Salesforce’s European Data Center Investments Increase Near-term Pressure On Bottom Line

Recently, cloud CRM software company Salesforce.com (NYSE:CRM) announced its plans to expand its operations in the European region. ^[1] Salesforce plans to open three new data centers in the U.K., France and Germany to lure government customers that require stricter data protection requirements, according to a Bloomberg report. Salesforce business is primarily concentrated in the U.S., which accounts for almost 71% of overall revenues. The European region contributes approximately 18% to overall revenues with Asia-Pacific accounting for the rest.

Currently, the company has four data centers in the U.S. and one data center in Japan to cater to its entire customer base. Salesforce plans to open the U.K. data center by August 2014, with two additional data centers in France and Germany to open by 2015. The expansion plans look to be a move to increase geographic diversity on part of Salesforce and become a global CRM player. Below, take a look at the potential opportunity for Salesforce in Europe and the impact of an expansion in operations on its stock price. We have a $49 price estimate for Salesforce which stands at a 17% discount to its current market price of $59.

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Does This Investment Contribute To Salesforce’s Bottom Line?

Salesforce’s recent financial results have been been a story of strong top line and deteriorating bottom line, as the company continues to invest heavily in its strong growth. In its recent fiscal earnings, Salesforce reported a revenue growth rate of 33.5% on a year-on-year basis. Concurrently, its expenses grew even faster, impairing its non-GAAP operating profit and producing a GAAP-based operating loss.  Investing in new data centers is a highly capital intensive proposition. Google spends approximately $4 billion a year on building and maintaining data centers that support its systems, which puts the high CapEx requirements in store for Salesforce in context. ^[2]

Salesforce’s capital expenditures increased from $152 million in 2011 to $299 million in 2013. Including the increases in capitalized software reserves, the company’s total CapEx spending increased from $212 million in 2011 to $574 million in 2013. The opening of new data centers in the next two years should expand CapEx requirements. Salesforce currently guides a CapEx spend of 5%-7% of FY15 revenues. Our CapEx widget below gives you an idea of an increase in CapEx spending on Salesforce’s stock price. The spike in CapEx as a percent of Gross Profit in 2013 is a result of our CapEx valuation methodology, which includes any increase in capitalized software reserves. Salesforce’s acquisition of ExactTarget added approximately $275 million in capitalized software, which led to an increase in total CapEx for 2013.

Additionally, Salesforce would have to increase its investments into operating activities such as Sales & Marketing, General and Administrative expenses to generate additional customers in these countries.  As an SaaS company, new revenue generation would tend to be spread across the subscription period, which is typically between 12 – 36 months for Salesforce. The first of these three data centers, the UK facility, is scheduled to open this August, though sites for the other two have yet to be selected.  They thus are not expected to open until 2015.  To the extent these investments and the associated expenses are made ahead of the revenue they are to support, they will erode profitability to a degree.

Expansion Into Europe Could Pose Long-term Threat To SAP’s Dominance

According to Gartner, enterprise software spending in the EMEA region is expected to increase at a compounded annual growth rate of 4.3% between 2012-16 to reach €70 billion (~$92.4 billion) by 2016. ^[3] This implies that the size of the EMEA enterprise software market at the end of 2013 should be approximately $81 billion. For its part, the company suggests the market for cloud software in Europe will be $29.4 billion by 2017. This is as reported by the Bloomberg report. The opportunity is rich.

Salesforce’s expansion into Europe directly stacks up against SAP’s (NYSE:SAP) position in the market. SAP is the leading software player in the European market and derives a close to 45.5% of its $22 billion revenues from EMEA. The company reached €975 million (~$1,295 million) in global cloud-based license sales and support revenues in fiscal 2013 and expects cloud revenues to grow 32% in fiscal 2014. ^[4] Although SAP should continue to hold Europe as its strong hold in the near term, Salesforce’s entry into the region with domestically located data centers should result in some migration of customers from SAP CRM deployments onto Salesforce’s platform in the long term.

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1. Salesforce.com Increases Commitment to Europe With New Strategic Investments, Salesforce Newsroom, March 2014 [↩]
2. Technology firms to spend $150bn on building new data centres, The Guardian, August 2013 [↩]
3. High-Tech Tuesday Webinar: Software Market Dynamics in EMEA in 2013 and Beyond, Gartner Research, October 2012 [↩]
4. SAP AG Management Discusses Q4 2013 Results – Earnings Call Transcript, Seeking Alpha, January 2014 [↩]