Salesforce.com: Profit Outlook Remains Cloudy

Aug.23.14 | About: Salesforce.com, Inc. (CRM)

Summary

Salesforce.com reported better than expected revenue and raised revenue guidance, causing the stock to soar.

Despite having achieved critical mass of over $1.3 billion in revenue per quarter, adjusting operating profit is less than 1% of revenue.

At age 15, Salesforce.com is much less profitable than Oracle and Microsoft were at a similar phase of development. This suggests structural differences in economics.

Assuming Salesforce.com continues to grow at a rapid clip for the next 3 years and significantly improves operating profitability, Salesforce.com appears overvalued.

Salesforce.com (NYSE:CRM) shares soared following the release of 2Q numbers and increased guidance for the full year. Taking a step back from the figures we've been directed to look at (Adjusted EBITDA, revenue backlog, etc.), one cannot help but notice that the company is barely profitable (using EBITA -earnings before interest, taxes, and amortization). Clearly the market believes it is just a matter of time before Salesforce.com generates meaningful operating profits. Is this a reasonable assumption? As outlined below, I think investors are setting themselves up for disappointment.

While Salesforce.com is on track to generate more than $5.3 billion in revenue this year, after deducting stock-compensation expense, it is on track to be just better than breakeven (adding back non-cash amortization expense associated with acquisitions to stated operating profit). For the second quarter, CRM reported a GAAP operating loss of $33.5 million. Adding back amortization of purchased intangible assets of $36 million and $9.9 million of debt discount amortization, I get to an adjusted operating profit of $12.4 million, which is equivalent to an operating margin of less than 1%. Should investors in Salesforce.com (or other SAAS stocks) be concerned about these low margins? Let's examine arguments as to why profits aren't super-meaningful put forth by bulls:

  1. Salesforce.com is still growing at a fast pace and needs to reinvest in order to continue to grow. Profits will come later.
  2. Profits will eventually mimic large software companies like Oracle (NASDAQ:ORCL) and Microsoft (NASDAQ:MSFT). These companies went through a heavy investment phase as well.
  3. Profits don't matter - the company will continue to be valued at a multiple of sales. If the multiple of sales remains constant and the company can continue to grow at 25+%, shares will return 20-25% (even with a constant multiple, returns would be lower than top-line growth due to share dilution from employee stock exercises).

While I have no counterpoint to #3 - it is possible (though unlikely) that Salesforce.com continues to defy gravity and trades on a large multiple of sales, point 2 can be quickly refuted:

Here is some Oracle history:

Year ended 5/31

1991

1992

1993

1994

1995

Revenue (in $ million)

1,027

1,178

1,502

2,001

2,997

Revenue growth

14.70%

27.50%

33.22%

49.78%

Operating Income

17.9

113.7

217

420

649.7

Operating Margin

1.7%

9.7%

14.4%

21.0%

21.7%

Equity

344.7

435

528

740.5

1211.4

Click to enlarge

Early Oracle history demonstrates a high growth rate and a strong operating margin. The same is true for young (15 year old) Microsoft:

Year end 6/30

1991

1992

1993

1994

1995

Revenue ($ million)

1843

2759

3753

4649

5937

Revenue growth

49.7%

36.0%

23.9%

27.7%

Operating Profit

640

990

1326

1726

2038

Operating Margin

34.7%

35.9%

35.3%

37.1%

34.3%

Click to enlarge

It is clear from the date above that Salesforce is an inferior economic animal relative to Oracle and Microsoft.

As for point 1, the notion that profits will materialize eventually, I don't disagree. However, based on CRM's performance thus far (the company is 15 years old), I do not believe it is at all realistic to expect 25%+ operating margins given that at $5+ billion in annual sales, CRM generates just 1% operating margins. There is not much evidence of scaling in this business, i.e. revenue growing significantly faster than expenses leading to an explosion in profitability. I believe the reasons the business has not scaled are as follows:

  1. By definition SAAS has relatively quick implementation times (vs. on premise software). This implies lower customer switching costs (evidenced by double digit churn rate) meaning that pricing here will always be more competitive (and likely deflationary) than traditional on-premise software. There are numerous providers of SAAS CRM software.
  2. Minimal cost of capital environment (huge valuations of SAAS companies) means that players are incented to continue to encroach on each other's turf to (1) allow companies to claim a large and increasing total addressable market (2) to facilitate revenue growth (even though it may be heavily loss-making revenue). This ensures that pricing will remain fiercely competitive for the foreseeable future (potentially beyond the time period of huge valuations given that these companies have large cash balances and can incur losses for a long time).
  3. Considerably less dominant market position - the most generous definition of market share I have seen for Salesforce.com estimates 17% market share vs. 40+% for Oracle in database and 90% for Microsoft. Again, this reinforces the notion of limited pricing power.

That said, from what I have heard, there is very little focus on costs (and that may be an overstatement!) at Salesforce.com and other SAAS companies. With a very, very low cost of capital (creating ability to continually raise new cash to pay bills) and investors looking the other way on profitability this makes sense. However, I expect that at some point (after growth has slowed considerably) we will see a major restructuring effort (likely under a new CEO). As noted above, I believe the Salesforce.com's business is structurally inferior to Oracle and Microsoft though I do believe it will ultimately prove profitable. Assuming that Salesforce can do $9 billion in revenue (19% CAGR) in 2018 (with an incremental 12% operating margin - this is quite generous vs. history) and execute a $700 million cost cutting program (equivalent to over 8% of the company's estimated cost base) in 2017-2018, I estimate just over $1.2 billion in 2018 operating profit. Taxing this at 35%, gets me to $780 million or $1.15 per fully diluted share. Assuming that Salesforce garners a 20x P/E multiple at this stage (forward growth prospects likely to be reduced significantly), this produces a 2017-2018 fair value of $23. Discounting back to today, I get a fair value of $17.25.

Despite the market's enthusiastic reaction to yesterday's results, I continue to believe that Salesforce.com's share price is disconnected from economic reality.

Disclosure: The author is short CRM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is long MSFT and ORCL