Salesforce.com's (NYSE:CRM) best days, in my view, are behind it. After an impressive market-beating performance so far in the year to date, up ~5% while the rest of the market is down about 7%, Salesforce looks to be on a path to correcting downward. Most investors have treated the technology industry - and the software sector specifically - as safe havens during the coronavirus pandemic. But obviously, there are a lot of nuances within software that make some companies more affected than others, and Salesforce unfortunately falls into that category.
After releasing disappointing first-quarter results and offering only a dim outlook for the rest of the year, shares skidded - and I think the correction has much further to go.
Steer clear of Salesforce here. In the software space, it's best to invest in pandemic-proof names that benefit from the shift to remote work.
Why CRMs are disproportionately affected during the coronavirus
I'll give Salesforce one positive note: over the past several years, the company has done an admirable job of expanding its product portfolio beyond its core Sales Cloud, the largest and most dominant cloud CRM (customer relationship management software). I don't necessarily agree with Salesforce's "buy rather than build" approach to growth and its aggressive M&A tactics, but Salesforce has proven its ability to join the ranks of mega-cap software companies like Microsoft (MSFT) and Oracle (ORCL) by offering a broad portfolio of technologies.
With that being said, we have to acknowledge that Salesforce's largest money-maker is still the Sales Cloud, contributing 29% to Salesforce's FY20 revenues. Salesforce's Marketing Cloud, meanwhile, contributed another 16% of revenues - so about half of Salesforce's revenue is exposed to users involved with sales and marketing.
CRM is such an attractive space because virtually every company has a sales department. And sales departments, particularly at B2B software companies, tend to comprise the single largest headcount out of any other department in the company. This makes Sales Cloud, which typically prices its services per user, per month (the "most popular" plan listed on Salesforce's website is the Enterprise plan costing $150/user/month), as shown below:
Figure 1. Sales Cloud pricing tiers
Source: Salesforce.com
Unfortunately, sales departments have also been among the most vulnerable in the pandemic. Outside salespeople (that is, the kind of people who proactively make "outside" calls to prospects and log their activities on a CRM) aren't able to be as productive given the recent travel bans, and overall business is down anyway - so when many businesses decided to slim down their workforces, sales departments often felt the biggest hit. Each layoff of a sales professional is a direct hit to Salesforce's subscription revenues.
The effect is less pronounced, but still applicable to marketing departments. As companies have cut marketing and advertising budgets, headcount in these departments have also moderated, leading to less users needing to use Marketing Cloud.
Dim guidance for FY21
So far through Q1, Salesforce has maintained fairly strong growth of 30% y/y, but that's helped by the company's acquisition of Tableau which started contributing to FY20 results in the third quarter. Its forecast for Q2, however - which still includes a no-Tableau 2Q20 comp - calls for things to get much worse.
Figure 2. Salesforce guidance update
Source: Salesforce.com 1Q20 earnings release
Q2 revenue is expected to decelerate about eight points to 22-23% y/y - suggesting that for Salesforce, the majority fo the coronavirus impact stemming from Sales Cloud and potentially other difficulties will be felt much harder in Q2 than in Q1. Then for the full year, Salesforce is dropping its outlook to ~$20.0 billion, or just 17% y/y growth - a sharp pullback from an original guidance view of $21.0-$21.1 billion, or ~23% y/y growth, issued in the fourth quarter of 2020. Wall Street consensus, meanwhile, had hoped that Salesforce would only cut its guidance to $20.75 billion, or ~20% y/y growth.
Considering both the gap to consensus estimates and Salesforce's prior guidance, it's surprising that Salesforce shares only fell by ~4% post-earnings. Salesforce's guidance also implies that, once Tableau starts getting worked into the prior-year comps in Q3 and Q4, revenue growth in those quarters will only be in the low teens to hit a full-year mark of 17% y/y, given the higher growth rates in Q1 and Q2.
Salesforce's guidance pulldown is also a reflection of the fact that the company has had to cancel a lot of customer conferences - including its famous Dreamforce event which last year drew 171,000 participants - from where it sources a lot of new prospects and upsells a lot of existing customers.
Mark Hawkins, Salesforce's longtime CFO, noted that the company's guidance forecast contemplated a slight rise in churn to account for the difficult macro conditions. Per his prepared remarks on the Q1 earnings call:
First, our guidance assumes our revenue attrition rises from less than 9% now to less than 10% temporarily for the rest of the fiscal year. Second, the guidance reflects the adjustment to incremental new business expectations that we made due to the COVID pandemic. Another important consideration when thinking about our FY 2021 guide is the magnitude of the above when applied for a term license products,"
Assuming only a one percent increase in attrition, however, might be too optimistic. On the bright side, Hawkins did note that Salesforce saw some positive trends towards the back half of April and early May that may help to alleviate some of thee concerns.
Profits continue to deteriorate
One other brief point we have to make: investors have long clamored for Salesforce to deliver profit growth, given its massive scale. But Salesforce continues to fail to deliver on this front.
The most recent Q1 probably had it the worst. Salesforce's pro forma operating margins foo to 13.1%, 520bps worse than 18.2% in the year-ago quarter, while GAAP operating margins slipped to negative.
Figure 2. Salesforce margin trends
Source: Salesforce 1Q21 earnings deck
The bright side is that some of the margin headwinds that Salesforce faced in Q1 won't recur - the company paid a lot in cancellation fees for its sales events. Per Hawkins' remarks:
Second, due to the cancellation of our physical events, this fiscal year in favor of virtual experiences, all event contracts that included cancellation fees for fiscal 2021 commitments were expensed in the quarter. This amounts to approximately $65 million."
This $65 million in cancellation fees works out to 130bps of margin impact; another ~$20 million (40bps) of impact came from mask donations to help the coronavirus aid efforts. The remaining ~350bps of margin loss, however, may be sustained weakness.
Valuation and key takeaways
With all these flaws, it's surprising that Salesforce has managed to maintain an optimistic valuation. At current share prices near $175, Salesforce's market cap is $157.21 billion. After netting off the $11.70 billion of cash and investments and $2.67 billion of debt on its balance sheet, its enterprise value is $148.18 billion. That represents a 7.4x EV/FY21 revenue multiple - which, for a company whose organic growth is expected to fall into the mid-low teens this year, seems quite rich.
Steer clear here and invest elsewhere.
