In the late 1990s, Marc Benioff co-founded Salesforce.com (NYSE:CRM), which would pioneer a new approach to enterprise software: on-demand applications. Instead of installing CD-ROMs on desktops and servers, a customer could now access and install new software from the Internet.
It also helped that the company used a subscription model to sell its software, instead of requiring large up-front license payments.
For the most part, the formula has worked, and Salesforce is now the largest on-demand software company. Revenues were $130 million in the fiscal third quarter, and there are roughly 556,000 subscribers.
But what about 2007?
Challenges to overcome
To keep growing, Salesforce.com will need to continue to snag big-time customers. True, the company has major implementations with companies such as Cisco (NASDAQ:CSCO), Symantec (NASDAQ:SYMC), and Sprint-Nextel. However, it needs to find more non-tech biggies.
Also, early in the year, Salesforce experienced a variety of service outages (especially in January). No doubt, this is something that can scare away major customers.
The good news is that the company responded quickly, and so far, performance has been solid. In the fiscal third quarter, Salesforce was processing 1.6 million transactions per hour with reliability greater than 99.9% (you can check out the performance data at trust.salesforce.com).
Finally, there is certainly competition. Companies such as Microsoft (NASDAQ:MSFT) and SAP (NYSE:SAP) are investing in the space. There are also upstart competitors, such as SugarCRM and NetSuite.
And who knows -- there may even be a play from Google (NASDAQ:GOOG), which is assembling a variety of on-demand applications that can be used in the corporate market.
Opportunities in 2007
Going into 2007, expect Salesforce to focus on organic growth. While the company has a large market cap and could pull off a major acquisition, it would be tough to buy a traditional software player. More than anything, it would probably be a distraction because of the complexities of integration.
Instead, it is likely that Salesforce will focus on smaller deals to plug gaps in its on-demand infrastructure. That was the case in 2006, when it bought Sendia so as to provide wireless capabilities.
Next, there should be a boost from partnerships struck in 2006, such as with IBM (NYSE:IBM), Cisco, and Deloitte.
Finally, the company will continue to expand from its CRM roots. This is because of AppExchange and Apex, which allow for the creation of new on-demand applications (such as for HR, expense reporting, project management, and so on). There are more than 430 applications, as well as a community of more than 23,000 developers.
Interestingly enough, the company has an incubator program. For $20,000 a year, a developer can rent a cubicle at the Salesforce office and build applications.
Quick valuation
According to a valuation performed by Merrill Lynch on IBM's purchase of FileNet, the median enterprise value (EV)-to-sales ratio is about 2X to 3X. As for the EV-to-EBITDA ratio, the median is between 10X and 14X.
In comparison, Salesforce's valuation does look extreme, with an EV/sales ratio of 9.6X and an EV/EBITDA ratio of 107.
But there are some caveats. First, because of its subscription model, Salesforce's revenues are recognized over time (there are no up-front license fees). Also, Wall Street likes the predictability of a recurring revenue stream. Finally, the company is growing at a hefty rate, which often results in a high stock price.
The Foolish bottom line
Just a few years ago, the on-demand model was considered a niche. Now, it's becoming a standard approach to delivering enterprise applications. In fact, a report from Gartner forecasts that 25% of enterprise applications will be on-demand by 2011.
Thus, with Salesforce.com's leadership position, extensive infrastructure, and innovation, the company has what it takes to grow into 2007 and beyond.
For further Foolishness:
Check out the other companies featured in "The Motley Fool's 2006 in Review and 2007 Preview" special.
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Fool contributor Tom Taulli does not own shares mentioned in this article. He is currently ranked 623 out of more than 18,000 investors in CAPS. Symantec and Microsoft are Inside Value picks. The Fool has a disclosure policy.
