We recently revised our price estimate for Salesforce.com (NYSE:CRM) to $50. Although our revision has created a 48% upside over our previous estimate of $34, we continue to be bearish on the long term sustainability of Salesforce’s success. Revenues for the company have grown at an annualized growth rate of close to 30% between 2008 and 2012. However, costs incurred in running business for Salesforce have grown at a much rapid rate. Between 2008 – 2012, cost of sales and operating expenses for the company grew at an annualized rate of 32.7% and 33% respectively. With expenses outpacing revenue growth, net earnings fell into the red in 2011 and 2012.
For fiscal 2014 ending January 2014, we estimate a steeper GAAP operating loss of approximately $163 million, compared to $111 million in fiscal 2013 for Salesforce, and expect this trend to continue for the next four years. We expect a non-GAAP operating profit of $495 million for the company in fiscal 2014, compared to $530 million from a year prior period.
In the current note, we highlight the key factors attributable to our bearish stance on Salesforce.
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Key Factors That Can Drag Salesforce’s Stock Price Downwards:
Ballooning Operating Expenses – We believe Salesforce’s stock is trading at a premium with a revenue growth rate that is higher than our estimates. While Salesforce’s top line growth is impressive, its inability to contain operating expenses raises concerns about its current market price. Salesforce has been sacrificing margins in a bid to fuel its enormous revenue growth rate, and this is visible in the amount of investments that company makes into sales, marketing and advertising. As a % of revenues, both cost of sales and operating expenses rose from approximately 20% to 22% and 71% to 82% between 2009 and 2012. For the first nine months in 2013, these percentages stood at 23.8% and 82.5% respectively.
Much of the increase in operating expenses arises from investments into R&D and sales and marketing activities, fueled by the need to expand its cloud market share. Although we expect operating expenses as % of revenue to decline due to heavy investments being made upfront, we expect absolute operating expenses to continue to be very high for Salesforce. As a result, we expect recurring instances of negative earnings which not only affects shareholders’ interests but also depletes the company’s cash reserves. And this could be a significant drag on the company’s business in the long term. You can check the negative impact of increasing operating expenses on the stock price by using the chart presented below.
IT Giants Can Displace Salesforce’s Market Leadership – Salesforce’s current position of a negative bottom line is a consequence of the current dynamics within the cloud computing industry. Businesses worldwide are choosing to deploy various software as a cloud service, rather than as an on-premise offering, to facilitate faster adoption and lower hardware and services costs. In response to increasing demand for cloud subscriptions, global IT solution providers are beginning to shift their on-premise application offerings onto the cloud, or have separate cloud offerings, to capture market share within the booming industry.
Salesforce is investing heavily into developing and promoting its products to utilize its first mover’s advantage and further gain a larger footprint in the cloud computing industry, before deep pocketed companies like Oracle (NYSE:ORCL) and SAP AG (NYSE:SAP) dive in. Competitors such as Oracle and SAP certainly have the financial resources to invest heavily into niche areas that offer high growth prospects and have recently ventured into the cloud services industry. While Oracle has embarked on a acquisition-based strategy to grow its cloud subscriptions, SAP is integrating its HANA platform with its application and cloud-based products; both of these companies have seen triple digit growth in cloud revenues.
We believe cloud market shares could change going forward as software giants like Oracle and SAP achieve greater success in selling cloud based services in place of their traditional offerings. In this case, a contraction in market share would result in a top line growth deceleration for Salesforce, given the more narrow focus of its business. Salesforce doesn’t have other operational divisions to support organic revenue growth. We believe the risk of a possible slowdown in top line growth could be a drag on its stock price in the future, should Oracle and SAP gain traction in the cloud computing industry with their recent cloud offerings.
On the flipside, Salesforce’s foray into mobile application development through the Salesforce1 platform could mitigate the risk of a slowdown in cloud revenues for the company through heightened competition. Technology research firm IDC predicts mobile application sales to grow 39% annually between 2013 and 2017 to reach $4.8 billion, from $938 million in 2012. Though SAP has the largest market share within the mobile application development market , Salesforce’s global CRM leadership, coupled with an increasing need for mobile enterprise applications (especially in the Customer Relationship Management realm) should bolster sales for the company.Notes:
- SAP Leads Burgeoning Mobile Enterprise Application Development Platform Market, SAP Newsroom, November 2013 [↩]