesforce’s technology as we put more and more of our presentations and demonstrations on You Tube.

Salesforce knowledge is available for compact center, customer portals and sites. Also, as released as part of Service Cloud II is Salesforce answers and if you have used that “answers” type functionality and kind of consumer services you know the power of our customers now being able to deploy answers for their own capability. Our solution for cloud source community knowledge that allows customers to tap into and listen to the cloud. We also teamed up with Cisco to offer a complete cloud contact center solution. This is just really cool.

Basically not only can you get all of the CRM services from Service Cloud II from us directly as a service right over the net, but all of that kind of IP and telephony and CPI infrastructure is also delivered directly as a service from Cisco. Really, really impressed with Cisco’s commitment to the services world, to cloud computing, by making their CPI as a service is evidence of that. I think last weeks’ announcement with Cody going through things like WebEx mail and all of their exciting movement to cloud computing is just a home run for Cisco and I would just like to congratulate them on their continued investment in cloud computing.

Finally, there are sales for Twitter, which allows customers to monitor and track conversations from Twitter from within service cloud, you are going to see a lot more of that tomorrow at Dream Force. Not only did we enhance our customer service offerings in the third quarter with Service Cloud II, we also announced an exciting new technology as well in the form of the five minute upgrade. Very simply, we already run kind of replicated data centers. Now the ability is while we are doing upgrades we keep our backup center live with our customer’s data giving them the ability to read that information. Then when we finish the upgrade all of the read/write capabilities are restored but in no case is the customer’s data unavailable, or at a maximum of five minutes.

This is a breakthrough in cloud computing. Really it is evidence of the power of having a multi data center architecture. We have three major data centers now that are in production on Singapore, on the West Coast and the East Coast of the United States. The network and meshing of these data centers has become a huge competitive weapon, when we look at many of our competitors who only have one data center, which is extremely unusual.

Now, new Service Cloud customers in the third quarter included AIG Edison, Google, [inaudible], Fujitsu Learning, Mitchell, [inaudible] and ACI Worldwide. In all there are more than 8,000 companies around the globe experiencing what Service Clouds do. Our custom cloud is also showing very strong momentum. Not only are we posting record sales results but transactional activity on the Force.com platform continues to grow at an outstanding rate. Just listen to some of these numbers. Now you know a few months ago we turned our ability for any Force.com app it instantly becomes a website. Now our customers have already built 10,000 websites with 170 million page views coming out of Force.com sites.

They bought no hardware. They bought no servers. They didn’t have to set up systems with Akamai or Limelight or any of those things. We do all of that power for them. 10,000 websites, 170 million page views. More than 135,000 custom apps built on Force.com’s platform. For those of you who are attending Dream Force tomorrow we are going to make some big announcements around that. You will be able to talk to many of these customers that have done this tremendous work and more than 200,000 developers in our developer program now today. More than 500,000 custom digital force pages have been traded. You probably remember it was two years ago at Dream Force that we announced that.

Now our customers have built ½ million customer user interfaces live in our system. Just making it incredibly fully integrated into their business processes. More than 188 million lines of Force.com code. That is the stored procedures, the triggers, the code we want to run on our servers is more than 12 times the 15 million times of code we had written just a year ago. If you remember I believe Apex announcement was three Dream Force’s ago. Now we are at 188 million lines of code. After our offer began in June more than 15,000 companies have already signed up for our new Force.com free edition spurring on application development and deployment as we look to remove the boundaries until software developers understand how to use this great new technology against .net and java.

The reason why? According to IDC, building apps on Force.com is five times faster and half the cost of .net or java. That is a great message for times like these. Of course there are a lot of other critical benefits to Cloud Computing. The appeal of our cloud platform, cloud infrastructure and cloud apps has grown as we have expanded the possibilities of enterprise cloud computing. You are going to find out as I have already alluded to a couple of times, we are going to seriously and comprehensively re-write the rules again.

