Tickers in this Article: CRM, MSFT, ORCL, SAP, RHT, VMW, GOOG, N, RNOW
I'm not too proud to admit that Salesforce.com (NYSE:CRM) confuses me on many levels. The organic sales growth is clearly there, but these are still early days, and it's uncertain whether Salesforce.com can withstand Microsoft (Nasdaq:MSFT), Oracle (Nasdaq:ORCL) and SAP (NYSE:SAP) taking serious aim at the cloud business. But, even more important is the question of Salesforce.com's profitability - the company's profitability under the generally accepted accounting principles (GAAP) looks rather lousy (as do the returns on capital), but the sell-side is not bothered by this, and the cash flow picture is more encouraging. All in all, though, this looks like an expensive stock that has to continue to execute flawlessly to justify its price.

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Mixed Fiscal Third Quarter Results
While some will focus on what looks like encouraging guidance from management, the reported results for the fiscal third quarter have some hair on them. Reported revenue rose 36% from last year and 7% from the last quarter, with constant currency growth of 34%. Subscription revenue rose 36%, deferred revenue rose 32% and billings rose 29% - dipping below the psychologically important 30% growth rate.

Profitability was not very good, but will anybody care? GAAP gross margin slid almost three points, and GAAP operating income reversed to a loss on a startling 52% jump in marketing and sales outlays. Even on a non-GAAP basis, operating income fell 1% from the year-ago level. (To know more about income statement, read: Understanding The Income Statement.)

Where's the Leverage?
I've been harping on the lack of sales leverage among cloud and software as a service (Saas) companies like Salesforce.com, Red Hat (NYSE:RHT) and VMware (NYSE:VMW) for some time. To be honest, sell side analysts and institutional investors just don't care right now. Cloud computing seems more like a mid-19th century land-grab, where the name of the game is to stake out the largest territory possible and worry about making a profit from it later.

If that works for you as an investor, so be it. To be fair, the company's operating cash flow has been growing, though I would point out that the "structural" free cash flow (that is, ignoring working capital changes) picture is not as strong. Sooner or later, Salesforce.com is going to have to show that it can deliver the profits to match its customer and billings growth, but right now that's "later." (To know more about cash flow, read: Analyze Cash Flow The Easy Way.)

A Pause, or a Sign of Trouble?
Management guidance was pretty strong, but some investors are going to fret about the billings growth this quarter. Weakness in Europe did no favors, and the company still seems to be executing strongly with Sales Cloud, Service Cloud and acquisitions like Radian6. What's more, the company's performance, in terms of billings, was not that much of an outlier from others like VMware.

Perhaps the real issue is still whether Salesforce.com can keep its first-mover advantage in cloud and SaaS customer relationship management. Big fish are starting to migrate into this pond, including the aforementioned software giants and others like Google (Nasdaq:GOOG) and NetSuite (NYSE:N). Moreover, given the money that Oracle is shelling out for RightNow (Nasdaq:RNOW) and the seemingly growing tension between Oracle and Salesforce.com, it looks like Oracle may be about to go after Salesforce.com - similar to how it went after SAP in the onsite CRM market.

The Bottom Line
Value-conscious investors don't own Salesforce.com, and aren't going to buy it just because of a modest post-earnings pullback. This is a growth and momentum story, and it's a little like playing chicken with a freight train. Sooner or later, Salesforce.com is going to disappoint vis-a-vis the invisible whisper numbers, and then suddenly issues like operating profitability and sales inefficiency will matter to analysts and investors.

There may be more capital gains left to squeeze out of this name, but there are too many questions and curiosities for me to be comfortable. At a minimum, if I were going to own an expensive hot software company today, I'd probably be more interested in something like VMware than Salesforce.com.

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

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