Are Salesforce Investors Reacting to the Wrong Thing?

In this podcast, Motley Fool senior analyst Emily Flippen discusses:

• Salesforce co-CEO Bret Taylor leaving his job a year after he got it.
• Whether the market is overreacting to Taylor's move and underreacting to a strong third-quarter report from Salesforce.
• Kroger's strong profits and prospects for expanding its grocery empire with a proposed acquisition of Albertsons.

Motley Fool contributors Jeff Santoro and Jamie Louko engage in a bull-vs.-bear debate over cloud infrastructure company DigitalOcean.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Dec. 1, 2022.

Chris Hill: Another co-CEO bites the dust, and we've got a bull-vs.-bear debate on cloud infrastructure. Motley Fool Money starts now. I'm Chris Hill. Joining me, Motley Fool senior analyst Emily Flippen. Thanks for being here.

Emily Flippen: Thanks for having me, Chris.

Hill: It was one year ago today on our MarketFoolery podcast that the lead story was Salesforce. The company's third-quarter results were really good, and they were overshadowed by the news that CEO Marc Benioff was being joined by Bret Taylor as co-CEO. Here we are one year later and once again, Salesforce's third-quarter profits and revenue came in higher than expected, and this is getting overshadowed again, Emily, by the news that Taylor is leaving the company. We will get to the results in a minute, but I'm struck by the fact that for the second time in less than three years, a co-CEO is leaving Marc Benioff and Salesforce.

Flippen: Benioff sounded sad about it in his commentary. It makes me wonder if it was never quite a great relationship to begin with, but you certainly do feel bad for Marc Benioff, now re-entering the role of sole as CEO. He is the co-founder of Salesforce, so he has been there since the beginning for this company. But Bret Taylor was an operational CEO, if you will, to match Benioff's visionary tendencies. Certainly the market did not appreciate this departure, not only because the tenure was so short, but also because it raised the questions of, well, what's going on behind the scenes in these relationships? Is Salesforce losing some of the operational capacity that they had with Taylor? It's a big question mark for Salesforce right now, but we do know that Benioff is a strong leader. The results from Salesforce were strong as well. Within its own, I don't think it changes the investment thesis for investors in this company, but it certainly raises some yellow flags.

Hill: We were talking before we started recording. You pointed out that there's not a huge dataset in terms of public company co-CEOs, but the dataset that we do have, as small as it is, it's not great. It's just like, I don't know. I'm now between this, the co-CEO -- maybe "debacle" is too strong a word, but the co-CEOs that didn't work out at Chipotle. We could name other companies as well. I don't know. You just used the phrase "yellow flag." It's now moved into that category for me as an investor. If I see a company in my portfolio is coming out with the news that the CEO is being joined by a co-CEO, I'm now no longer looking at it as glass half full.

Flippen: It's such a fun dynamic to try to bait because you don't really know what's going on behind the scenes with co-CEOs. So it's really easy to point out, well, this is a structure that's never going to work in the first place, because what you're doing is we're moving the single point of responsibility that exists for an organization. When you're the CEO of a company, even if you're not making decisions that affect the company itself, you are the responsible party for that company's performance. At any time you're dividing up responsibility among two people, it can turn into a battle of, well, that wasn't my call; that was the co-CEO's call. You are then potentially exposing yourself to more in-fighting. Now there are some good examples of companies that have made this work. Atlassian and their two co-CEOs/two co-founders have done an incredible job of leading that company to a long track record of success.

But I do think, to your point, we don't have enough data. There is such a small subset of companies that have ever operated under the regime of two co-CEOs to really draw out whether or not it means good things or bad things for companies. But because we have seen so many high profile blow-ups, I think it's fair to say it is a yellow flag. Whenever I see the structure coming into play, what I want to see is some conversation around how they're going to divide up those responsibilities. Where do they see their circle of competencies? What decisions are they making? What conflict resolution policies do they have when those decisions come into conflict with each other? All of these things happen behind the scenes, which can make it so challenging for an individual investor who doesn't have insight into how these decisions are being made to figure out, is this a bad structure or is this potentially a good structure?

Hill: Shares of Salesforce are down 10% today. As you said, this was a really solid quarter. Are we seeing a little bit of headline risk here that whatever drama there is surrounding the co-CEO leaving is masking what on the surface appears to be really good results?