Tomorrow we are going to kick off our biggest and baddest, most impressive Dream Force ever. We already have about 18,000 people registered for this event. That is amazing for us. It is significantly up from last year, as you know where we were I think at about 10,000. So a big, big increase for us. We expect it to be a full house tomorrow. You had better come early if you want to be in the main keynote room. Otherwise we will have an overflow room available as well.

But you are going to see our vision for the future of cloud computing and not just at the enterprise software industry. We are going to bring together some tremendous concepts. I am not going to go into details on the call. I am going to save it for tomorrow. But believe me, by the time I get to the investor lunch we are going to have plenty to talk about and how we have fundamentally changed what is CRM. What is custom application development and deployment. What are enterprise apps. What do customers want to be doing. Let me tell you that you know we have three clouds; our sales cloud, service cloud and our custom cloud. We will have a fourth cloud tomorrow and we will begin a Cloud Force II celebration tour to introduce our almost 70,000 customers around the world to this fourth cloud which we believe they are going to love it.

I am willing to kind of put my reputation on the line here on this call to say that by the end of the keynote tomorrow if these customers aren’t shooting out of their seats then something is really wrong over the past year creating this product. Finally, you want to save Thursday for some huge ISV announcements. We are going to have some of the biggest CEOs in software there. Top ten, independent software company CEO’s who we have not yet announced will be coming to talk about their technology being written natively on Force.com.

You will be very surprised when you see who the first person on the stage is on Thursday and who follows that individual because these are perhaps the top CEOs in the software industry, in enterprise software, seen in the same shows as Force.com as their software service, cloud computing standard platform, taking some of their mainstream products and move them onto Force.com.

We think this is a key catalyst for our customers to have the confidence and the motivation to go even further with Force.com. Then we will move into a tremendous keynote with one of the great speakers in the world, Collin Powell. Again, we are just expecting our best Dream Force ever. I am looking forward to seeing all of you there. I am looking forward to talking and taking questions at the lunch and to review all of the announcements that are going to happen tomorrow, and also again there are going to be some great announcements on Thursday. Some tremendous announcements on the platform day as well.

With that, let me turn it over to our Chief Financial Officer, Graham Smith, for a detailed review of our excellent third quarter financial results.

Graham Smith

Thank you Marc. Solid execution and an improved demand environment enabled us to once again report excellent results for our fiscal third quarter. We saw continued strong revenue growth while earnings and cash flow growth doubled from a year ago.

Let me begin with a brief review of the P&L. As Marc indicated revenue for the third quarter was approximately $331 million, an increase of 20% from the year-ago quarter and well above our previous outlook. Three factors contributed to the performance. First, as Marc mentioned our new business growth rate in the third quarter was our best this year. On upgrade business, which is an important component of overall new business saw a significant improvement too, particularly in our SMB business.

However, although the demand environment felt better in Q3 than it did in Q2 it is important to understand we are still managing in a generally tough environment with longer sales cycles and smaller average deal cycles.

Second, although our dollar attrition rate remains in the high teens, it did decline for the first time in several quarters. Third, a weaker dollar clearly helped the top line. Excluding the effects of roughly $4 million year-over-year currency benefit, revenue growth in constant currency was 18% or 2 points less than our reported growth rate of 20%.

International revenues grew more rapidly than North America. International reached 30% of total revenues for the first time in Salesforce.com’s history. Americas revenue was approximately $233 million, a year-over-year increase of 16%. Europe revenue was approximately $61 million, a year-over-year increase of 26% in dollars and 24% in local currency. In Asia revenue was approximately $37 million representing dollar growth of 31% and local currency growth of 21%.

GAAP gross margin for the quarter was approximately 18.2% up roughly 60 basis points from a year ago. Our gross margin improvement in Q3 was a result of a mix shift between revenue lines, high margin subscription revenue replacing more of our total revenue, representing I should say, more of our total revenue than low margin professional services. Average selling price per subscriber for each service addition continued to be stable.

