Salesforce CEO Marc Benioff walks among attendees as he delivers his keynote address at the Dreamforce event in San Francisco, California August 31, 2011.ROBERT GALBRAITH
Investors who throw their nets into the market to fish for value should pass on Salesforce. That's not to say that the customer relationship company's valuation doesn't keep things interesting.
While Salesforce has done a remarkable job building itself into a dominant name in the software-as-a-service market, concerns about profitability and poor margin leverage remain. That's especially evident when compared to rivals Oracle and IBM.
What's more, with a forward P/E of 67, which is more than six times that of both Oracle and IBM, investors want to know what they're going to get for their money. Shares were falling 4.9 per cent in mid-day trading on Monday to $40.27. Salesforce has slipped 3.5 per cent this year compared to a 14 per cent gain for the S&P 500 and a 13.5 per cent advance for the Nasdaq Composite Index.
It's beginning to look as if Salesforce's top line growth, which has been impressive, is no longer the selling tool that it used to be for those looking to buy the stock.
For any other company, I would be happy with the results that Salesforce produced. On balance, though, this company is still generating gaudy growth numbers, including 28 per cent and 29 per cent surges in revenue and subscription revenue this quarter, respectively. The problem is, good growth (top line) numbers haven't trickled to the bottom line, which is what killed the dot-com era.
What's more, this is a story about performance relative to expectations. To that end, I wasn't particularly impressed with numbers that arrived as expected. This is even though professional services and other revenue totalled $50-million and grew 25 per cent year-over-year. After all, with a forward P/E that presumes excellence, it will take more than meeting the Street's long-term growth expectations to command respect.
Management also spoke favourably about its "billings" or "unbilled deferred revenue." These represent future billings under the company's subscription agreements that have not been invoiced. In other words, "billings" represents revenue that is contracted, but not yet invoiced and is off the balance sheet. This is an important metric in the software services/cloud subscription model that gauges the company's ability to generate recurring revenue.
In the quarter, billings grew 33 per cent to $1.67-billion. While this number is indeed impressive and speaks to Salesforce's strong market-share growth, investors have to remember that this figure is not always "direct," since it includes existing customer renewals and longer invoice durations. Therefore, it doesn't reflect the company's organic billings growth.
Profitability still a question mark
Again in this quarter, the bottom line lagged the top line. And it doesn't appear as if management cares a heck of a whole lot about shoring up this aspect of the business. The company posted a GAAP net loss per share of 12 cents. And on a non-GAAP basis, which includes the effect of $115-million in stock-based compensation, the company earned 10 cents per share.As has been the case for some time, margins weren't any better, as the company shed 160 basis points year over year in non-GAAP gross margins. Likewise, operating margins were below Street estimates by roughly 70 basis points and down 1 per cent year over year. While I've always wanted to like this company, the operating-margin performance, which has suffered due to Salesforce's aggressive growth plans, gnaws at me in ways reminiscent of the dot-com era.
Along similar lines, the fact that the company insists on paying its executives via stock-based compensation, continues to eat into Salesforce's profitability. Granted, it's not unusual for growth companies to adopt this form of compensation. But it's not 1998, either – although the company's name fits perfectly in that era. At some point, investors need to demand for better bottom line performance.
Although Salesforce enjoys a good chunk of the SaaS (software as a service) and cloud market today, rivals are not letting off the pedal. Aside from IBM and Oracle, names such as Red Hat and Microsoft have been making significant capital investments to position themselves for the opportunities ahead. Microsoft can become a true threat, once Office Live is fully embraced.
Microsoft will have an advantage from the standpoint that customers will resist the urge to jump on a different platform, if Microsoft can sell the benefits of seamless SaaS/cloud integration with Windows and Office. Salesforce will eventually find that it has to spend more on sales and marketing, plus other acquisitions, in order to preserve the market share that it currently has. This only adds more margin pressure on an already feeble situation.
Without question, Salesforce.com has to improve its deficits in profitability, if it truly wants to keep the bears in hibernation. As "the cloud" and "big data" markets become more defined, this is only going to heighten the demands on Salesforce.com to perform. Unfortunately, performance now must include the bottom line as the market seems no longer impressed with the company's revenue growth. Accordingly, the stock remains expensive and absent better margin leverage, it doesn't make sense to own it here.
At the time of publication, the author held no position in any of the stocks mentioned.