Salesforce Q3’15 Review: YoY Sales Growth Slows; Provides Softer FY16 Guidance

Cloud Customer Relationship Management company Salesforce.com (NYSE:CRM) reported a mixed set of results on Wednesday. Quarterly revenues for Q3FY15 stood at $1.383 billion, higher than its earlier guidance of $1.365 billion – $1.37 billion. However, the growth rate slipped during the quarter, declining from 37% in Q3FY14 to 30% in Q3FY15. Although a part of the slowdown is attributable to Salesforce’s sheer size and scale, which makes it difficult to maintain a growth rate over 35%, we believe company-specific factors also contributed to a possible slowdown during the quarter.

Strong operational discipline and cost management helped a strong expansion in operating and net income levels in fiscal year 2015. Non-GAAP operating income expanded nearly 47% on a year-on-year basis from $284 million to $417 million, resulting in an increase in margins from 9.72% to 10.61%. Furthermore, non-GAAP earnings increased from 28 cents per share in Q3FY14 to 38 cents per share this quarter following the robust growth in non-GAAP operating income. However, loss per share in GAAP earnings widened to -32  cents in 9MFY15 compared to -19 cents in 9MFY14, due to an increase in income tax provisions in fiscal year 2015.

See our full analysis for Salesforce.com

Business Realignment Weighs on Q3FY15 Top Line Growth

Revenues from subscriptions and support grew 28% in Q3FY15, slower than the 36% reported in a similar period last fiscal year. Similarly, revenues from professional services decelerated from nearly 50% in Q3FY14 to 33% this quarter. Comparatively, year on year growth in Q2FY15 for both the subscription and professional service divisions stood at 37% and 58% respectively. The company reported a change in strategy to provide custom, industry-specific Customer Relationship Management platforms across six industries to enhance customer value.

We believe the segregation of sales personnel and allocation of new client accounts following this business realignment could have contributed to a slowdown in revenues during the quarter. Although the third quarter has been a softer quarter for Salesforce, with fewer subscription renewals historically, the move to build solutions for specific industries instead of rolling out an industry-agnostic CRM platform requires significant industry-specific training on part of the sales personnel, impacting near term sales growth.

Year-on-year growth in revenues from the Americas region, which accounts for the largest share of sales, decelerated sharply from 41% in Q3FY14 to 29% in Q3FY15. European revenues also decelerated in Q3FY15 compared to a prior year period, due to a challenging macroeconomic environment in the Eurozone region. Shares of Salesforce dropped about 4.5% after the company provided revenue guidance of $6.45 – $6.50 billion for FY16, lower than consensus estimates of about $6.52 billion and our estimate of $6.66 billion.

Going forward, we expect near term sales growth to remain constrained, given the reduced efficiency of the sales personnel in the new organizational setup. However, long term sales are likely to benefit from successful execution of the “New Industries Strategy” as new customer adoption and renewal rates are expected to increase from these industry-specific solutions.

Expanding Margins Could Improve Valuation Prospects

Salesforce has been fueling its robust revenue growth by investing heavily into its operations, driving down margins over the years. The company has always been known for its strategy to prioritize revenue growth over profitability. Non-GAAP operating profit margins have nearly halved in the past five years, dropping from 16.5% in FY10 to 8.93% in FY14. Within the application software vertical, Customer Relationship Management has been the fastest growing sub-segment and is pegged to grow to $37 billion by 2018. Given the rapid evolution of competition in the CRM market in recent times, we believe the pace of investment into Research & Development and Sales & Marketing operations is justified, so as to maximize product functionality while growing its customer base and market share.

For the nine months into FY15, non-GAAP margins expanded nearly 1% to 10.6%, driven by lower General & Administrative expenses. Margins in the fourth quarter have historically been close to margins in Q3, and we expect full FY15 non-GAAP operating profit margins at about 10.75%. Going forward, we expect non-GAAP operating margins to gradually expand to 13% by FY21. The competitive nature of the booming CRM market, particularly in the SaaS-based CRM segment, should reign in pricing going forward and subsequently, operating profit margins. We have factored in low margin expansion prospects into our discounted cash flow valuation for Salesforce. However, there could be a 19% increase in our Salesforce price estimate if the company manages to expand its non-GAAP operating profit margins to 14.5% by FY21.

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