Turning to our operating performance, GAAP operating margin for the third quarter was roughly 9.1%. That is up 330 basis points from last year. For the three quarters of this fiscal year, our operating margin is 9.4% which is also up 330 basis points versus the same three quarter period a year ago. We are pleased with our progress against the 250 basis point target we set at the beginning of the year.

We achieved these margins while absorbing stock based compensation expense of approximately $20 million in Q3 and $63 million for the year-to-date. Excluding those expenses our operating margin would have been roughly 15% in the third quarter and roughly 16% for the full year-to-date.

We finished the quarter with roughly 3,800 employees. That is an increase of approximately 160 from last quarter. As Marc mentioned earlier, we made the decision to significantly increase our hiring in Q3 as a result of the stabilization in new business we had seen in the second quarter. Based on our Q3 results, we believe this was definitely the right decision. While we have increased our rate of hiring, and are once again focusing on the distribution capacity to position us for growth, we don’t anticipate returning quite to the high levels we saw last fiscal year; certainly until we see a few more quarters of growth in new business. In the meantime we expect our rate of hiring in Q4 to be similar to Q3.

Moving onto cash flow, operating cash for the third quarter was approximately $36 million. That is an increase, as Marc mentioned, of just over 100% compared to Q2 last year. On a trailing 4-quarter basis we generated nearly $255 million of operating cash flow or just over $2 per share. We expect Q4 operating cash flow to be slightly higher than what we generated in Q4 last year.

Free cash flow which we define as operating cash flow less capital expenditures was roughly $21 million for Q3. Over the past four quarters free cash flow of $196 million translates into roughly $1.50 per share.

Moving onto the balance sheet, strong cash generation over the past year created a cash and cash equivalents balance of $1.7 billion approximately at the end of Q3. That is an increase of just around $265 million from a year ago. This total cash balance equates to about $8.50 per share.

Deferred revenue rose 16% from a year ago but declined $4 million from last quarter to $545 million. In constant currency terms the sequential decline was closer to $10 million after taking into account the roughly $6 million currency benefit we experienced in the quarter from the weakening dollar. Invoice durations which can have an impact on deferred revenue did not change meaningfully during the third quarter.

We expect deferred revenue to increase significantly in Q4. Our best estimate is by a similar amount to last year. But, as we have described on prior calls, there are many factors that can impact deferred revenue including; average invoice duration, invoicing linearity in the quarter, foreign currency movement, early renewals and so on. In this context it is important to understand that it is difficult for us to predict movements in deferred revenue with a great deal of precision.

So let me close with our outlook. We are encouraged by stronger new business, lower attrition and our biggest customer addition quarter ever. In that context we now expect Q4 revenue to be in a range of $340-342 million. This has the effect of raising our full-year guidance to approximately $1.29 billion up from our prior estimate of $1.27 to $1.28 billion. Because the demand environment improved in Q3 and because growth remains our top priority, as I mentioned earlier we are expecting to continue hiring in Q4 at roughly the same pace as we did in Q3.

We have expanded the scope of Dream Force to accommodate an even larger audience and we estimate that Dream Force’s net cost will reduce Q4 EPS by roughly $0.04 versus roughly $0.02 a year ago. With that context, we expect fourth quarter GAAP EPS to be in a range of approximately $0.14 to $0.15 which has the effect of raising our full-year guidance to $0.62 to $0.63 and this EPS estimate includes the following approximations for Q4; $26 million of stock based compensation; $2.6 million in amortization of purchased intangibles related to previously announced acquisitions, a non-controlling interest charge of $1.5 million, a GAAP tax rate of 40% and an average fully diluted share count of approximately 132 million shares.

