Salesforce Q3 Earnings Preview: Double Digit Revenue Growth And Margin Downtick To Continue

by Trefis Team
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Salesforce.com (NYSE:CRM) is expected to announce its Q3 fiscal 2014 earnings on November 18.

Salesforce Business Overview

Salesforce provides various Software-as-a-Service (SaaS) offerings specializing in the Customer Relationship Management (CRM) industry. It leads the global CRM market with a revenue share of 19.5% and surpassed revenues from traditional on-premise software giants SAP AG (NYSE:SAP) and Oracle (NASDAQ:ORCL) in 2012. Salesforce’s revenues, which are derived entirely from selling and servicing its cloud CRM and software products to clients, have grown at an annualized growth rate of 29.7% between 2008 – 2012. In contrast, the cloud CRM and software industry witnessed an annualized growth rate of 22.2% during the same period. The high growth rate in the $124 billion cloud CRM and software industry is indication of increased adoption of the faster and cheaper SaaS options by businesses globally.

The market leadership position for Salesforce comes at the expense of operating and net income margins. In 2012, the company posted operating and net income losses of $111 million and $270 million due to continued outpacing of expenses over revenues. For the first two quarters in fiscal 2014, Salesforce reported 29.6% growth in y-o-y revenues over 2012 along with a steeper operating loss of $84 million compared to $36 million in 2012. This is an indication that the company is fueling higher-than-industry growth by investing heavily into developing, selling and marketing its products. While sacrificing margins seems fair for short term growth, Salesforce’s current strategy could cripple the financial position of the company in the long run with intensifying competition within the global cloud services market.

For the current quarter, we expect sales to continue growing at double digit pace driven by growing adoption of cloud technologies from businesses. Additionally, we expect the company to continue posting negative operating margins as a result of rising costs.

See our full analysis for Salesforce.com

Cloud Adoption From SME Businesses Should Drive Top Line In Near Term

Since the beginning of centralized computing, businesses have been migrating towards leaner IT services to improve hardware efficiency and reduce work loads for businesses. In addition to improving efficiency, cloud services offered cheaper options to the traditional on-premise software offerings for businesses to cut down corporate IT budgets. These possibilities have been favored by Small and Medium Enterprise (SME) businesses which fueled growth for the global cloud services market. Going forward, we expect increasing cloud adoption from SME businesses to drive revenues in the short term, evident from the 28% annualized growth rate expected in the global SME cloud services market between 2012 and 2015. [1]

Deferred revenues are also an indication of a service company’s top line prospects for the future. Salesforce derives a majority of deferred revenues from its subscription services. Deferred revenues increased at an annualized pace of 31%, from $0.47 billion by the end of fiscal 2007 to $1.8 billion by January 2013. However, they have not followed the same growth trajectory in fiscal 2014 and have seen a decline in the first six months thus far. With 90% of deferred revenues being accounted from subscriptions, this could imply a reduction in total number of subscribers for the company. However, unbilled deferred revenues which represent revenues from subscriptions that have been contracted but not invoiced yet rose from $3.5 billion as of January 31, 2013 to $3.8 billion as of July 31, 2013. On the whole, we could see strong growth in new license and subscriptions revenues from growing SME cloud adoption and higher conversion of unbilled deferred contracts for the next few quarters.

Larger IT Players Could Pressure Revenue Growth Rate With Cloud Entry

The continued weakness in global macroeconomic environment has forced large enterprises globally to move to cloud in a bid to save on IT expenses. This shift in customer preference has lured traditional deep pocketed software providers such as SAP, Oracle and IBM into the cloud arena. In addition to offering software packages as a service, these providers are also aiming to provide various platforms and infrastructure as a service. This means that databases, operating systems and servers in the future could be installed and managed by the cloud provider, giving the end-user a hassle-free experience.

In the long term, we believe Salesforce could face considerable pressure from these larger players with new and complete cloud offerings. Salesforce only operates within the CRM and marketing segments and would have difficulties in drawing large corporations that could prefer having a single IT service provider. However, Infrastructure-as-a-Service (IaaS) and Platform-as-a-Service (PaaS) models are still quite far away from implementation across the world due to security risks arising from having entire data blocks off-site. In the near term, we expect Salesforce to remain the global leader in the CRM market.

Rising Costs Should Continue To Push Margins Into Red

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% during 2009 – 2012. Much of the increase in operating expenses arises from investments into R&D and sales and marketing expenses, fueled by the need for such investments in expanding its cloud market share. We forecast operating expenses as % of revenues to decline going forward. However, there is considerable downside risk to the stock, should the percentage remain at current levels as can be seen from the chart below.

Additionally, non-cash expenses such as stock based compensation have been increasing as % of revenues. Recurring instances of negative earnings as a result of these expenses not only affects shareholders’ interests but also depletes cash reserves and could be a significant drag on the company’s business in the long term. The company’s management expects operating margins to remain negative for many quarters to come.

We will be revising our price estimate of $33 for Salesforce once the company announces its Q3 results.

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Notes:
  1. Parallels SMB Cloud Insights™ for 2013, February  2013 []
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