Cloud software and services continues to take share in the enterprise IT market, and Salesforce.com (NYSE:CRM) remains a major player within that trend. Even so, growth is slowing and the company has yet to make a convincing case that there is all that much latent margin leverage in the business model. With attractive top-line growth and a “clean” play on the growth of SaaS/PaaS, I expect Salesforce.com to remain a relatively popular software stock, but I likewise expect bears to continue complaining (loudly) about the valuation, particularly given the weak margin leverage and an underlying growth rate that may be weaker than it first appears.

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On-Target Probably Not Good Enough
Salesforce.com didn't have a bad quarter, but I suspect that the stock's valuation keeps it in that realm where the implicit expectation is always to beat, not just meet. To that end, the fact that Salesforce.com is not immune to same tough macro environment that has impacted Oracle (Nasdaq:ORCL), IBM (NYSE:IBM), SAP (NYSE:SAP) is probably an unwelcome reminder that Salesforce.com is not so different after all.

Reported revenue rose 28% this quarter, coming in slightly ahead of the average of Street estimates. Subscription revenue rose 29% as reported, with billings up 17%. Although “normalized” billings were up more than 30%, I think this likely overstates the real underlying growth rate. Keep in mind, this number includes renewals and longer invoice periods. Adjust that out, and it looks like the net new organic billing growth rate was in the single digits (and credit to JPMorgan's analyst John DiFucci for first laying out that adjustment approach).

Margin leverage was once again underwhelming. Reported non-GAAP gross margin declined 160 basis points from last year and declined about 70bp after adjusting further for an IP licensing agreement. Non-GAAP operating income rose 18% (and fell 13% sequentially), leading the operating margin down a full point from last year and 70bp below the Street average. Adjusted for that IP agreement, the operating margin comes in 90bp higher – 20bp higher than the Street estimate and just 10bp lower than last year.

SEE: Understanding The Income Statement

A Big Deal Seems To Be A “When, Not If” Event
Due in part to Oracle's acquisition of Eloqua, expectations have been set for some time now that Salesforce.com will need to do another deal to continue building its marketing cloud, particularly in the automation space. Even apart from Oracle-Eloqua, Salesforce.com lags rivals like Adobe (Nasdaq:ADBE), IBM, Hubspot, Neolane, and Marketo (Nasdaq:MKTO), and I would expect management to address that gap.

I suppose internal product development is possible, but companies ranging from Adobe to IBM to Oracle to Red Hat (NYSE:RHT) have all repeatedly turned to M&A to fill gaps, and I expect that will be the case here as well. Any of those three smaller companies (Hubspot, Neolane, Marketo) could draw a bid, as well perhaps as ExactTarget (NYSE:ET), and Salesforce.com has the financial wherewithal to get a deal done.

Plenty Of Directions Left For Growth
While I do have my issues with Salesforce.com's valuation and margin structure, I do not believe that the company is lacking in growth opportunities. Sales Cloud and Service Cloud have already proven to be quite successful for the company, and I believe Marketing Cloud will be a success as well (though the company likely needs to do that aforementioned deal). Beyond these are the opportunities to continue building Force.com in the platform market, as well as entering into markets like analytics and security.

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
Salesforce.com has rarely ever looked all that reasonably priced by conventional cash flow standards. This new generation of software companies just doesn't have the same sort of leverageable business model, and I believe that will ultimately limit the long-term free cash flow margins. What's more, even a long-term free cash flow growth assumption above 20% only produces a fair value target in the low $40s.

Perhaps the stock is more attractive on a relative valuation basis when compared to companies like NetSuite (NYSE:N), Workday (Nasdaq:WDAY), ServiceNow (NYSE:NOW), or Marketo, but I'm not a big believer in this valuation approach. Accordingly, Salesforce.com remains a stock that (to me) is much more interesting to watch than to own.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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