Over the past three years we have grown revenue from just under $500 million to almost $1.3 billion and at the same time improved our operating margin from breakeven to just below 10%. Of course that is a GAAP operating margin. While we remain committed to improving margins our primary focus continues to be growth. We currently expect revenues for fiscal 2011 to grow by approximately 15-16% over fiscal 2010. It is difficult to be more precise at this point because we have Q4, our largest new business and renewal quarter ahead of us.

As far as profitability is concerned next year, although we haven’t finished our detailed planning, we are not necessarily expecting our operating margin to grow at quite the same pace as it has for the last three years. We will provide more details when we announce our fourth quarter results.

To close, we are very pleased with our Q3 performance and believe we are well positioned to finish the year with a strong Q4. I look forward to seeing many of you at Dream Force tomorrow. For those who can’t make it, I look forward to discussing our fourth quarter results in February.

With that I would like to open the call up to your questions. Operator?

David Havlek

Just quickly while the operator is queuing your calls, let me quickly provide some detail on some of the planned activities we have tomorrow at Dream Force for the analyst community. First, as a member of the financial community you are a VIP attendee. On arrival please proceed to VIP Check In, get your badge and information. As Marc noted, you are entitled to special VIP seating at his keynote at 9 a.m. tomorrow morning. Go to the VIP sign at the front of the main stage. Please plan to get there early because we are expecting a packed house.

After the keynote you are invited to a special VIP luncheon with company execs, customers and partners. That lunch is in [inaudible] North, Room 135 and then there will be a Q&A session with Marc and Graham at 1 p.m. following the lunch. All of these sessions will be web cast. Those of you who pre-registered we have pre-populated your calendars complete with meetings [inaudible] or iPhone the details. You should have also received an email and you can contact any of your IR folks here at Salesforce. If you haven’t registered it is not too late. Walk up’s are welcome. I look forward to seeing you tomorrow.

With that…

Marc Benioff

Let me just add one thing to that. I think it is extremely important for the financial analysts, the technology analysts and the press that are attending tomorrow and listening to this call and others who are not, unlike a lot of other vendors who tend to herd the analysts or control the analysts into certain rooms or certain programs, ask them to attend only certain things or create a controlled environment for them, that is not our position in our company. You are free to attend every keynote. You are free to attend every breakout session and there is a huge trade show floor of several hundred ISV’s who are building on our platform where you can assess the quality of their applications and the momentum of the market, as well as we have mentioned over 18,000, maybe 20,000 attendees there tomorrow.

We want you with them. We want you talking to them. You are free to attend the lunch. No hard feelings if you don’t want to because we really want to emphasize you are free to do whatever you want. It is a key part of who we are as a company. We know other companies are not like that. We just want to reinforce to you it is not a controlled environment for financial or industry analysts or press or bloggers. You have free reign of the conference. We will make all things available to you including the Black Crowe concert tomorrow night.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Mark Murphy - Piper Jaffray.

Mark Murphy - Piper Jaffray

We are occasionally running into customers that are indicating Salesforce.com has become a top three or top five line item in their IT budgets. In many cases they say they are not scrutinizing it because of the value it has created. I am just wondering if you can comment on the role that Force.com is playing in terms of driving customers to purchase those kinds of VLA’s or creating other kinds of stickiness within the customer base?

Marc Benioff

You are really touching on really our fundamental core product strategy which is to cement ourselves as the standard in the enterprise of our customers. Of course in many cases we have started a small implementation or what we refer to as “seed.” We then talk about how we want to grow those implementations. Then we tried and turn those implementations into what we call ELA’s or enterprise wide agreements.

The technology you will see announced tomorrow and released in the first part of next year, that you will see when we announce it and when we release it I will just give you a little preview. The strategy behind it is an expansion strategy. It is all about we have looked at the category that we think will accelerate users into the enterprise.

