The Short Case on Salesforce - Risk Not Priced Into Stock

| About:, Inc. (CRM) (NYSE:CRM) is a classic case of a good product with a bad stock. I have used the customer management software [CRM], and I must say that I am quite impressed. It’s very user friendly and its advantages over CRM sold in a box are numerous and more than I can list here. Analyst reports with strong buy recommendations rave about the future of on-demand CRM and Salesforce. There’s just one problem: too many people on Wall Street know about it and love it.

With so many people excited about the real future of on-demand, Wall Street is pricing Salesforce as if the profit is already in the corporate coffers. Leading the speculation is the idea that everyone will want on-demand CRM. However, this may not be a good assumption. My assumption is that some people will want on-demand and some people will prefer box software. Sure, on-demand has lower start-up costs, but box software can have lower long-term costs.

Salesforce has done a good job of protecting against hackers. However, there will always be firms will want the added security of local customer information regardless of however slight the risks are of data intrusion of customer info being sent over the web. As we now see, the expense of only one data intrusion can far exceed any savings from reduced IT departments. Salesforce’s shortcoming is that it doesn’t offer fully featured in-the-box solutions along with its on-demand service, something which Oracle (NASDAQ:ORCL) and, soon, Microsoft (NASDAQ:MSFT) do offer.

The conventional wisdom for on-demand software it is that its recurring revenue. And Salesforce’s less than 1% churn rate adds huge credibility to that claim. However, on-demand software has one disadvantage to it which is not being adequately priced: with recurring revenue comes recurring obligation to maintain the service. Conventional wisdom also says that low earnings are OK for stocks with strong potential growth. So instead of earnings, we can look to revenue and its growth, right?’s revenue may be recurring but so is its cost of revenue. A much more accurate measure of Salesforce’s value is gross profit because it will never be the case that Salesforce receives revenue for which is doesn’t provide on-demand service or pay a cost of goods sold. On a good day, Salesforce’s Enterprise Value-to-Revenue ratio is around 9.5. So what, Salesforce has 3 times the revenue growth of other techs, right? The problem is that the other techs that Salesforce is being priced in comparison to are profitable operations. Yes, Google has an EV/Rev of 13, but it also has a P/E of 50 in comparison to Salesforce’s P/E of 11,500.

The future P/E ratio of Salesforce is also riding quite high as well. So maybe Salesforce’s 2-year forward P/E of 60 makes it a bargain? If the analyst earnings forecast were written in stone, I might agree with you; however, the $5 billion question is whether these forecast can adequately predict the effect of the two barbarians knocking at the gate, Oracle and Microsoft. Salesforce may go on to do well in the world, but there is tremendous risk that isn’t being priced into the stock.

Disclosure: Author has a short position in CRM

CRM 1-yr chart