Pre-Earnings: Expect Top Line Acceleration, Margin Contraction

| About:, Inc. (CRM)


Revenues for the company have seen tremendous growth, registering an annualized growth rate exceeding 30% since 2008.

This high growth $4 billion software company also is aggressively investing in its business. recently announced a strategic shift to offer specific solutions across industry verticals, a move that may depress operating profit margins. (NYSE:CRM) is scheduled to report its Q1FY15 results Tuesday, May 20. The company is the world's largest pure-play cloud software company, with annual revenues of approximately $4 billion and a market capitalization over $30 billion. Salesforce's Customer Relationship Management (CRM) offering competes against on-premise offerings from software giants such as Oracle (NASDAQ:ORCL), SAP (NYSE:SAP), Microsoft (NASDAQ:MSFT) and IBM (NYSE:IBM) in the rapidly expanding CRM marketplace.

Salesforce became the market leader in the global CRM market with a market share of approximately 16.2%. Revenues for the company have seen tremendous growth, registering an annualized growth rate exceeding 30% since 2008. However, revenue growth has been fueled by aggressive investments, as evidenced from the 31% growth in cost of revenues during the 2008-2013 period. Similarly, Salesforce's operating expenses expanded at an annualized rate of 34%. This rapid rise in expenses often resulted in weak operating, and subsequently, net profits for the company.

The company recently changed its Go-to-Market strategy to cater to specific industries individually, which could very well enhance revenue prospects going forward. However, the creation of individualized sales teams should weigh on Salesforce's near term results. Sales and Marketing spending accounts for approximately 70% of Salesforce's gross profit, and we expect this share to expand further in fiscal 2014. Moreover, the company is investing capital into new data centers in the U.K., France and Germany. In short, this high growth $4 billion software company is aggressively investing in its business.

Growth In Cloud CRM Market, Strong Sales Team Should Boost Deferred Revenue Base

Salesforce had deferred revenues of approximately $2.52 billion as of January 2014, up 35% on a year-on-year basis. The current portion of deferred revenues amount to $2.47 billion, while the remaining is contributed by the non-current portion of billed subscriptions. Additionally, the company's unbilled deferred revenue reserve, which includes future billings under the company's subscription business that have not been invoiced, stand at $4.5 billion as of FY14 end. On a year-on-year basis, unbilled deferred revenues have increased approximately 29% from FY13 end. In total, billed and unbilled deferred revenues stood at a whopping $7 billion for the company at the end of January 2014.

The massive deferred revenue reserve for Salesforce ensures strong top line growth in the near term. The reason for Salesforce's strong performance in deferred revenues is attributable to two factors. On the macro front, cloud services are witnessing rapid adoption across industry verticals. Moreover, CRM has seen greater traction in the cloud space compared to other enterprise software suites particularly because of the flexibility it gives to an enterprise's sales team.

Specific to Salesforce, the strong deferred revenue trajectory underpins the exceptional capability of its sales team in selling its product offering. The company's sales and marketing personnel witnessed a 33% expansion in headcount between January 2013 and January 2014, partly due to aggressive hiring and partly due to the consolidation of ExactTarget. Salesforce states that it intends to focus on adding new customers and increasing penetration within its existing customer base through the additional personnel, which should contribute to further increases in its deferred revenues, resulting in strong revenue growth.

"New Industries Strategy" Should Depress Operating Profit Margins

Salesforce recently announced a strategic shift to offer specific solutions across industry verticals such as financial services/insurance, healthcare/life sciences, retail/consumer products, communications/media, public sector and automotive/manufacturing. This particular strategy allows the company to charge a premium and derive greater value by clearly demarcating industry verticals and delivering specific solutions to customer needs in a particular industry instead of a generic cloud deployment.

However, the decentralization of the sales team and the creation of individualized, industry specific sales teams requires added investments for hiring and training purposes. This should inflate general sales and marketing and administrative spend in the near term. Additionally, specific solutions across industry verticals should lead to an increase in R&D expenses. We believe this increase in operating expenses could result in a contraction in margins throughout fiscal 2014.

Disclosure: No positions.