How do we go from a Trojan horse strategy where we have gotten through the doors and the horse is there in the middle of the city but we want lots and lots of guys to come out of the horse. To do that of course we have the sales cloud with the service cloud with a lot of customer applications. That is what you are seeing with these customers who have built these custom applications so we are beyond sales and service users and then to other things like recruiting and project management or so forth we have built an application we believe will take us much, much further and as we have detailed conversations about this which I am looking forward tomorrow at lunch, you will see and keep in mind during my keynote the whole fundamental strategy; the product strategy, the packaging strategy, the pricing strategy, the feature strategy, the branding strategy, is to move our approximately 70,000 customers to be enterprise wide with us.

We think the biggest expansion opportunity for growth and our growth stance is in many cases within our own customers. Although we added a record number of customers this quarter at 4,700, we continue to make this a major theme of the company. It is how we compensate our sales people. It is the work we do in these kind of cloud forces where we schlep around the world and kind of keep reiterating our conversations because the reality is customers are looking for new ways to manage and share information and they are tired of getting the answer from Microsoft, buy more people servers, buy more visual studio, buy more Oracle databases.

They are looking for new ways to do that. One of my big revelations when I went to Oracle Open World was spectacular conference. It is hugely accelerated from when I was last there which was actually in 1999. But, I was shocked that as I went up and down all the little escalators that as I got to the bottom of a lot of the escalators I was greeted by an Oracle [eXo data] computer. While I understand [eXo data] computer is great for Oracle’s strategy and I am sure it is a high margin product and I am sure it is high quality and well made and the point of course for every Oracle customer as they came down the elevator to look at the [eXo data computer] and it has flashing lights on it and all these things is “buy one.”

That is when I said, wow, this is a clear differentiation of strategy. Where certain vendors their strategy is to sell you more hardware and more software and continue to enrich their cash cows, our strategy is no software or hardware at all. I think customers will want that message and I think in this environment need that message. I think that has really helped us and I think you will see from this quarter’s results we have that. Keep this in mind at the point tomorrow this is our key strategy that we want to be enterprise wide. When we go to our customers, there is a certain customer this week and I won’t tell you who it is, they have a few hundred thousand employees. We are in the tens of thousands employees with them and I am like how do we get the other 270,000?

I have that in the back of my mind and I think that this service that we are going to be releasing in the first part of next year that we are going to announce tomorrow is going to be a key way to do it. I am very motivated, excited and pumped up about it and it is hard for me not to give you any clues but I really believe and I agree with you that our opportunity is enterprise-wide and that is where I have the mindset of our management team.

Operator

The next question comes from the line of Sarah Friar - Goldman Sachs.

Sarah Friar - Goldman Sachs

I wanted to ask about the forward guide for fiscal year 2011. I appreciate you putting a stake in the ground but as I look at it suggests that bookings and probably revenue growth are going to probably decelerate from where we are this year, which has been a much tougher year. So, given your commentary you think we are shifting back to better growth why aren’t we seeing that more in the revenue guide for next year?

Graham Smith

I think really this comes down to Q4, it is as you know our biggest quarter ahead of us and it is also our biggest renewal quarter ahead of us. I think we feel good about giving the guidance in the range we have. I think before we can give any more precision around next year’s top line growth rate we have to see if we have sustained improvement that we saw the beginnings of in Q3 and then we have also seen good signs on the attrition front but as you know that is a big variable in our top line equation as well. So I want to get through Q4 and then sort of assess where we are.

Marc Benioff

I would really like to just add to that if it would be alright with you. You know we are in the third quarter. We just finished the third quarter. If you look back a year ago finishing up the third quarter was not necessarily as much clarity not just for us but for all companies over the next six months, right? In terms of what was about to happen in the world. I think because of that we are just being mindful and I think appropriately so. In kind of giving you a preview of where we think we are going to be next year.

