Salesforce: The Cloud Titan Keeps Growing

Summary

• Salesforce posted a strong end to FY18, with fourth-quarter earnings that topped analyst consensus and FY19 guidance above expectations.
• The company's 24% y/y top-line growth showed barely any deceleration from 25% growth last quarter; the outlook also calls for robust 21% y/y growth in FY18.
• On top of beating analysts' pro forma earnings estimates, Salesforce also turned a positive GAAP quarter.
• Salesforce is also pointing to ~20% operating cash flow growth in FY19, implying that the company is trading at a very reasonable forward OCF multiple of 24x.
• Among SaaS stocks, Salesforce is one of the most modestly valued despite its consistently strong execution.

Salesforce (NYSE: CRM), the world's largest pure-play SaaS company, has done it yet again. For much of the company's decade-long lifespan as a public entity, it has spun out quarter after quarter of earnings beats and guidance raises, shepherding the stock's measured yet steady rally from its post-recession lows to a high now of over $115. Yet despite the expansion in the stock price and amid a cry from some investors who criticize Salesforce for not generating enough GAAP profits yet, Salesforce's fundamentals have risen in tandem with its shares. Marc Benioff, the company's iconic CEO, has made clear that he isn't satisfied with leaving Salesforce at the $10 billion annual run rate it just crossed this quarter - he's already drawn a line in the sand for $20 billion.

This means that Salesforce's growth isn't about to taper off anytime soon. Despite longstanding investor fears that Sales Cloud, the company's flagship product, will soon stop growing (it's already tapered down its growth to the mid-teens), Salesforce's platform and other tertiary clouds are becoming massive businesses in their own right. On the side, Salesforce also has a nascent pool of "strategic investments" in companies like Twilio (NASDAQ: TWLO) that it could eventually acquire. The possibilities for this cloud giant are still very much an open-ended game.

As such, Salesforce is still spending nearly half of its revenues on sales and marketing to chase growth. You could argue that other mega-cap tech success stories followed the same kind of playbook; Facebook (NASDAQ: FB), for example, didn't generate the massive profit margins it does now until recently. Directly after its IPO a few years back, the company was still focused on user acquisition and content development; Mark Zuckerberg didn't care at all about the bottom line. The company executed far ahead of plan regardless and is now worth half a trillion dollars. While Salesforce isn't growing quite as fast as the social media giant, give it breathing room to achieve scale before hankering after profits.

Despite consistent execution and a growth runway that seems to keep leading upward, Salesforce remains one of the reasonably valued stocks in the software sector at ~6.5x forward revenues, with advances in its stock price keeping pace with its revenue growth. In contrast, other large-cap cloud stocks like Workday (NASDAQ: WDAY) and Adobe (NASDAQ: ADBE) hover around 10x revenues (a ~50% valuation premium to Salesforce), despite delivering about the same quality of execution.

CRM EV to Revenues (Forward) data by YCharts

Salesforce is the cloud stock to keep in your portfolio for years and years. The company's agenda is massive and covers nearly every aspect of application software. Even if the company doesn't have much to show for it in GAAP profits, its growing cash flows can at least hold investors over. Salesforce is pointing to 20-21% OCF growth in FY19, implying a massive ~$3.3 billion in operating cash flows (a sizable 26% OCF margin). This also means the company's current enterprise value of $80.3 billion only values the company at about 24x FY19 OCF - a very reasonable multiple to pay for such a robust grower.

Multi-product growth stretches into yet another quarter

Let's dive in deeper into Salesforce's Q4 results. One of the most useful ways to check in on the company's performance is to look at its growth by "cloud", as shown in the chart below:

Figure 1. Salesforce Q4 growth by productSource: Salesforce earnings press release

As shown above, Sales Cloud really is tapering off - it grew just 16% y/y in the quarter to $931.8 million. CRM is one of the largest areas in software - there are typically more sales people, and thus more potential CRM users, than any other function in any business - but with Salesforce's multi-year #1 ranking in the CRM leaderboards, there's not much more ground left for Salesforce to cover.

The company's other "clouds," however, are pulling their weight. Service Cloud, the company's next-biggest offering (a software tool for service desk employees), grew 28% y/y to $789.3 million in revenues for the quarter, actually an acceleration over the 25% y/y growth it saw last quarter. Ditto for the Salesforce Platform, which grew 37% y/y and accelerated over 34% y/y growth last quarter. As the IT market tilts toward open networks and connected ecosystems, Salesforce's platform business can help to greatly extend its presence with developers tools and third-party applications. Marketing and Commerce Cloud also saw growth in the 30s, with revenues of $397.6 million growing 37% y/y.

Salesforce has a strong track record for innovation, with major releases this year including the rollout of the Einstein AI feature. Even as Sales Cloud and other large, saturated products continue to taper off, Salesforce can be expected to replace that growth with something new.

Adding in the company's professional services revenues, Salesforce generated total revenue of $2.851 billion in the quarter, up 24.3% y/y and surpassing analyst estimates for $2.811 billion (+22.5% y/y).

A slight improvement in margins

What does frustrate some investors is the fact that Salesforce is only improving its operating margins at a snail's pace, while other similarly-sized cloud companies like Red Hat (NYSE:RHT) have already begun generating massive profits.