Flippen: I will say, I think this is a bit of an overreaction, and I think the market's overlooking what aspect of Bret Taylor's career that is potentially also coming into play here. Taylor used to be on the board of directors for Twitter. But with the Musk transition, that board has been resolved. This could be a situation. Dissolved, not resolved. Hopefully to be resolved at some point in the future, but dissolved for the time being, which has put Taylor in a position where maybe his career is just coming to a crossroads. He has an entrepreneurial pass, like you mentioned. He spent a long time working for large organizations, Salesforce, Facebook, even leading them through their IPO as CTO. There are ways for him to potentially evolve his career. That could simply have nothing to do with the performance of Salesforce or co-leading with Marc Benioff and much more to do with his individual career.

Hill: Let's move to groceries. Kroger's third-quarter profits and revenue came in higher than expected. The grocery chain also raised guidance for the full fiscal year. Kroger is the parent company of a number of grocery brands, including Ralphs and Harris Teeter. I don't think this should surprise anyone who's actually been to a grocery store lately, just the fact that a grocery store chain is doing well in these inflationary times.

Flippen: We're all feeling it in our pocketbooks. Anytime, for me, my weekly grocery shops have dramatically increased in price. My instinct when I see Kroger and other grocery stores doing well as a consumer is to be a little bit put out. It's great that you're doing well, but what about my pocketbook? But there have been a lot of eyes on Kroger, given its earlier announcement this year of their intention to acquire Albertsons, combining two of the largest grocery store chains in the U.S. They think that will lower prices for consumers. There's some regulatory questions about whether or not that would actually be anticompetitive. But regardless, there are a lot of eyes looking on Kroger as a result of this acquisition, and they certainly met expectations in the quarter. Revenue rose more than 6% year over year. That's excluding fuel.

Their gross margins actually held steady, which is extremely impressive for a grocery store chain to achieve during these inflationary periods. Their same-store sales or their comparable-store sales rose nearly 7%. As a result, they raised guidance across the board, including and most importantly for their store brands. I think this is where the story gets a little bit more nuanced than just saying, well, people are buying more groceries, inflation is hard, corporate greed is up. Kroger has actually put a lot of effort into developing and expanding their private-label brands. Those private labels themselves saw same-store sales growth of nearly 10%. That's just the, I should say same-store sales, probably a bad comparable.

But comparable growth for those brands of 10% in the quarter, which is extremely impressive for a company of their size, and their operating profits have actually declined minorly in part because of some of this accounting funkiness with the impact that inflation has on their inventory accounting systems. But also in part thanks to increases of expensive operation. It's not like Kroger is doing so exceptionally well in these inflationary times that they are taking a victory lap. This is still a very low-margin business. They're trying to squeeze out the margin that they can to provide value for customers by launching and pushing their private-label products, which sell at lower prices in comparison to higher-value brands. This is a good business, but one that is still attempting to navigate an uncertain economy the same way we are as consumers.

Hill: It is a low-margin business, which is why the stat you just shared about their in-house brands and the comparable growth there is as impressive as it is. This is a business that has historically done a good job with its acquisitions, with incorporating the brands that they acquire and bringing them under the Kroger umbrella. They've never attempted it with a grocery chain the size of Albertsons. How much of a challenge is that for them? I'm assuming part of the navigation they have to do is prepare for the Albertsons acquisition while also making it clear to regulators that they're doing their due diligence and that they are laying out a good case for why this acquisition should go through. Because I could see competitors making the case to regulators, you shouldn't let something the size of Kroger acquire something the size of Albertsons.

Flippen: It's a fair argument to be made, which does put the onus on Kroger to prove that they can lower prices as a result. Their argument is, hey, we're up against unprecedented competition right now. Walmart, even Amazon, all these e-commerce players getting into grocery, and this combination will allow us to be more efficient, scale larger, and provide lower prices for consumers. That's their argument to regulators. But to your point, Chris, getting them to buy that argument, challenging especially in an environment that has a lot of scrutiny from regulators, but also it's probably going to be very expensive for Kroger. We've already seen some of these costs start to weigh on the business. I wouldn't be surprised to see their bottom line contract as this integration and this acquisition is swallowed by Kroger. Expect for the nonadjusted bottom line to be impacted if this acquisition does continue to move forward. But long term, I do think this combination, if it's allowed by regulators and if it's achieved appropriately, could be wonderful in terms of just expanding Kroger's reach and hopefully improving its margin.

Hill: Emily Flippen, always great talking to you. Thanks for being here.

Flippen: Thanks for having me again, Chris.

Hill: Before this next segment, I got to give you a heads-up on something we're going to be doing all month. If you listened to our MarketFoolery podcast back in the day, you know that the man behind the glass, Dan Boyd, and I have a tradition in the month of December. Back in 2015, we were complaining to each other about the lack of creativity that radio stations have when they switch their format to playing all holiday music. To be clear, it's not that we're anti-holiday music. We are fans of holiday music. What bothers us is that radio stations play the same 50 songs over and over. No disrespect to Mariah Carey; love that song. "Jingle Bell Rock"? Sure. Play that once for old time's sake. But over and over? This was something that Dan and I could not abide.