That is really very much how we view this. We think it is important to give you these numbers. We are giving you these numbers. We are being mindful and we are being appropriate I think because we still are in a very volatile world and while we certainly felt like in the second quarter we got our sea legs and in the third quarter we have resumed a growth stance and in the fourth quarter we are getting our excitement back, we are really in a position now while we really want to give you numbers because we have always given you numbers in the third quarter we recognize the last time we did that in the fourth quarter the entire planet, the world changed, and we moved into one of the most unusual economic situations in the world. All of us have lived through that.

Then we had to start to make changes for our business like many companies did. So because we are still basically several months away from finishing our fourth quarter which is our biggest quarter of the year, we are not yet through Dream Force. We haven’t made this product announcement. We are just giving you numbers we feel are appropriate. I hope that is important and that you can understand our mindfulness around that.

Operator

The next question comes from the line of Analyst for Heather Bellini – ISI Group.

Analyst for Heather Bellini – ISI Group

On financial force, what is your strategy there and how is it different from say Net Suite that has not been able to gain much traction in the space?

Marc Benioff

Thank you very much for that question. Financial Force is not part of Salesforce.com. It is a company that is an independent company that was started by a company in Europe called Unit 4 Aggresso and Unit 4 Aggresso and one of their subsidiaries, CODA, is one of the largest ERP providers in the European area. I think they are the second largest behind SAP.

Unit 4 Aggresso took a product they were working on inside CODA called CODA To Go, which was a native, general ledger payable/receivable and has ported it onto Force.com. We have had them on stage a few times profiling it mostly so other software developers could get excited about building similar things, and they have had some very exciting customer traction which it is not appropriate for me to speak for their company. Hopefully when you go by their booth tomorrow at Dream Force they can tell you what their customer numbers are and you can look at their demonstration and analyze their growth rate and their competitiveness.

We are so excited about this new company, Financial Force.com, we invested a relatively small amount of money, very small, to pick up a very small position because we view the company as doing things we want to encourage which is native Force.com development. But it is not part of us. I can’t speak for them. I actually have no details and that is really all I can say. You should go by their booth tomorrow and see them. Thanks for your question.

Operator

The next question comes from the line of Adam Holt – Morgan Stanley.

Adam Holt – Morgan Stanley

My question is about sales capacity and investments on a go-forward basis. You all were pretty aggressive over the past 12-18 months in hiring sales capacity. I wanted to get an update as to where you think you are in winning that capacity to be productive and if anything do you feel like you have some excess capacity as you start to get into an economic recovery? Secondarily, how should we think about the balance of billings growth going forward and expense growth going forward?

Graham Smith

I think this year has clearly been a tough year from a sales capacity point of view. We did add a lot of sales headcount last year as you point out. We have been much slower additions in the first half but certainly we are looking to pick that up in the second half.

I think the way to think about this is we are still committed to improving margins. That is an important thing for the company. On the other hand we feel there are lots of regions in the US and other key markets internationally where we are very under-penetrated. We will look to continue to expand our distribution capacity as much as we can because that is clearly the key growth driver for the company.

Marc Benioff

I would just add to that we internally still see ourselves very much as a distribution-constrained organization in that is we would like to have more sales people on the street around the world in every major geography in every major region. What is unique about Salesforce.com is we are appropriate for a 100 employee company, a 1,000 employee company, a 10,000 employee company, a 100,000 employee company or a 400,000 employee company.

We just don’t have as many people as we would like on hand to be able to appropriately cover, communicate and build relationships with that market. Of course we have segmented our sales force. We manage it extremely well. We have some of the top sales managers in the world. We continue to acquire new ones. But we want more. When you compare us against the much, much larger enterprise software companies our sales force is still between 1/10th and 1/20th their size of the largest players.

We think our products are far more competitive, far more exciting, far more important and we need more people to get out there and explain it to them. We want to when it is appropriate and when it is appropriate to take on a growth stance, which is what we are doing now, work to on-board them as much as we can which is why you saw us increase headcount in the third quarter after holding basically back in the first and second quarter. We want to do that again in the fourth quarter and actually go into the year.

