Why Salesforce.com's Future Growth Is Already Factored In

May.11.14 | About: Salesforce.com, Inc. (CRM)


Salesforce.com's top line is growing nicely, but its valuation largely reflects this.

The firm registers a 3 on the Valuentum Buying Index. We prefer higher rated firms.

In the valuation context, other big-cap software giants such as Microsoft look like a steal compared to Salesforce.com.

Salesforce.com (NYSE:CRM) is a company that requires a significant amount of monitoring. Even small changes in the trajectory of its future revenue growth could have large implications on its intrinsic value. Though the fiirm is well-positioned for the shift to cloud computing and revenue expansion is impressive, we think its valuation already reflects this growth potential. Let's walk through how we capture its strong top-line growth in the DCF and apply the Valuentum process to shares.

For those that may not be familiar with our approach, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Salesforce.com posts a Valuentum Buying Index score of 3, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. We generally prefer ideas that register a 9 or 10 (a "we'd consider buying" rating) on the Valuentum Buying Index as new additions to our portfolios. Once they are added, we tend to hold them until they register a 1 or 2 (a "we'd consider selling" rating) on the Valuentum Buying Index. Salesforce.com does not come close to registering the rating necessary for consideration. With that said, let's move into why.

Salesforce.com's Investment Considerations

Investment Highlights

  • Salesforce.com's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
  • 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's cash flow generation is robust, but its financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health.
  • 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.
  • The company continues to experience strong revenue trends, but costs are expanding rapidly as well. Though there is great debate regarding the application of GAAP and non-GAAP earnings per share within any informative analysis, we think enterprise cash flow is the key to assessing intrinsic worth. Our fair value estimate for Salesforce.com considers its discounted future free cash flow stream and net balance sheet, lessening the dependence of either non-GAAP or GAAP multiple analysis, which could be misleading.

Business Quality

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 with its weighted average cost of capital. 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 9.5%, which is below the estimate of its cost of capital of 10.7%. As such, we assign the firm a ValueCreation™ rating of POOR. 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 19.4% 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 decreased about 37% from levels registered two years ago, while capital expenditures fell about 79% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Salesforce.com's shares are worth between $43.00 - $65.00 each. The estimated fair value of $54 per share is roughly in-line with where the company is currently trading (about $50 at the time of this writing). Though the ValueRisk rating is not as high as other volatile equities, we wouldn't think much of a 10%+ decline from current levels in the context of the fair value range. We think this is a fair assessment at this juncture. Our model reflects a compound annual revenue growth rate of 24.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 34.9%. This is simply fantastic growth that we're building in, and the decline is more a reflection of the law of large numbers than any fundamental impediments to continued expansion. Our model reflects a 5-year projected average operating margin of 12.2%, 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 15.5% for the next 15 years and 3% in perpetuity. The phase II growth is among the best in our coverage universe, and its resulting fair value is in-line with the market price. Investors should take this to mean that future growth is largely priced in. For Salesforce.com, we use a 10.7% weighted average cost of capital to discount future free cash flows.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint.

For relative valuation purposes, we compare Salesforce.com to peers Adobe Systems (NASDAQ:ADBE) and Microsoft (NASDAQ:MSFT), among others. Though these are not necessarily competitors, we think the comparisons help investors keep perspective on what else is out there. For example, Microsoft is trading at less than 13 times normalized earnings, and this doesn't adjust for the software giant's large cash balance. Clearly, we think Microsoft's valuation opportunity is much more compelling than Salesforce.com's in this light -- and the former has a strong and growing dividend.

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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 $54 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 $43 per share (the green line), but quite expensive above $65 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 $54 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 $73 per share in Year 3 represents our existing fair value per share of $54 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

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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: MSFT is included in the Dividend Growth portfolio. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.