Salesforce 2016Q4 Earnings: Revenue Growth Sustainable; But Profitability Nowhere in Sight

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Cloud computing behemoth Salesforce.com (NYSE:CRM) continued to defy the law of large numbers in fiscal 2016 fourth quarter results reported on February 24th. [1] The company had a stronger than expected quarter due to a surge in demand across all product categories and geographies. A number of factors, which include closing over 600 seven-figure plus deals and the first nine-figure deal, suggest that Salesforce may still be far from slowing down. [2] Profitability remains the only concern since Salesforce GAAP EPS stayed in red in the fourth quarter at $(0.04), though the non-GAAP EPS analysts track were $0.19. This trend is not expected to change in the medium term despite a sustained moderate improvement in the operating margin over the last seven quarters. Nevertheless, shareholders responded positively to the earnings, resulting in a 10% jump in Salesforce’s shares following the release of the results.

Salesforce’s fiscal 2016 fourth quarter earnings snapshot:

  • Revenue grew by 25% year on year to $1.81 billion
  • Non-GAAP operating margin improved by 177 basis points year on year to 12.1%
  • Non-GAAP EPS was $0.19, compared to the prior year figure of $0.14.
  • Full year fiscal 2017 revenue is guided to expand by up to 22% to $8.12 billion, while non-GAAP EPS is guided to increase to $0.99-$1.01.

Our price estimate of $65 for Salesforce.com is slightly lower than its current market price.

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See our complete analysis for Salesforce.com here

Operational Metrics Suggest Revenue Growth is Sustainable

Salesforce’s revenue growth in the fourth quarter was particularly strong because of the positive confluence of all underlying factors. The company witnessed strong growth in each of its product categories as well as its geographical markets. The Apps Cloud and Others segment clocked in 43% year on year growth in the fourth quarter, the highest among all segments. The Service Cloud and Marketing Cloud both grew by over 30% year on year, and the flagship Sales Cloud expanded by 12% year on year in the fourth quarter.

A closer look at the data provided by Salesforce suggests that the outstanding revenue growth may be sustainable in the medium term. Granted, the company is likely to grow at a slowing pace every year, but the pace of slowdown is likely to be very gradual rather than sudden.

First and foremost, Salesforce closed over 600 seven-figure plus deals in the fourth quarter, which is an all-time high for the company. [2] To have achieved this while on an $8 billion revenue run rate in the next fiscal year is no small feat. It suggests that Salesforce has the capacity to keep expanding its customer base with a bigger average deal size even at its current scale.

The second data point which suggests ample growth potential is the fact that over 70% of Salesforce customers, still use only one cloud. [2] This presents an enormous cross-selling opportunity for the company. Even though Salesforce is now present in the end-to-end CRM process, this factor suggests that customers still do not use it as a comprehensive CRM platform. Instead, Salesforce products are currently being used to satisfy specific, narrow requirements of its customers. If the company is able to grow the popularity of its entire product portfolio, it could potentially transform into a much more closely integrated strategic partner of business enterprises. Naturally, this could result in an even bigger average deal size and continued revenue growth.

Lastly, Salesforce’s deferred revenue growth continues to outpace its revenue growth. Deferred revenue is the revenue that is not yet recognized on confirmed contracts. In fiscal 2016, deferred revenue touched a high of $4.3 billion, which is a growth of 29% year on year. Deferred revenue provides the clearest indication of future revenues of cloud computing companies. In the case of Salesforce, the sustained growth in deferred revenues suggests that Salesforce is still closing new deals at a strong place, thereby locking in future revenues.

Therefore, we believe that Salesforce is likely to continue to perform well in terms of revenue growth in the medium term.

Still a Long Way from Profitability

Salesforce’s top-line performance may be indisputable, but the company is still a long way from profitability. Its GAAP loss per share increased to $0.07 in fiscal 2016, compared to a loss of $0.42 per share in the previous fiscal year. The company continues to be unprofitable primarily due to the high stock-based expenses that are included in sales and marketing expenditure. Salesforce’s sales and marketing expenses as a percentage of revenue declined by 2 percentage points year on year in fiscal 2016, but at 49%, it is still too high for the company to be profitable.

Salesforce has made some positive strides in the last two years by improving its non-GAAP operating margin in seven consecutive quarters. As a result, its general and administrative expenditure as a percentage of sales contracted by 200 basis points in fiscal 2016. After improving the non-GAAP operating margin by 177 basis points in the fourth quarter, Salesforce has guided an expansion of up to 150 basis points in fiscal 2017.

Arguably, the heavy expenditure on sales and marketing is what’s driving the company’s enviable revenue growth. Used to incentivise employees, stock-based compensation expenses are high.  A pull back on sales and marketing could potentially have a detrimental impact on sales growth. Clearly, so far revenue growth has been the top priority for the company. But if it hopes to turn profitable in the near term, it may have to sacrifice some of the revenue growth in the future.

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Notes:
  1. Salesforce Investor Relations []
  2. Salesforce Fiscal 2016 Fourth Quarter Earnings Call Transcript, Seeking Alpha, February 24, 2016 [] [] []