At the same time we want to continue to do a great job with our margins. Of course, over the last few years we have done I think a spectacular job with our margins. I think on a fully annualized basis over the last three years we have added 300 or more basis points per year. I don’t think there are too many enterprise software companies other than Salesforce.com who over the last three or four years of added 300-400 basis points a year.

Every time we do that we look at, we are balancing giving our investors more profitability, which we are committed to against, are we expanding our distribution capacity fast enough? Of course, if we didn’t expand our profitability, if we had held our margin at zero but say had not brought it up to over 9-10% which is kind of where we have gotten to, we would have been able to do more on account executive and distribution capacity. But we find a healthy balance. Then we want to take that healthy balance and deliver bookings and grow the company.

Now through all of that we are still the fastest growing enterprise software company of our size. We have certainly grown our margin faster we think on a GAAP basis than any other enterprise software company, as I mentioned 300-400 basis points per year over the past 3-4 years and we have grown our revenue, as you can see this year approximately 20%. Now as we move into next year again it is balanced. Give the investors what they want.

They want more margin, we are committed to that. The question becomes how much more. Higher, more distribution because we have some great new products coming so we want to bring that to all the customers out there who are being held back by the tyranny of enterprise software. Then we want to continue to feed our cash flow and grow our companies and do the right things, fundamentally for our investors. That is how we think about it. I hope that answers or kind of puts the color around Graham’s specific numbers.

Operator

The next question comes from the line of Laura Lederman - William Blair & Company.

Laura Lederman - William Blair & Company

You have built up a ton of cash. Can you talk about whether you are going to let it sit on the balance sheet, whether acquisitions become more interesting? Buybacks? Just give us a better sense on that. Also following up on the last question, obviously delivering 300 basis points of margin improvement year after year, you can’t obviously expect to keep that up but kind of ballpark would you expect to deliver maybe half of that? I realize it is tied to revenue growth but if you could just sort of give us some sort of band it would be helpful.

Graham Smith

I think we are very happy with our cash balance. Clearly we focus a lot on cash generation. We believe that is a good proxy for the progress of the company. We don’t comment on M&A activity and clearly we have done acquisitions in the past; small ones. We continue to look at things. There is no specific news or forward thoughts there.

I think in terms of the second question about how margins are going to move next year, I think I did say ultimately we have to complete our planning process and Marc has just spent a minute or two talking about that balance we are trying to strike between growth and profitability and adding distribution capacity remains the number one priority for the company and we just have to get that balance right so it would just be premature for me to try and give you a read on that. And Q4, as we have also said, is also such a huge quarter for us that will have an impact on our ability to deliver different margins next year.

Operator

The next question comes from the line of Kash Rangan - Merrill Lynch.

Kash Rangan - Merrill Lynch

A clarification for you, Graham and then a question for Marc. You said similar growth in deferred revenue to last year. I guess you were referring to percentage growth Q3 to Q4 right?

Graham Smith

No, actually my words were quite specifically chosen. We expect the deferred revenue to grow roughly by the same amount, the dollar amount. I stressed the word roughly because as I gave you some reasons that you know it is a tough number for us to estimate with a great deal of accuracy. We are just trying to give you a ballpark number of what we are expecting and that is the same dollar kind of increase we saw in Q4 of last year.

Kash Rangan - Merrill Lynch

Does that imply the same kind of dollar amount. I respect the fact you are trying to be conservative but it signifies a deceleration in bookings growth of 12-13% so I was trying to be sure I wasn’t wrong-headed in the way I interpreted your comments and that is why I asked that question.

Graham Smith

Actually I am not trying to be conservative. I am just trying to give you a read on how I see the numbers as they are. I think it is what we think, clearly just remember in that bookings number you all calculate it is a combination of a couple of things. It is new business that we sign in the quarter. It is also based around the billings of renewals. So there are two factors that go in there. That is sort of our best read on it at the moment. That is where we think we are. It is a tough number to calculate or estimate.

