Salesforce.com (NYSE:CRM) is the market leader in the "software as a service" (SaaS) market which offers remote network-based access via the internet. Utilizing SaaS allows companies to avoid purchasing servers, as files can be saved on a host's web based-software application for a periodic subscription fee. The primary advantage of SaaS is that it decreases IT costs of small and medium sized businesses.
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According to Morningstar's (Nasdaq:MORN) Sunit Gogia, the model utilized by Salesforce.com is similar to Google's (Nasdaq:GOOG) Gmail, which can be accessed anywhere, versus Microsoft's (Nasdaq:MSFT) Outlook, which must be purchased for the system on which it will be used. Firms do not have to buy expensive servers or software, but can simply access their files online.
Salesforce.com has a strong balance sheet with enough cash to cover its convertible notes which are due in 2015. Overall, the firm does not heavily rely on debt for its operations, as deferred revenues are the largest source of liabilities.
Revenue streams arise through two basic mean: subscriptions/support and professional services with subscriptions contributing 94% to the top line. Furthermore, while the gross profit margin for professional services is negative, subscriptions and support have an impressive margin of nearly 650%. As this cloud computing technology has only recently gained momentum, marketing and sales are approximately 50% of revenues.
The major advantage of such a business model is that current customers are expected to provide an annuity of payments while new marketing and sales expansions would contribute to ongoing revenue growth. Large scale customer acquisitions would also significantly decrease the marketing and sales expense.
The most pressing risk to Salesforce.com and other players in the industry, such as Right Now Technologies (Nasdaq:RNOW), is that a lack of barriers to entry provide opportunities for large blue chip firms such as Oracle (Nasdaq:ORCL), Microsoft, Google and SAP (NYSE:SAP) to enter the market.
Cicso Systems (Nasdaq:CSCO) has explicitly stated, "changing technology trends such as the increasing adoption of virtualization, the rise in scalable processing, and the advent of cloud computing and cloud-based IT resource" will become an area of future focus. Likewise, Oracle just announced that the company has established the OracleCloudComputingSolutionsCenter in Beijing. Microsoft even started offering companies substantial rebates to switch from Salesforce.com services to its own.
The recent hype with cloud computing and SaaS has attracted other entrants into the industry. However, Salesforce.com and Right Now Technologies are not priced accordingly, as their valuation reflects that they will experience the same continued levels of stellar growth. Currently, Salesforce.com is trading at a P/E of 265, P/B of 15.5, P/Sales of 12.5 and P/CF of 50.3, which are well above the industry average.
Assuming that revenues continue to increase by 25% over the next five years and net profit margins remain at the 5% level, the stock is overvalued. In the best case scenario analyzed, where margins would increase to 10% and a 40% five-year compounded revenue growth rate is observed, my valuation model suggests that the stock would be worth $144 in five years. However, this type of growth and margin improvement could only be realized in the absence of competition.
The Bottom Line
Salesforce.com finds itself in a new growing industry. However, based on market and valuation factors, the shares are currently overvalued. (Bubbles are deceptive and unpredictable, but by studying their history we can prepare to our best ability. Check out 5 Steps Of A Bubble.)
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