2023 has been a solid year for investors. Through late December, the tech-heavy Nasdaq Composite index returned 45% while the S&P 500 returned 25%. One of the prominent investment themes of 2023 was artificial intelligence (AI), with much of the hype captured by the Magnificent Seven stocks.
While these shares performed well during 2023, it would behoove investors to think beyond this cohort as it relates to investing in AI. Cloud-based customer relationship management (CRM) business Salesforce.com (CRM 0.42%) has posted a respectable operating performance so far this year. In fact, after a 100% return, Salesforce is the top-performing Dow Jones Industrial Average stock of 2023 at the time of this writing -- and I think it's headed even higher.
Let's dig into what helped propel such a massive move in Salesforce stock this year, and why 2024 could be the start of a new growth story for the enterprise software leader.
The beginning of a new chapter
For many years Salesforce was known for its aggressive growth tactics, mostly in the form of splashy acquisitions. While Wall Street and investors historically cheered these deals, Salesforce arguably bit off more than it could chew following its $28 billion purchase of messaging and productivity tool Slack back in 2021. While the integration efforts have been a bit sluggish, causing many to believe Salesforce overpaid, the deal actually carried a silver lining.
In retrospect, the Slack acquisition more or less forced Salesforce's management to take a step back and reevaluate the entire business. This means that firing on all cylinders in the name of revenue growth was no longer the top priority. Instead, Salesforce realized that it needed to mature and start focusing on both revenue and profitability.
While this may sound obvious, keep in mind that the last couple of years have been difficult for cloud software businesses as customers have been operating under much tighter budgets due to a challenging macroeconomy. In a way, the Slack acquisition could not have come at a worse -- or better -- time, depending on how you look at things.
After reporting earnings for the third quarter of its fiscal 2024, ended Oct. 31, Salesforce demonstrated that it is serious about long-term sustained profits. Moreover, the role that Salesforce will play in AI looks discounted, if not misunderstood, as Wall Street continues to be enamored by the Magnificent Seven.
Image source: Getty Images.
Don't miss the forest for the trees
The table below illustrates Salesforce's revenue growth across its various products over the last year:
| Category | Q3 FY 2023 | Q4 FY 2023 | Q1 FY 2024 | Q2 FY 2024 | Q3 FY 2024 |
|---|---|---|---|---|---|
| Sales | 17% | 16% | 13% | 12% | 10% |
| Service | 16% | 15% | 13% | 12% | 11% |
| Platform and other | 22% | 18% | 12% | 11% | 11% |
| Marketing and commerce | 18% | 16% | 10% | 10% | 8% |
| Data | 16% | 20% | 20% | 16% | 22% |
| Total subscription and support revenue |
18% | 17% | 13% | 12% | 12% |
Data source: Salesforce Investor Relations.
You can see that the company's revenue is decelerating. Although this might not appear encouraging on the surface, there is more to the story. Salesforce has spent much of 2023 relentlessly focusing on operating margin and increased profitability.
CRM Operating Margin (Quarterly) data by YCharts
The chart above illustrates Salesforce's quarterly operating margin over the past five years. Since early 2022, the company's margin profile has steadily improved and flowed straight to the bottom line.
For the third quarter, Salesforce generated $1.4 billion in free cash flow, an increase of 1,088% year over year. Moreover, on a year-to-date basis, the company's total free cash flow of $6.2 billion represented 67% annual growth.
It's obvious that Salesforce has turned into a leaner operation in the face of decelerating revenue. Nonetheless, with strong margins and robust cash flow, Salesforce looks ready to get back to making some noteworthy investments -- this time in AI.
During the third-quarter earnings call, Salesforce CEO Marc Benioff stated that "the AI revolution is a productivity revolution." This is an important, yet subtle, remark. Remember, at heart Salesforce is a CRM for sales and marketing professionals. But over the years, the company's major acquisitions have included analytics tool Tableau, data integrator MuleSoft, and messaging tool Slack. All of these fit squarely into workforce productivity services.
What Benioff is alluding to above is that Salesforce can actually offer customers an end-to-end spectrum of productivity and automation tools wrapped around AI. In fact, Benioff also said that Salesforce Data Cloud was "the foundation of every AI transaction" during the third quarter. As seen in the table above, while the company's overall revenue growth is slowing, the Data category is the only one that increased year over year.
Given the company's myriad subscription platforms, I think it's only a matter of time before the secular demand fueling AI helps the company's other revenue streams return to more robust growth.
The valuation is compelling
CRM PE Ratio (Forward) data by YCharts
The chart above shows the forward price-to-earnings (P/E) ratio of Salesforce, benchmarked against a peer set of other enterprise software businesses. The key takeaway is that Salesforce's forward P/E of 32 is the lowest among these comparable companies. While some investors could argue that Salesforce is a more mature business compared to the likes of Atlassian, Datadog, and ServiceNow, the disparity among valuation multiples is tough to ignore.
Given management's commentary on the earnings call, coupled with Salesforce's increasing cash flow, I can't help but think that the next phase of growth is right around the corner. I view Salesforce as an under-the-radar AI opportunity and shares look like a bargain at current trading levels. Now looks like a great time to begin dollar-cost averaging into a position.
