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Anyone who’s used multiple CRM programs before switching to Salesforce.com (NYSE:CRM) can usually attest to the quality and efficiency that Salesforce provides. Of course, the firm is much more than a CRM provider, but that is where it really built its name, breaking away from the traditional enterprise software model of sending out software on CDs. Today, the firm stands tall as an industry innovator on multiple fronts ranging from software distribution to subscription revenue modeling. It’s been deemed a headache “solver” for small-to-medium-sized businesses by helping reduce the need for specialized IT personnel. It’s easy to conclude that Salesforce.com has done everything right and the company looks like a great company going forward. But we don’t take that view.

Salesforce has definitely done plenty of things correctly, but looking ahead, much uncertainty remains. New and lucrative areas like cloud computing are as appealing as they are dangerous. And large players like Oracle (NYSE:ORCL), SAP (NYSE:SAP) , and Microsoft (NASDAQ:MSFT) loom in the background, always looking to replicate Salesforce’s successes. Easier said than done, of course, but hungry sharks are still hungry sharks. In our view, Salesforce is a great company but a horrible stock to own, given its valuation metrics, need for continued substantial growth to sustain the stock price and volatile profit margins.

1. Paying an Arm and a Leg

No matter how you slice or dice the major price-multiple valuations, investors are paying an arm and a leg – even though the firm has achieved spectacular top-line growth over the short- and long-term.

Valuation Chart:

CRM

Industry Average

S&P 500

Forward P/E

400.0

28.2

14.6

P/B

14.5

3.7

13.2

P/S

10.5

3.4

13.2

P/CF

41.3

14.1

33.3

All these current price-multiple valuations are also higher the 5-year averages for these respective numbers. The numbers speak pretty clearly about how overvalued the firm is from a price-multiple perspective - whether it’s compared to the industry average or index averages. In our view with these price-multiple valuations Salesforce has no room to fall short of market expectations.

2. Extreme Growth Needed to Sustain Stock Price

The biggest issue facing the price of Salesforce.com’s stock is the company’s growth numbers. One way or another, investors are paying dearly for strong and sustained top line growth.

Revenue Trends

2010

2011

Latest Qtr

Year over Year Growth

21.25

26.93

33.85

We’re concerned about how long Salesforce can sustain this pace given its current product portfolio. Although the firm is expanding into other areas such as cloud computing, that could be anybody’s game. Salesforce’s previous innovations don’t it will continually out-school entrenched competitors like SAP, Oracle, and Microsoft. These companies didn’t get to their size by sitting at the top of the mountain. Instead, they looked around for someone else’s mountain to take so they could expand. These strong competitors see Salesforce as prime target in cloud computing. If Salesforce fails to respond, the stock will likely drop like a rock.

3. Yo-Yo Profitability

Salesforce profit margins are yo-yo-like. They’re up, they’re down, they’re sideways. They go in about every direction you can imagine.

Operating Profit Trends

2010

2011

Latest Qtr

Year over Year

80.84

-15.42

-108.48

Given the firm’s maturity it’s surprising that almost half (46%) of the revenue is still eaten up by marketing expenses. That’s a huge issue. Salesforce must find a more scalable business approach that allows it to increase profit margins. That might not do much about margin volatility but at least the firm would be working off a higher point.

Margin volatility primarily revolves around locking up large deals, which reduce the firm’s acquisition cost per subscriber and effectively scale. Even then, we remain somewhat concerned since the firm’s attrition rate bounces around in the mid-teens. Thus, even Salesforce can start landing large deals, there would still be a whole other can of worms relative to attrition and the reliance on a smaller base of large deals than a larger base of smaller deals.

Conclusion:

Salesforce is a great company that offers a great service. But, as a stock, it isn’t worth the premium. The firm has some real concerns - ranging from profit-margin volatility to substantial competition . To become more bullish on the firm, we want to see it develop a clear plan to improve profitability and dominate the cloud-computing space.

Source: 3 Reasons Why Salesforce and Its Stock Price Are Hanging on by a Thread