Salesforce.com (NYSE:CRM) beat market expectations in its Q2 fiscal 2014 earnings released on August 29. Revenues grew by 31% on a yearly basis to $957 million.  While its core businesses Sales Cloud and Service Cloud continued to grow at a rapid rate, a major boost came from the marketing portfolio after the acquisition of Exact Target. The company saw further market share gains in the customer relationship management (CRM) software market.
However, as expected, the robust growth comes at the expense of lower operating margins. Surging marketing and R&D expenditures both outpaced revenue growth and weighed on its operating margins and profits. GAAP net income swung to black after a hefty tax benefit, non-GAAP net income declined by ~5% to $58 million. The company announced another round of job cuts to lend support to declining margins.
Free cash flow declined by 25% to $80 million during the quarter as capital expenditure increased threefold. Based on the growing adoption of its Marketing Cloud coupled with continued growth in its core offerings, the company raised its fiscal 2014 revenue guidance for the second time this year. The company now expects revenues to range between $4 billion and $4.02 billion, up from the earlier guidance of $3.83 billion and $3.87 billion. This would imply nearly 30% growth on a yearly basis. For the next quarter, the company expects revenues to cross the one billion mark for the first time to reach $1.05-$1.055 billion and non-GAAP EPS of $0.08-$0.09.  Below we take a detailed look at the key highlights of the earnings.
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No Dull Moment For Cloud CRM Services, Maketing Cloud Gains Traction
The growth in Sales Cloud and Services Cloud was mainly driven by the continued adoption of cloud-based CRM services, especially by small and mid-sized companies. The company seems to be widening the market share gap with its competitors as on-premise CRM software majors Oracle and SAP reported mid-single digit growth while Salesforce again reported ~30% growth in its overall revenues. Salesforce is also gaining traction with big enterprises.
What comes as a big positive is that its Marketing Cloud suite now seems to be making inroads into the market. The key change in the cloud-based software landscape is that more software sales are being driven by marketing and IT related spending is no longer restricted to IT departments of a company. This was the main reason for Salesforce.com’s focus on the marketing software space. Salesforce had been beefing up its social media offerings for a while and acquired a number of companies in the last two years. However, with the latest acquisition of Exact Target, its efforts seem to have begun paying off now. As competition rise for its core CRM business, we expect Salesforce’s Marketing offerings to offset the impact and drive the growth in the longer term.
Deferred or unearned revenue on the balance sheet grew 30% in Q2 over the same period last year to approximately $1.8 billion.  Deferred revenue implies that the contract has already been signed and advance payment has been received against it, but it is recognized on the income statement only when the product or service has been delivered. Further, unbilled deferred revenue (excluding Exact Target), which is the revenue that is contracted but not yet invoiced and is off balance sheet for now, grew 36% to $3.8 billion ((ref:2)) The growth was much higher than the historical average and points to high revenue growth in the near term as Salesforce begins to realize these sales on its income statement. ExactTarget’s unbilled deferred revenue totaled approximately $137 million.
Rising Costs Continue To Weigh On Profit
Despite strong revenue growth, rising costs remains a big concern. As expected in our pre-earnings note, overall gross margins declined slightly to below 81%. While the company blamed the Exact Target acquisition and Oracle deal for its decline in margins, the cost of revenues has been trending higher for the last couple of quarters. Soaring R&D and marketing costs more than offset the revenue growth and weighed on operating profit margins. R&D costs (excluding stock based compensation) have risen nearly 50% to $122 million. Marketing expenses (excluding stock based compensation) are up by nearly 26% at $425 million as the company invests and pushes its new businesses, particularly Marketing Cloud. The company has announced 200 job cuts as part of its strategy to curtail costs to improve margins.
Further, as discussed in our previous earnings, a significantly higher stock-based compensation is also a negative. The company expects its FY14 GAAP EPS to near around ($0.44)-($0.42), whereas non-GAAP EPS is expected be around $0.32-$0.34. This is partly due to stock-based compensation, which is expected to be around $0.81 per share. Total stock-based compensation is expected to be more than 10% of FY14 revenues. While this is a non-cash cost and doesn’t affect cash flows directly like cash compensation to employees, it does result in stock dilution.Notes:
- Salesforce.com Announces Fiscal 2014 Second Quarter Results, Salesforce, August 29 2013 [↩]
- Salesforce.com’s CEO Discusses F2Q14 Results – Earnings Call Transcript , Seeking Alpha.com, August 29 2013 [↩] [↩]