Salesforce: It's A Buy

Summary

• Salesforce is a high quality business delivering a mission-critical customer relationship management function to enterprises.
• The business has progressively expanded its foothold into adjacent markets, which will increase customer retention and contribute significantly to revenue.
• Salesforce is attractively priced and should be bought at these levels.
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Business Summary

Salesforce (NYSE:CRM) pioneered cloud-based, customer relationship management, and has since added a suite of ancillary services including a Service Cloud, a Commerce Cloud and a Marketing Cloud for digital marketing campaigns. Salesforce has a market capitalization of almost $135B, and generates close to $13B in annual revenue. The company's flagship product is used by sales and marketing teams to manage sales prospects through a funnel from initial lead all the way to customer and to run campaigns against a prospect database. Salesforce has been a standout for high growth investors over the last 10 years and has delivered investor returns of nearly 27% p.a over this period. Salesforce is a core holding for the Project $1M portfolio.

Investment Thesis

Core product is very sticky

Salesforce is part of the revolution away from on-premise customer management to consumption of services in the cloud. In this model, customers aren't paying for a perpetual license, they are just paying for what they consume. The advantage for customers is the avoidance of cumbersome updates of difficult on-premise installations and lengthy upgrade cycles as well as high upfront costs.

However, the beauty here is that for really sticky, mission-critical services, the lifetime customer value is potentially much higher, as retention rates for subscriptions are incredibly high. The offering that Salesforce has fits squarely into this category. Sales prospects and sales leads are the lifeblood of a company. Companies are loath to bring any system change or disruption to their sales people, unless they want major flow on impacts to revenue. IT teams are hesitant to recommend changeover to new systems even for systems that may be cheaper, because the retraining involved to learn a new system and potential data loss in a changeover is incredibly disruptive to a salesforce. Time training on a new system is time away from selling and that hurts revenue. This is reflected in Salesforce retention rates which are in excess of 90%.

Successful Penetration of adjacent markets

The value chain that is involved in managing a customer creates core activities in acquiring, managing and closing a prospect, which is the core salesforce functionality. Additionally, there are then a number of related activities that stem from this process as well. They include things like managing support cases and trouble tickets, and tracking resolution of these items. There are also a different set of activities like running and managing marketing campaigns to move prospects through the funnel, from an initial lead through to a qualified lead to ultimately acquire a customer.

With its best of breed customer relationship management tool, Salesforce has been able to successfully expand its core service to these adjacent services as well. Service Cloud helps a company manage support cases and trouble tickets, while Marketing Cloud deals with digital campaign management and user targeting. Salesforce has successfully managed to grab a much larger share of the customer management value chain and significantly increase revenues by using its core sales portal as a beachhead. Enterprises are beginning to embrace the idea of system and platform consolidation to better track system and license spending, and thus the idea of a core platform that can execute multiple mission-critical functions well is something that is gaining significant traction in mid market and large enterprise alike.

Exceptional Network Effect

I have a particular focus on investing in growing businesses with really strong network effects, and Salesforce is a business that has these network effects in spades. The network effect in Salesforce's case really stems from 2 distinct sources. One is that as the dominant CRM portal with strong market share, Salesforce usage is exceptionally high in the industry. There are an army of salesforce consultants whose job it is to just customize and implement Salesforce. More importantly, there are millions of users of Salesforce products, including sales coordinators and sales professionals that have grown accustomed to using salesforce to manage their funnels and activity to maximize their productivity. This "training moat" represents a huge barrier for a competing product to overcome. Each incremental sales professional that starts their career using Salesforce is yet another user that needs to be retrained and be made productive on a new system, further widening the Salesforce network effect.

The other part of the network effect that Salesforce has is an internal network effect. As an enterprise standardizes on Salesforce to managing its sales pipeline, the customer support problems and prospect marketing very quickly emerge as pain points that also require standardization and management. Rather than have the hassle of investing in multiple systems and moving data back and forth between them, other teams in an organization start to see the value of having all aspects of customer management standardized on Salesforce.

Soon the Operations support team, and the Marketing team have been trained and have users on Salesforce, and are requesting additional licenses. Over time, many parts of the business have been trained and are using Salesforce to the overall productivity benefit of the company. Any proposed change to an alternate system by any one division not only potentially impacts the productivity of that division but the company more broadly.

Thus, Salesforce's adjacent offerings are critical to the longevity of its customer retention. Not only do they bring in additional revenue for the Company, but they also make it virtually impossible for the company to leave Salesforce's grip, without significant productivity loss. This is borne out in Salesforce's metrics. More than 50% of its enterprise customers use multiple clouds, and customer retention is above 90%, something that will probably trend higher with increased adjacent offerings.

Massive markets with long term runway

Salesforce will generate close to $17B in revenue for 2019, with a market for its products and services that the company previously estimated last year was more than $140B, which subsequently increased to $160B with the acquisition of Tableau. This means that the company has a substantially long runway to capitalize and ride industry tailwinds which favor consumption of cloud applications, and has captured barely more than 10% of what it anticipates its market potential to be. Just as significantly, many of its addressable markets are growing at rates well into the double digits.

Salesforce Investor Presentation, 2018

Dreamforce 2019 Update

There was much positive news for Salesforce coming out of Dreamforce, Salesforce's annual conference, which was held recently. Salesforce increased 2019 revenue guidance to $17B and more significantly increased its 2024 revenue target to $34-35B. This is significant, as it implies the company sees still strong growth in its core segments, with revenue doubling over the next 5 years.

Valuation

While Salesforce trades at a forward P/E of almost 60x earnings, this is not an accurate reflection of the earning potential of the business given that it continues reinvesting in the business and that earnings are artificially lower than where they could be if the levels of investment in marketing and sales were decreased. Given CRM's strategy is to acquire as much market share as possible, sales and marketing expense is high, with no converse upfront recognition of revenue (revenue being recognized over customer lifetime), artificially depressing profitability. CRM also produces copious amounts of cash, with 20% of revenue being converted into free cash flow by the company.

Price/Sales is arguably the better way to value this business, and at 9x sales, this business is significantly cheaper than Adobe (ADBE) and Workday (WDAY) which trade at 14x sales and 12x sales respectively. This is a business that still expects a very high rate of revenue growth in the near term and isn't materially slowing down.

Concluding Thoughts

CRM has a meaningfully advantaged position in large markets which are growing at double digits, and will continue to do so for some time to come. It is providing mission-critical software to enterprises, where it has a core foothold as the best in class point solutions for sales management. The current valuation is attractive, given stickiness of the service and opportunities for growth still available in very large markets.

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.