Kash Rangan - Merrill Lynch

A question for you Marc, adding the fourth pillar, which you are going to be announcing tomorrow. How are you thinking about segmenting the sales force to get the best productivity within the account? Any changes to management you are likely to be making? Adding new people? Or creating new business unit structures? Anything at all you can help us get comfortable with as you scale this company? What are you going to be doing differently as you add on new products?

Marc Benioff

We have made a lot of those changes already. We have been driving those changes forward. We think we are currently appropriately structured. We will continue to of course enhance our structure as the business changes but you won’t see us announce any major change regarding product organization tomorrow. We are going to be listening very, very closely to our customers as we announce this product and based upon what they say we of course make changes at that point.

Operator

The next question comes from the line of Analyst for Michael Nemeroff – Wedbush.

Analyst for Michael Nemeroff - Wedbush

Can you go over the Q4 cash flow again and your expectations for CapEx and cash flows in 2011?

Graham Smith

Well, we said we expect Q4 operating cash flow to be slightly above the level of Q4 operating cash flows last fiscal year. We did not give any forward guidance on cash flow or CapEx. I will say on CapEx if you look at our CapEx additions over the last few quarters they have sort of run along at a relatively steady run rate so I think that is sort of pretty clear what the trend is on CapEx but we didn’t give any specific forward guidance around those numbers.

Operator

The next question comes from the line of Brent Thill – UBS.

Brent Thill - UBS

The improvement you mentioned you saw in the quarter, do you see that evenly across the small and mid segments or was one category potentially stronger than other categories?

Marc Benioff

We saw across many of our categories, of the eight major categories that I measure more than five of them, I think it was 5-6 improved. So we are very positive about that. By the way, those categories included the specifics to your question, the small and medium business had a spectacular quarter actually. We don’t normally call them out but they just completely blew us away.

David Havlek

Operator, we are going to go ahead and take one more question. Again, for those of you we didn’t get to in the queue, we look forward to seeing you tomorrow at Dream Force and also we will have the Q&A session with Marc and Graham. Let’s go ahead and take our last question today.

Operator

The next question comes from the line of Robert Breza - RBC Capital Markets.

Robert Breza - RBC Capital Markets

Can you talk a little bit about, you talked about adding sales capacity. Can you talk about maybe where you are making other additional investments or where you might be making investments whether that be in specific geographies? Anything would be helpful.

Graham Smith

Well the headcount we have added to date this year a lot of it is focused on development. You are going to see the fruits of that at Dream Force tomorrow and hopefully you will be as excited as we are. I think going forward we will switch that emphasis to much more on distribution capacity for the fourth quarter and next year because as I mentioned earlier we have definitely held that back a bit until we saw clearer signs of an improving execution and demand environment.

So I don’t think we want to be more specific than that. I think certainly we will be looking to focus most of it on distribution capacity in the U.S. and internationally across our top markets.

Marc Benioff

I would just add to that I think after an unusual year, a year of some downs and some ups that as we finish up the fourth quarter by the end of January and as we get ready to talk to you again on a formal basis in February we are going to have a lot more clarity about the kind of investments we are making and the level of growth we are able to take on, the confidence we have in the business.

We wanted to give you these early indicators because we think it is appropriate but we are being mindful and we are being thoughtful about what the numbers are we should be giving you. A lot based on the global environment that we are all existing in. Although Salesforce.com has had, I think, a spectacular year, certainly against any of our peers or competitors that could be said, we have had that great year because of this process that we undertake.

David Havlek

That is a great note to end on. We want to thank everybody for joining us today. We look forward to seeing you at Dream Force. If you still want to get in on the festivities tomorrow please contact me directly, David Havlek at dhavlek@salesforce.com or contact my team. Thanks for joining us. Have a good day.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Salesforce.com F3Q10 (Qtr End 10/31/09) Earnings Call Transcript
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