As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Salesforce.com's (CRM) case, we think the firm is fairly valued at $49.
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors.
Salesforce.com posts a VBI score of 3 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and very bearish technicals. We compare Salesforce.com to peers Adobe Systems (ADBE), Oracle (ORCL), and Microsoft (MSFT). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
• Salesforce.com earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 20.9% during the past three years.
• Salesforce.com is a provider of enterprise cloud computing solutions. The company delivers customer relationship management, or CRM, applications via the Internet, or "cloud." The company sells to businesses of all sizes across industries on a subscription basis.
• Salesforce.com has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 6% in coming years. Total debt-to-EBITDA was 2.3 last year, while debt-to-book capitalization stood at 21.8%.
• Salesforce.com is well-positioned to capture the fundamental shift toward cloud computing, which has changed the way companies connect with customers, employees, partners and products. The firm's Sales Cloud, for example, enables companies to grow their sales pipelines and react to real-time customer and contact info.
Fiscal 2014 Third Quarter Results
Salesforce.com, one of the largest firms in enterprise cloud computing, reported excellent fiscal 2014 third quarter results in November. Revenue surged 36% year-over-year, while deferred revenue expansion largely kept pace (up 34% year-over-year). Unbilled deferred revenue, or business that is contracted but unbilled and off balance sheet, was $4.2 billion, up 40% from the same period a year-ago. Though non-GAAP earnings per share came in at a meager $0.09 during the period, the firm posted operating cash flow of $138 million, which was up 30% on a year-over-year basis. Capital expenditures jumped to $74 million from $51 million in the year-ago period, resulting in free cash flow of $64 million (or about 6% of sales). Salesforce.com ended the quarter with $1.09 billion in total cash and marketable securities.
Looking ahead, the firm raised its full fiscal 2014 top-line guidance $30 million to the range of $4.05-$4.055 billion (an increase of 33% year-over-year) and narrowed its diluted non-GAAP earnings per share target to the range of $0.33-$0.34 (was $0.32-$0.34). Our top-line forecast is slightly better than the updated range, while our fiscal non-GAAP 2014 bottom-line estimate remains $0.34 per share (as presented in our 16-page report). Salesforce.com issued full-year 2015 guidance in the range of $5.15-$5.2 billion, up more than 28% at the high end of both respective annual ranges. The 2015 target was slightly lower than our forecast of $5.23 billion for the fiscal year, but we wouldn't be surprised if Salesforce.com raises its fiscal 2015 guidance to our number in coming periods. In any case, Salesforce.com was very proud to note that it is going to be the first enterprise cloud company to deliver more than $5 billion in revenue next year.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Salesforce.com's 3-year historical return on invested capital (without goodwill) is 20.9%, which is above the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Salesforce.com's free cash flow margin has averaged about 20.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Salesforce.com, cash flow from operations increased about 61% from levels registered two years ago, while capital expenditures fell about 99% over the same time period.
The estimated fair value for Salesforce.com is $49 per share. Our model reflects a compound annual revenue growth rate of 28.2% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 32.7%. Our model reflects a 5-year projected average operating margin of 9.8%, which is above Salesforce.com's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 17.5% for the next 15 years and 3% in perpetuity. For Salesforce.com, we use a 10.7% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $49 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Salesforce.com. We think the firm is attractive below $34 per share (the green line), but quite expensive above $64 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Salesforce.com's fair value at this point in time to be about $49 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Salesforce.com's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $67 per share in Year 3 represents our existing fair value per share of $49 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
(click to enlarge)
(click to enlarge)
(click to enlarge)
Additional disclosure: MSFT is included in the portfolio of our Dividend Growth Newsletter.