So we decided to do our small part to broaden everyone's horizon of holiday music. This month, Monday through Thursday, from now until Christmas, we're replacing our usual outro music with something that you are not going to hear on your local radio station. If you're wondering what the song is, just check the show notes on your podcast app.

Now, on to the next segment. Running a business means dealing with competitors, and it's tough to compete with a company that is roughly 1,000 times bigger than yours. But that's exactly what DigitalOcean is trying to do in the business of cloud infrastructure. With more, here's Ricky Mulvey. 

Ricky Mulvey: Welcome to bear-vs.-bull. We pick a company, find some analysts, and then flip a coin to see which side they'll take. Today, the company is DigitalOcean, a cloud infrastructure provider for small to medium-sized businesses. On the bull side, making his bull-vs.-bear debut -- it's not bear-vs.-bull; it's definitely bull-vs.-bear -- making his bull-vs.-bear debut, it is Jeff Santoro. Welcome.

Jeff Santoro: Hey, Ricky. How are you doing? Happy to be here.

Mulvey: Doing well. Thanks for being here. And on the bear side, returning champion Jamie Louko. Thanks for playing.

Jamie Louko: I hate to put a stifle on Jeff's debut, but it's going to be a tough panel today.

Santoro: Yeah, we'll see.

Mulvey: Oh, there's no easy outs in bull-vs.-bear. Let's get started. Jeff Santoro, five minutes for the bull side. Time is yours.

Santoro: All right. Let's say you're a small or medium-sized business, or maybe even a start-up. You have as little as two employees, maybe a few dozen. It's 2022. You absolutely need cloud infrastructure to compete. There's no way around it. So you have several choices. You can go to the cloud behemoths like AWS, Google Cloud, Microsoft Azure, and you know what you're going to get. It's going to be a quality product. But the question is, at what cost? You will literally be a tiny fish in a massive pond. The pricing is going to be opaque, customer support might be difficult to navigate, and the offerings are super complicated, especially for a small business that doesn't have a team of software developers and engineers to navigate that scenario. Enter DigitalOcean. They offer transparent, affordable pricing. It's easy to understand. There's 24/7 customer support, no matter how big or small your business is.

There's a community of developers ready to add extra support. It's the ideal choice for start-ups and small or medium-sized businesses that have a limited staff and limited financial resources. This is the market that DigitalOcean caters to, and it's done so very successfully. It's also a big market opportunity. By one estimate, DigitalOcean has a total addressable market of $72 billion, and that's projected to double by 2025 to $145 billion. Just to put that in perspective, DigitalOcean's trailing 12-month revenue as of this past quarter was only $533 million. Even if that TAM number is wildly optimistic, the market opportunity is still huge for DigitalOcean. Now what happens when these small businesses become large businesses? Well, DigitalOcean is going to need to adapt and grow with its customers so it can continue to support them.

But the evidence so far is that their customers are really happy with the platform, and that should really help with churn and keep customers as the company scales. To drive this point home, in the last quarter, DigitalOcean's net dollar retention rate was 118%. That means that customers now are spending 18% more than they did a year ago. Importantly, this number includes churn, so that's customers that have left. This number was also 107% when the company first came on the public markets back in Q1 of 2021. It's grown pretty strong over the time that they've been publicly traded. What's even more impressive about that churn number and about the net dollar retention rate is that a lot of small businesses go out of business. Some of that churn isn't companies leaving because they're not happy with DigitalOcean; it's because they simply went out of business. So that makes the churn number and the retention rate number even more impressive.

Let's take a look at DigitalOcean's most recent quarter, which was Q3 of 2022, reported recently. I want to compare a couple of important metrics to that first publicly reported quarter, Q1 of '21. Year over year, revenue growth has never been below 29%. Gross margin has expanded from 58% to 65%. On the bottom line, the company has gone from a net loss of $3 million in that first reported quarter to net income of $10 million in most recent quarter. Free cash flow has been positive in every quarter, except the first one when they were on the public market.

Lastly, one thing that I like to look at when I evaluate businesses is their operating expenses as a percentage of revenue. In Q3 of 2022, their operating expenses were 58% of revenue, and in the year-ago quarter, that number was 62%. We've seen that improve over the past couple of months. Now, what about moving forward? Well, Q4, management is expecting $161 million of revenue at the midpoint.