As seen from the company's common-size income statement showing its expenses as a percentage of revenues, the major culprit for this is sales and marketing:

Figure 2. Salesforce expense percentagesSource: Salesforce earnings press release

Salesforce stubbornly held its sales and marketing expenditures flat at 48% of revenues, a huge proportion of its total revenue base. There are startups with much smaller revenues that are spending ~50%, usually by the time a company reaches Salesforce's scale, it's no longer spending this much on sales.

As previously mentioned, however, Salesforce is focusing on growth. As long as the company continues to deliver positive revenue surprises and lifts its guidance every quarter, its sales dollars are being well spent. At any point in the future, Salesforce can start to crank down its sales spending to a normalized ~20-30% of revenues, "freeing up" 20 points of margin against the very small 2% net margin the company generates today. Expanding Salesforce's earnings margin from 2% to 22% would mean multiplying its net earnings by more than 10x. As ludicrous as this sounds, when a business is built on top of such high (74%) gross margins, it has this huge profit potential down the road.

Meanwhile, as discussed, Salesforce is generating massive cash flows (due to upfront software billings generating cash flows in advance of being recognized as revenues and flowing to the bottom line). OCF grew 27% y/y in FY18 to $2.7 billion, and the company is expecting further 20-21% growth in FY19.

On a bottom line perspective, it's not like Salesforce is out of whack with Wall Street estimates either. Salesforce's pro forma EPS of $0.35 beat consensus targets by a penny.

Final thoughts

Staying invested in Salesforce is one of the best ways to play the secular shift into a software-driven business world. The well-known mantra that "software is eating the world" is very much a reality, and it's specifically the SaaS giants like Salesforce that are entrenched in their markets and carry #1 Gartner rankings in a broad suite of products that are best positioned to capitalize on this growth. Long-term investors in Salesforce have enjoyed a stock that has routinely outperformed market indices year after year.

Forget about the bottom line and Salesforce's astronomically high, meaningless P/E ratio for now. The company is choosing to invest into growth instead of delivering profits and dividends - and for a company that has so ambitiously laid out a plan to hit $20 billion in revenues by FY21-FY22 (implying sustained growth of ~20% for each of the next four years), its current 6.5x revenue multiple is cheap. Salesforce is the kind of growth stock that continues to execute against targets and outperform regardless of the rainy days in the market.

Analyst’s Disclosure: I am/we are long CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[User 40187946]

It’s heading higher.

[Retrostar]

There is just something about their CEO that seems dishonest and insincere, can't put a finger on it. Like we're not seeing everything. It's a vibe I'm getting.

[mccornbread]

Ding ding ding!!! Snake oil salesman... how many other CEO’s go on Mad Money to talk up the stock EVERY quarter... beat by a couple pennies.... increase revenues by $100 million... sell a dream about $20 billion in rev...

[ChuckXX]

Retrostar; I have read several articles that report he is a " Huge Waster of Shareholder Money" in oh so many ways. Case in point: The ridiculous skyscraper he is building in San Francisco. S.F. is probably one of the most expensive cities in the world and of course thats where he's building his H.Q. I also have read that he throws wildly lavish parties and doesn't think twice about spending company money like a drunken sailor. So just like Enron it will eventually come to an end but when is anybodys guess.

[zvilleguy]

Most confusing company and stock. It has all the data to support it going up and going down. Total mind twister.

[casper77]

Did you forget to include information about GAAP earning?

Let me help. CRM's own forecast for FY2019 (so take out the effect of the recent tax cut which confuses earning numbers) is $0.61- $0.63. That makes a PE of about 190. It is also printing shares like crazy.

[Sharon Keren]

Very good article. Thank you (long crm)

[Sharon Keren]

BTW, they say they will be the fastest to grow from 10bn to 20bn. Anyone knows who was the fastest..? That might give us a time frame for the expected leap.

[Hans.K]

Nice peptalk. I'm happy P/E and more ratio's do not count :-)

[alpine]

Great report, and having listened to their conference call, I feel quite "assured" that MB, KB and the CFO have got more than what it takes to take CRM to $20B and beyond. As for the margin worries you raise in your report, I feel that we do not know, and perhaps will never know answers to the following questions that will answer your (and most investors') worries about CRM's long term EPS trajectory, i.e. large opex spending, but benefits from them not going to be known for a while:
- they are, to me, making lots of vertical (industry) specific capabilities, save for biotech/pharma, where VEEV seems to have already taken the lead, and perhaps, it is the most difficult vertical for CRM to build a meaningful capability in;
. they are also building strong horizontzal, i.e. cross-industry capabilities, from Einstein, to seamless use of their software from the innards of the enterprise to the outer reaches of each of these enterprises' customers. As an example, when they talked about their applications plugging and playing with Amazon Echo and such, I really didn't "get" what they are up, but can only have "blind belief" they are doing something that will leverage their sales capabilities, across the world, as these IoT platforms seem to be proliferating everywhere. (But I did miss their not mentioning Apple even once, as they too are so much into end-users).

Great quarter, but as always, when it comes to CRM, much of what they do, and where they gain such tremendous growth is just a "black box". Esp, when you think, how come ORCL, SAP even MSFT can't just reverse engineer their software and go to market? These guys just seem to be "magicians"!