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Salesforce.com Still Seeing Good Growth, Weak Margin Leverage
As is so often the case with popular growth stocks that sport rich valuations and purport to shake up an industry, Salesforce.com (NYSE:CRM) generates plenty of controversy. While the company continues to generate respectable free cash flow (FCF), skeptics question whether the company can grow enough to support its valuation and start posting real operating leverage. I do believe that software as a service (SaaS) really is a big shift in the enterprise software sector, but I continue to struggle to see how Salesforce.com can grow enough to validate its valuation.
Forex Broker Guide: Using the right broker is essential when competing in today's forex marketplace.
In-Line Will Do for Q3
Typically, a stock with Salesforce.com's valuation would sell-off on "only" meeting estimates, but in the sour third quarter tech market, that is good enough for most investors.
Revenue rose 35% as reported, or 37% on a constant currency basis. Deferred revenue rose 41%, with current and non-current rising 35% and 414%, respectively, as reported. For better or worse, a lot of analysts and investors tinker with Salesforce.com's reported results to try to suss out a "true" sense of the growth rate. In that respect, it looks like new organic billings growth was in the 20 to 30% range.
Salesforce.com continues to see weak profit leverage. Gross margin slid by more than a point, whether you go with the GAAP or non-GAAP numbers. Operating income was likewise soft, albeit in line with analyst expectations. GAAP operating loss increased, with the operating margin dropping another 500 basis points (BPs). Non-GAAP operating income rose 18%, but the margin fell about a point and a half from last year and almost three points from the second quarter. While some of this can be tied to dilution from deals (Buddy Media), aggressive hiring and stock compensation continues to chew into profitability.
SEE: Analyzing Operating Margins
SaaS a Good Place to Be, Maybe Even More So Today
Companies in the SaaS space have done pretty well this quarter, with companies including Ellie Mae (Nasdaq:ELLI), LogMeIn (Nasdaq:LOGM) and ServiceNow (NYSE:NOW) all doing pretty well with respect to analyst expectations. To some extent, that's a byproduct of the SaaS model - these offerings generally draw from operating budgets (which have stayed relatively strong) as opposed to capital budgets (which companies have cut back in response to uncertain business conditions and worries about next year).
Can Service and Marketing Provide the Next Leg of Growth?
If Salesforce.com is going to move from a $3 billion a year company to a $10 billion a year (or more) company, it's going to have to come from greater adoption of the company's full range of offerings. At the company's most recent Dreamforce, management talked about how roughly 80% of sizable deals included Sales Cloud, but only about 20% included Marketing Cloud. Along similar lines, around 60% of new bookings had been coming from existing customers adopting more clouds.
I'm not sure how the Salesforce.com model works if Marketing Cloud and Service Cloud don't become bigger contributors and more customers don't adopt multiple Cloud offerings. It seems pretty clear that Salesforce.com struggles to deliver operating leverage as it is, but seeing customers adopt more of its offerings should allow for substantial revenue growth with much less incremental marketing spend. Similarly, other software companies like Red Hat (NYSE:RHT) have been pushing the same model, but have to really see that leverage materialize.
SEE: A Primer On Investing In The Tech Industry
The Bottom Line
I know that Salesforce.com is one of those companies and stocks that drives some bears to distraction, particularly given the weak operating leverage, the presence of huge competitors such as Oracle (Nasdaq:ORCL), Microsoft (Nasdaq:MSFT) and SAP (NYSE:SAP), and the complicated/non-intuitive accounting that goes into the revenue, deferred revenue and billings numbers.
I also know that Salesforce.com's valuation is exceptionally demanding. Even 25% annual free cash flow (FCF) growth (20% annual revenue growth and a 40% improvement in free cash flow conversion over 10 years) points to a fair value only about 10% higher than today's price. That's a huge amount of growth, and it has only been done a few times before. Investors who believe that Salesforce.com really is the next Oracle might want to stick with these shares, but the risk/reward balance just doesn't appeal to this investor.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
Forex Broker Guide: Using the right broker is essential when competing in today's forex marketplace.
In-Line Will Do for Q3
Typically, a stock with Salesforce.com's valuation would sell-off on "only" meeting estimates, but in the sour third quarter tech market, that is good enough for most investors.
Revenue rose 35% as reported, or 37% on a constant currency basis. Deferred revenue rose 41%, with current and non-current rising 35% and 414%, respectively, as reported. For better or worse, a lot of analysts and investors tinker with Salesforce.com's reported results to try to suss out a "true" sense of the growth rate. In that respect, it looks like new organic billings growth was in the 20 to 30% range.
Salesforce.com continues to see weak profit leverage. Gross margin slid by more than a point, whether you go with the GAAP or non-GAAP numbers. Operating income was likewise soft, albeit in line with analyst expectations. GAAP operating loss increased, with the operating margin dropping another 500 basis points (BPs). Non-GAAP operating income rose 18%, but the margin fell about a point and a half from last year and almost three points from the second quarter. While some of this can be tied to dilution from deals (Buddy Media), aggressive hiring and stock compensation continues to chew into profitability.
SEE: Analyzing Operating Margins
Companies in the SaaS space have done pretty well this quarter, with companies including Ellie Mae (Nasdaq:ELLI), LogMeIn (Nasdaq:LOGM) and ServiceNow (NYSE:NOW) all doing pretty well with respect to analyst expectations. To some extent, that's a byproduct of the SaaS model - these offerings generally draw from operating budgets (which have stayed relatively strong) as opposed to capital budgets (which companies have cut back in response to uncertain business conditions and worries about next year).
Can Service and Marketing Provide the Next Leg of Growth?
If Salesforce.com is going to move from a $3 billion a year company to a $10 billion a year (or more) company, it's going to have to come from greater adoption of the company's full range of offerings. At the company's most recent Dreamforce, management talked about how roughly 80% of sizable deals included Sales Cloud, but only about 20% included Marketing Cloud. Along similar lines, around 60% of new bookings had been coming from existing customers adopting more clouds.
I'm not sure how the Salesforce.com model works if Marketing Cloud and Service Cloud don't become bigger contributors and more customers don't adopt multiple Cloud offerings. It seems pretty clear that Salesforce.com struggles to deliver operating leverage as it is, but seeing customers adopt more of its offerings should allow for substantial revenue growth with much less incremental marketing spend. Similarly, other software companies like Red Hat (NYSE:RHT) have been pushing the same model, but have to really see that leverage materialize.
SEE: A Primer On Investing In The Tech Industry
The Bottom Line
I know that Salesforce.com is one of those companies and stocks that drives some bears to distraction, particularly given the weak operating leverage, the presence of huge competitors such as Oracle (Nasdaq:ORCL), Microsoft (Nasdaq:MSFT) and SAP (NYSE:SAP), and the complicated/non-intuitive accounting that goes into the revenue, deferred revenue and billings numbers.
I also know that Salesforce.com's valuation is exceptionally demanding. Even 25% annual free cash flow (FCF) growth (20% annual revenue growth and a 40% improvement in free cash flow conversion over 10 years) points to a fair value only about 10% higher than today's price. That's a huge amount of growth, and it has only been done a few times before. Investors who believe that Salesforce.com really is the next Oracle might want to stick with these shares, but the risk/reward balance just doesn't appeal to this investor.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.
by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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