Why May Be a House of Cards

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Click Here Now (NYSE: CRM  ) , a cloud computing company known for its customer relationship management software, or CRM, has very rapidly become one of the largest software companies in the world. Over the past decade, Salesforce has increased its revenue by a factor of more than 20. Over the past five years, revenue has grown at an annualized rate in excess of 30%. Another year of 30% revenue growth is in cards for 2014 if the company's guidance is to be believed, and there seems to be no indication that growth will slow anytime soon. But even a cursory look at the company's financial statements reveal some big problems, and the massive revenue growth is masking some serious issues.

Where are the profits, exactly?
While Salesforce's revenue growth rate has been impressive, the company's operating profit has been negative for the past three years, and the losses have been accelerating. Part of this is due to a heavy reliance on stock-based compensation, an expense which topped $500 million, or 12% of revenue, in the most recent fiscal year.

Under generally accepted accounting principles, or GAAP, stock-based compensation is counted as an expense, and this is why Salesforce's GAAP operating profit and net income have been negative. But the company likes to tout its non-GAAP numbers, which add back stock-based compensation. Under this system, Salesforce is profitable. In the previous fiscal year, the company lost $0.39 per share on a GAAP basis, but earned $0.35 per share on a non-GAAP basis.

Should stock-based compensation be counted as an expense? It is non-cash, after all, so it doesn't "cost" the company anything. But stock-based compensation is often used in order to attract and retain talent, and if the company didn't give out stock options, salaries would almost certainly need to be higher. Coupled with the dilution caused by the ever-increasing share count, it's clear that stock-based compensation is certainly not free.

The problem is deeper than just stock-based compensation, though. Here's a look at a few troubling trends that have played out over the past few years:

As Salesforce has grown, one would assume that the company would get more efficient over time. Economies of scale should kick in, and the cost to capture each additional dollar of sales should decrease. If there is truly high enough demand to drive 30% annual revenue growth, then Salesforce shouldn't need to spend as much as it had to four years ago in order to win a sale.

This isn't the case, though. Operating expenses have grown faster than revenue, and each additional dollar of revenue seems to cost the company more than the previous one. In fiscal 2011, operating expenses were 74.5% of revenue. In fiscal 2014, this number has grown to 82.3%. This isn't how economies of scale is supposed to work.

You could argue that Salesforce is investing in its future, and that recognizing its subscription-based revenue makes this sort of analysis tricky to begin with. But even ignoring the fact that operating expenses are growing relative to revenue, the fact that these costs are eating up more than 80% of revenue is troubling.

All of this is complicated by the fact that at least some of Salesforce's revenue growth has come from acquisitions. Salesforce has spent a little over $4 billion over the past five years on acquisitions, with $2.6 billion spent last year alone. So the rate of organic revenue growth is significantly lower than the rate of total revenue growth. There's nothing wrong with acquisitions, but it's clear that Salesforce won't continue to grow at 30%-plus per year without continuing its spending spree. And without any profits to fund these acquisitions, more debt is likely.

Meanwhile, companies like Microsoft (NASDAQ: MSFT  ) are looking to capture a bigger piece of the CRM pie. Microsoft recently announced an update to its suite of Dynamics business applications, promising greater functionality and lower costs for customers. Microsoft's strategy is to combine every functionality companies need into a single product, bringing sales and marketing together with a heavy focus on social media. This allows Dynamics to be potentially less expensive than comparable functionality from Salesforce.

Source: Microsoft

Microsoft's enterprise dominance in other areas, such as productivity software, will give the company a big advantage going forward. Companies that already use Office 365, for example, can adopt Dynamics instead of dealing with an additional vendor, and other Microsoft services like Skype and Yammer are directly integrated. By leveraging its other enterprise services and its huge install base, Microsoft poses a big threat to Salesforce's market-leading position.

The bottom line
Salesforce's inability to turn a real profit -- along with costs rising faster than revenue -- is a problem that is going to eventually catch up with the company. Acquisitions are driving some of the rapid revenue growth, but this isn't a sustainable situation. With competition from Microsoft and others getting more intense, Salesforce is going to have a difficult time maintaining the revenue growth that Wall Street has come to expect. Once this revenue growth evaporates, the stock price, currently trading at about nine times sales, will have nothing holding it up.

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Read/Post Comments (6) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 11, 2014, at 9:59 PM, rrickett wrote:

    "may" is an understatement in this article. The author is very uninformed of the the SaaS model that SFDC has been very successful in implementing to date. MSFT Dynamics -- please look deep .. weak at best ... cobbled together technology. Please do not write about what you do not know to be true.

  • Report this Comment On March 11, 2014, at 11:23 PM, banmate7 wrote:


    I'll bite. Enlighten me as to what SFDC has in the way of technology that MSFT doesn't.

    Keep in mind that MSFT possesses the entire cloud computing stack: IAAS, PAAS, & SAAS. Moreover, MSFT has a range of SAAS applications not just CRM. These apps are integrated, using common data models, without the need for 3rd party identity management in governing credentials.

    Mind you, MSFT owns its own critical PAAS components, like MS SQL Server. They have comprehensive cloud infrastructure, as well as the Office franchise, which is intrinsic to many businesses. Lets I forget, MSFT also has a retail mobile footprint, small, but growing.

    Now tell me again, what does SFDC have over MSFT in technology? Even better, why should I invest in SFDC over MSFT?


  • Report this Comment On March 12, 2014, at 8:57 AM, dj235 wrote:

    If I was Marc I would pay my money to purchase 1 billion in services for salesforce, why? a billion dollars in revenue is worth 10 billion in market valuation.

    Show me the numbers. Tell me what the company looks like in 2020. Every way I run the numbers I come up with a price of $52 to $67.

    10 to 12 billion dollar company?

    825 to 850 million shares outstanding?

    Market valuation $50 to $58 billion?

    Profit? Most likely not, but they need to have $3 to $3.8 billion profit.

    Tell me what you see the numbers at, tell me the price in 2020. This stock is a complete joke.

  • Report this Comment On March 13, 2014, at 2:27 PM, Decoy0527 wrote:

    SalesForce is an amazing story. I shorted at $34 and watched in amazement as the bottom line losses got larger, the projected bottom line losses got larger, and the stock price doubled. Not giving up yet, but it's a long shot that I will get out even. Benioff is an excellent salesman, some Wall Streeters like his story, Cramer touts for him, and the "earnings" reports are flat out misleading. This will be interesting if, as I assume, the losses keep mounting.

  • Report this Comment On March 13, 2014, at 3:19 PM, Pancakes22 wrote:

    Billion dollars in revenue equals 10 billion in market cap?


  • Report this Comment On March 15, 2014, at 8:29 AM, Ludraman1 wrote:

    House of cards argument !

    The whole article is about stock based compensation even though it suggests that there is a second point about operating expenses. The operating expenses are increasing because of stock based compensation. Whenever the stock price increases, the expense related to stock based compensation will increase.

    The expense part of a stock option is the difference between the market price and what they employee pays (if anything). So if the share price is $100 and the employee is granted a share for $0, the expense to the company is $100. Very expensive but it shouldn't affect your view of the share price.

    If the share price drops to zero, then the expense drops to zero. All that remains to determine the value of the share is the revenues and other expenses.

    The important points is about value to customers - that determines the long term value of the stock.

    The rest of your argument is a table comparing and MS CRM from Microsoft, seriously ?

    Disclosure: I worked for, own a lot of stock and love the product.

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