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Salesforce.com (NYSE:CRM) and other SAAS stocks have soared again in 2013. In addition to the expectation of achieving continued growth in the number of clients, investors are optimistic about the prospect of customers both developing custom applications to run on the Force.com platform and third party developers creating, selling and supporting niche applications. However, I think that the expectations for client uptake of third party vendor applications are unrealistic and could potentially create a significant liability for Salesforce.com in the future.

When a business makes a decision to purchase a piece of software from a third party to perform a specific function or workflow task, it has a couple of key selection criteria: (1) Does the functionality meet the needs of the business? (2) What is the reliability of the software? (3) What is the cost of the software relative to the cost of how things are being done currently and relative to competing software products? (4) Is the software robust? Will it be updated to accommodate changes as the world changes and as the customer's business grows and changes? (5) Closely tied to #4 - Can the customer be confident that the vendor of the software will be around to maintain the software and provide services for the next 5-10 years?

In the on-premise software world, customers pay software makers a license fee and then pay something called a maintenance fee (typically 18-22% of initial license cost paid on an annual basis) in exchange for software updates and customer support services. In the world of the cloud/SAAS, there is no upfront license fee per say (although customers will pay for implementation and customization) but everything (software cost and maintenance) is bundled into the monthly fee that is paid on an ongoing basis. Typically customers will investigate the financial health of a software vendor. This is one of the reasons software companies tend to have strong balance sheets with a lot of cash and very little, if any, debt. Customers want to be sure that a vendor will be around for the next 5, 10 or 20 years.

While customers can see that Salesforce.com maintains an OK balance sheet with over $600 million in cash and another $300 million in non-current securities (though it has $1.8 billion in debt, a good portion of which is in the form of converts), the financial health of its third party vendors isn't very visible at all. While some customers will give 3rd party vendors the benefit of the doubt given their affiliation with Salesforce.com, IT directors tend to be fairly risk averse. Rarely are they lauded as superstars within their organizations when everything is up and running but they can certainly end up in the hot seat when something doesn't go according to plan. One of the things which can go wrong is that a third party application developer could go bankrupt. This creates uncertainty for customers. What happens when the maker of an app goes bust? Who services the customer? I don't believe there is a set protocol for these events. Given this risk, I suspect IT managers would be hesitant to invest too much into buying third party apps on Force.com.

I wonder how Salesforce.com will deal with bankrupt application makers. Will it take on the responsibilities of the third party app providers by hiring people to update the apps and service the customers of the apps to try to maintain customer satisfaction? Or would the better course be to cut bait? It is a decision the company will have to make (probably not much of this happening now given the buoyant venture capital financing environment for developers) in the not-too-distant future.

Should Salesforce.com opt to perform the responsibilities of its developer partners, I would think this could end up being a very costly endeavor which could impair profitability and draw heavily on the cash pile. Of course, with the stock approaching its 52-week high, this, like other questions about risk (or even the question of why this company hasn't achieved profitability yet) aren't being asked. While the market is suspending disbelief on Salesforce.com and SAAS in general, shares have soared. However, at some point, investors will start asking the tough questions again. When that happens it will be evident that the company's business model is unproven, there are potential contingent liabilities, and shares sell at extremely high multiples of revenue. I remain short Salesforce.com.

Disclosure: I am short CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Is Salesforce.com's Platform As A Service A Potential Liability?