That would be a year-over-year increase of 34% and would continue that revenue growth streak that I mentioned earlier. For the full year, revenue target is $574 million at the midpoint, and that's actually raised from where the guidance was in Q2. It would mean full-year revenue growth of 32% compared to 2021. Lastly, free cash flow margin was 15%, and management is expecting that to grow to 20% by 2024.

The last thing I want to talk about is valuation. Despite all these strong results, DigitalOcean trades for around 5.5 times trailing sales and 70 times free cash flow, and both of those metrics are just about at their all-time low. You can buy shares of DigitalOcean right now for almost as cheap as it's ever been.

Just to sum it up, DigitalOcean has carved this niche within a market opportunity that has massive secular tailwinds. If it continues to please its customers and can grow with them while continuing to take share of the growing SMB market, this will be a winning investment for years to come.

Mulvey: Jeff Santoro, thank you for the bull case. Yeah, competing with Microsoft, Amazon, Google, that sounds difficult. Taking the bear side, Jamie Louko, five minutes is yours.

Louko: Thanks, Ricky. As much as I love DigitalOcean, I have a few problems with the company. The first is that it's facing some huge competitors. DigitalOcean is up against rivals like Amazon Web Services, Google Cloud, and Microsoft Azure in this space. While DigitalOcean is the only platform that has major SMB offerings, this could definitely change. Amazon has about $35 billion in cash. Microsoft has $63 billion in cash and is generating $23 billion in trailing 12-month free cash flow. Google is generating $22 billion in trailing 12-month free cash flow and has about $62.5 billion in cash on the balance sheet. Comparatively, DigitalOcean has just $825 million in cash and marketable securities, and about $41 million in trailing 12-month free cash flow. While Amazon, Microsoft, and Google don't have leading SMB cloud solutions yet, that could change, and all three companies have more than enough money to build market-leading products if DigitalOcean continues to gain steam and these companies want a piece of that pie.

But why haven't these large rivals done it yet? Potentially, these three big players don't have established solutions because there hasn't been consistent demand for it yet. Now that Amazon, Google, and Microsoft see that there is established demand for these SMB cloud solutions, these three competitors could just funnel money into this niche offering quite easily. DigitalOcean came in and picked this low-hanging fruit at the beginning, but they basically had no competition thus far. As rivals pick up the pace in this niche offering, the company's growth could slow. The company isn't seeing this yet, as DigitalOcean is expecting about 34% 2022 revenue growth, but that's because these rivals haven't started investing in this SMB space yet. That is my first risk. The other risks with DigitalOcean is its balance sheet.

Typically, cloud companies have a strong balance sheet with little debt and lots of cash, but that's not the case with DigitalOcean. They have cash and marketable securities of about $825 million, but long-term debt of $1.5 billion. This brings up two main concerns. The first is that this large debt pile potentially indicates that DigitalOcean has been fueling its growth with debt. Once the company can't take on any more debt, growth could slow dramatically. The second is that in an environment with high interest rates, the company can afford to take on additional debt to continue to fuel this top line growth. With this lopsided balance sheet, the company will be forced to pay off this debt instead of using its cash to invest, to keep its leadership role in this space. That's already going to be hard to do, considering that rivals are likely going to come into this space in the future, but this factor makes it especially hard.

DigitalOcean has been a success story so far. There's no doubt about that. But the company's future looks a lot more uncertain than it ever has. With rivals putting lots of money and potentially out-investing DigitalOcean in this space over the coming years, the company has previously been operating in a market with relatively low competition, and it's likely been relying on debt to fuel this growth. All of these factors could be major headwinds to the company's adoption and market share growth over the next five years. Therefore, I'm not expecting the same success over the past five years for the next five for DigitalOcean, and prospective investors shouldn't either. This could make it hard for DigitalOcean to live up to its valuation of 72 times free cash flow. Yes, while that might be an all-time low, it's still exorbitant for a company with this many headwinds on the horizon. With rising competition, an upside-down balance sheet, and a valuation that could potentially be really hard to live up to over the next five years, DigitalOcean is in a really uncertain spot, and I'm pretty concerned about the company's long-term future.

Mulvey: Yeah, they might need to buy some servers. Jamie Louko, thank you for the bear case. Jeff Santoro, thank you for the bull side. Hey, Motley Fool Money listener, you can decide who made the better argument at @MotleyFoolMoney on Twitter. 

Today's lucky winner will a receive physical pond. This freshwater body is larger than a pool, but smaller than a lake. You can bring a fishing pole, but leave your swimming trunks at home. This pond houses a diverse array of fish, amphibians, and even a snapping turtle. It just requires a little bit of maintenance. Its current owner gives this pond one and a half thumbs up, and it should be yours if you win bull-vs.-bear.

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.