Steep Net Income Decline Despite Tax Benefit Underlies Salesforce’s Lopsided Growth Strategy

Salesforce.com (NYSE:CRM) reported its fourth quarter and full year fiscal 2014 results yesterday, February 27, after the close of markets. (Fiscal years end with January.)  Revenues crossed the $4 billion mark for the full year, reaching $4.07 billion at a growth rate of 33.5%. ExactTarget, which Salesforce acquired in July 2013, contributed $196 million in revenues in fiscal 2014. Deferred revenue levels also grew 35% to reach $2.52 billion. Additionally, the company has a robust unbilled deferred revenue pipeline amounting to approximately $4.5 billion.

However, margins for the company continued to tread a downward trajectory as operating expense grew even faster than revenue for the third successive year. Salesforce posted an GAAP operating loss of $286 million for FY14, which translates into a staggering -7% operating profit margin. Comparatively, GAAP operating profit margin last fiscal was about 3.6%. Non-GAAP operating income excludes the impact of non-cash expenses such as stock based compensation and amortization of intangibles, and is a better benchmark to gauge the performance of a company with significant non-cash expenses.

Even on non-GAAP terms, Salesforce posted a decline in margins. Non-GAAP operating income stood at $364 million, which indicates a non-GAAP EBIT margin of 9% compared to $357 million (~11.7% non-GAAP margins) from a year prior period. Heavy investments into R&D and SG&A activities combined with constant expansion in stock compensation payments have been detrimental to the company’s non-GAAP and GAAP margins. We expect to see continued erosion in margins for Salesforce in the near term, as competition intensifies within the cloud enterprise software industry and Salesforce’s increases its investments to increase its lead over competitors.

Salesforce finished fiscal 2014 with a GAAP net income loss of $232 million despite receiving a favorable tax benefit of approximately $126 million. What’s more worrying  is that Salesforce’s loss before tax deductions nearly tripled, increasing from a loss of $128 million in the previous year to $358 million in fiscal 2014. We currently are in the process of updating our price estimate of $50 for Salesforce to incorporate the latest Q4 earnings.

See our full analysis for Salesforce.com

Factors Weighing Down On Salesforce’s Margins

As stated above, Salesforce’s erosion in margins is driven by its operating expense growth outpacing revenue growth. Salesforce’s SG&A expenses increased 35% over CY12 to $2.77 billion. R&D spend for the company increased at a steep 45.2% rate over the 12 months to reach $624 months. In comparison, Salesforce’s revenues only grew at 33.5% compared to last fiscal, which puts downward pressure on margins. Salesforce’s high operating expenses indicates the highly competitive SaaS marketing and CRM industry.

Salesforce markets and sells its services primarily through a direct sales channel, with telephone sales personnel based in regional hubs and field sales personal based in territories. Both these sales personnel are supported by sales representatives who are primarily responsible for generating qualified sales leads for the company’s top line growth. Compensation for these sales representatives and personnel is usually made on a commission basis. In addition, the company’s employee stock compensation have been on a constant upward trend, amounting to about 12.5% of fiscal 2014 revenues, up from 6.8% in fiscal 2010.

The company also has a network of partners consisting of various independent software vendor, IT consulting firms and system integrators that provide lead referrals and contribute through an indirect sales channel. Salesforce pays these indirect partner channels a fee based on the first-year subscription revenue from the customers they refer. As its business expands, we expect Salesforce to expand both its direct sales personnel and indirect partnerships which should continue to weigh down on margins.

As a percent of revenue, Salesforce’s operating expenses far outweigh those of legacy software players such as Oracle (NYSE:ORCL) and SAP AG (NYSE:SAP). The primary reason for this higher expense allocation to both R&D and S&M is to maintain its competitive lead and support its hyper growth rate in the top line. Salesforce has a stronger presence in the small and medium enterprise market, which typically have low renewal rates and require substantial sales and marketing and service activity. Investments into R&D and S&M activities ensure Salesforce an expansion in its market share within the CRM industry.

Additionally, Salesforce reported a total of 200 large deals, that crossed seven figures in revenues for fiscal 2014, compared to 150 in fiscal 2013. ^[1] Currently, the growth in number of large deals signed by Salesforce is in close correlation with overall revenue growth. If the growth in number of large deals outpaces overall revenues going forward, we should see some lift in margins as large enterprises offer scale and pose a lower operating burden, relative to deals with smallercompanies.  This should lift the company’s financial health in the long run.

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1. Salesforce.com’s CEO Discusses F4Q2014 Results – Earnings Call Transcript, SeekingAlpha, February 2014 [↩]