While a great deal of commentary regarding the over-valuation of Salesforce.com's (CRM) stock price has pointed to accounting gimmickry that has arguably kept CRM's shares in nosebleed territory, very little has been said about a fundamental reality that poses a far greater risk, not only to the company's market cap, but more importantly, to its much hyped top line.
For several years now investors and institutions have been in awe of the remarkable revenue growth Salesforce.com has been able to achieve. Quarter after quarter and year after year, revenue has grown at a remarkable clip. That continued to be the case even as customer billings came in lower than expected in the company's most recent quarter. That miss knocked shares down, but since then share prices have stabilized, albeit at a lower level.
While some concerned analysts and commentators continue to focus on cash flow and profitability which they rightly should, little is being said about an inevitable slowdown in revenue growth, even as the company continues to add to its highly compensated sales team during an overall downturn in the economies of most developed countries. What is not being considered is just how vulnerable the company is to aggressive competition from companies that are late to the party, but which both collectively and separately have significantly greater financial wherewithal to mount aggressive sales campaigns that will sooner or later force CRM to rethink its strategy.
Consider the following scenario. Salesforce.com stockholders along with many analysts believe that at some point in the future the company will have attained such a commanding lead in market share that the company will be able to scale back marketing expenses along with many other growth related expenses with the result that along with economies of scale will cause massive margin expansion along with impressive gains in cash flow and earnings. This they expect to continue for the foreseeable future once these changes are instituted, thus justifying the company's current share price.
Now consider the following. In general, various companies sales strategies look at a variety of different ways to achieve sales and profitability goals. One such strategy is to compensate the sales force by providing pricing that makes the company's product the most attractively priced in its peer group. Salesmen generally are expected to produce higher levels of sales volume due to the fact that the company is providing them with a product that on its own merits can be shown to be the superior value. Per unit compensation is generally lower because the salesperson is being handed a product that sells itself.
At the other end of the spectrum another type of sales force consists of a group of highly skilled professionals who are able to generate high margin sales via exceptional selling skills to a more select group of prospects. Salesmen in this group are expected to favorably differentiate the company's products even though they may be equivalent to lower priced competitor products. In this situation, successful salesmen will be much more highly compensated than those in a company that provides a product at a price point that attracts prospective customers to the product and where salesmen are considered by the competition to be order takers.
The middle ground is made up of a sales force that balances pricing with value. It is neither the cheapest nor is it the most expensive alternative for prospective customers. Here the sales force is reasonably compensated. They must compete both against lower priced competitors as well as against a more skilled and highly compensated sales force at the other end of the spectrum.
Do CRM competitors need to overpay their sales forces to compete with Saleforce.com? The answer is likely no. Competition will go after Salesforce.com on price. Offering lower priced alternatives will cost CRM competitors far less in sales expense relative to what Salesforce.com has to pay. The advantage goes to the competition.
Historically, Salesforce.com has lavished exceptionally generous compensation packages on its sales force. Initially such compensation was justified due to the fact that the product being sold was a novel one that required a great deal of customer education and persuasion along with a great deal of product knowledge. It was selling a new product that was not well understood and which required faith on the customers' part to complete the sale. As the company progressed and its product began gathering greater acceptance, sales exploded. The company's sales force was pushing into virgin territory and facing virtually no niche competition. Management understandably perceived an opportunity to corner a market before any real competition entered its space. Initially large software vendors didn't pay much attention to the company as they saw little if any impact on their bottom lines. As the years passed, Salesforce.com's revenue numbers continued to climb at a rapid pace and the company continued to reward its sales force with attractive compensation plans to keep momentum on track.
Fast forward to the present. The cloud is no longer a vague concept understood by few. Behemoths such as Microsoft (MSFT), Oracle (ORCL), and SAP (SAP) have had to not only acknowledge the viability of cloud products, they have had to accept the fact that if they don't enter the cloud in a meaningful way, they risk becoming irrelevant in a very important and rapidly growing segment of the market. Perhaps a bit late to the party, they nonetheless are now offering products that compete with Salesforce.com's offerings, albeit in some cases with truncated or application specific versions. The land rush to acquire companies that can add to the appeal of a particular company's offerings is apparent to all that follow the goings on in the cloud space. Competition is heating up and beefing up.
Here is where things begin to go wrong with the Saleforce.com model. The company continues to add to its sales force at a rapid clip. The company also continues to richly compensate successful sales efforts. To-date, this strategy has given the company a commanding lead in its space. As competition becomes more meaningful, sales compensation becomes more of an issue. On the one hand Salesforce.com (CRM) continues to award lavish compensation to its sales force. On the other, competition will soon turn its model upside down. Many believe that Salesforce.com software is overpriced and that this provides an opportunity to competitors to offer a product that will meet the needs of many CRM customers at a much lower price. For example, how profitable must a competitive offering from MSFT be to make MSFT a viable competitor in the space. One possible answer is "not very," and this is precisely where the competition will likely hit CRM. MSFT can subsidize its push into the space with its massive stockpile of cash not to mention the enormous cash flow its existing products generate. To varying degrees, the same is true of other entrants into this space. This will likely pressure CRM margins going forward.
How will Salesforce respond? They can cut prices, but given the company's current margins, doing this alone will likely push the company into a money losing position and cripple its cash flow and thus its opportunity to respond to burgeoning competition. They can cut their sales force and/or lower incentive compensation, but this will hit the top line at a time when the competition is adding to its product offerings and likely will cause a marked slowdown in sales growth. They can do both and look for a balance that will allow them to be profitable and grow at the same time. While the middle way appears to be Salesforce.com's best course of action, it will undoubtedly cause the market to revalue the company based on a more fundamental analytic model. More conventional metrics will be applied to stock analysis of CRM.
Should the market recognize the perceived lack of sustainability in Saleforce.com's current strategy (as may currently be the case), the company's stock will likely see substantial erosion in share price. Should CRM attempt to rebalance and reduce sales and related costs, revenue will suffer while margins improve, but competition will likely continue to pressure both the top and bottom lines and in the light of this radical but more practical approach, the market will likely more realistically project future growth and punish share prices accordingly. Either way, Salesforce.com is no longer operating in a vacuum. Competitive pressure is beginning to build and the company must respond. The most reasonable course of action is to right size growth and cut expenses to position the company to be able to respond to these new competitive threats. Either way, CRM's share price appears poised for a fall.
Disclosure: I am short CRM.
