Salesforce Financials Revisited

It has been over two years since I looked at the financials of salesforce.com so I thought is was well overdue. To recap on previous analysis here are the links:

http://leontribe.blogspot.com/2008/09/valuing-salesforcecom-and-its.html

http://leontribe.blogspot.com/2009/02/salesforcecom-revisited-still.html

In September 2008 the price of salesforce (CRM) was $58.00 and the price of Microsoft (MSFT) was $27.34

In February 2009 the price of salesforce was $28.00 and the price of Microsoft was $16.15

As of today (4 May 2011) salesforce is $133.66 and the price of Microsoft is $25.81

I make no bones about the fact that my opinion is that the share price of salesforce is expensive for what it is. However, as can be seen, the market disagrees with me and that is why I am in IT and not retired on a luxury yacht sailing around the Bahamas. This is also why you should get financial advice from a licensed professional and not necessarily listen to the opinions of a CRM consultant. To be fair I am not the only one who is pessimistic on the prosperity of salesforce’ share price (http://seekingalpha.com/article/264023-how-salesforce-com-could-get-crushed-this-quarter, http://online.wsj.com/article/SB10001424052748704150604576166280156761902.html#articleTabs%3Darticle)

That being said, how are the fundamentals of the business going?

Subscription Numbers

I recently came across a little treasure known as the detailed salesforce financials (http://bit.ly/fJyolc). The last page has all the subscription numbers ever released by salesforce, including confirmation that the number of users (subscribers) has not been released since the end of 2007 (at least not to an accuracy greater than to the nearest million).

After a bit of digging, the conclusion I have come up with is this is no longer released because it covers all of salesforce’s products e.g. Chatter, force.com, Sales Cloud, Service Cloud etc. Therefore a strict comparison of numbers against, say, the subscriber numbers of Dynamics CRM is not valid as it is one Microsoft product versus the entire suite of salesforce products. To make the comparison meaningful, we need to assume that the majority of the subscriptions salesforce has is with the sales product, which may not be true.

One interesting note to be made is that if we look at the subscription and support revenue per subscriber and customer a clear trend emerges. That is, while the number of people at a customer site using salesforce products is increasing, the revenue from each one is, on average, decreasing and the overall result is the revenue from each customer is relatively flat.

Quarter	Customers	Subscribers	Average Customer Size	Revenue	Revenue Per Subscriber	Revenue Per Customer
Q2 FY08	35,300	800,000	22.7	$159,998	$200	$4,500
Q4 FY08	41,000	1,100,000	26.8	$196,517	$179	$4,800
Q4 FY09	55,400	1,500,000	27.1	$266,110	$177	$4,800
Q3 FY10	67,900	2,000,000	29.5	$306,870	$153	$4,500
Q4 FY11	92,300	3,000,000	32.5	$428,534	$143	$4,600

This would support the hypothesis that salesforce customers are bringing additional staff on to salesforce products but onto products with a smaller monthly price tag e.g. Chatter. If salesforce ever release subscription numbers for individual products we will have a better idea if this hypothesis is valid. The alternative hypothesis is that customers are downgrading their services i.e. moving from Sales Cloud Professional down to Sales Cloud Group, which I think would be unlikely.

Looking at the last two lines is interesting. In Q3 FY10, the average customer had 30 staff each spending $153 per user per quarter. In Q4 FY11, they added 3 subscribers but the average went down to $143 per user per quarter. This is consistent with simply adding three paying Chatter subscribers to the average customer and the same mix being true for new customers. To put it another way: the growth in the last twelve months can be explained simply by the upsell of Chatter subscriptions and the signing up of new customers. The model suggests that there has been minimal upsell of additional Sales/Service Cloud subscriptions to existing clients. It also suggests around 25% of the million additional subscribers between Q3 FY10 and Q4 FY11 are Chatter subscribers.

For a comparison of how these numbers compare to Dynamics CRM, check out my upcoming presentation at  Decisions Spring 2011. click here to register:

P/E Ratio

The P/E Ratio, at a given point in time indicates the number of years a share will earn back its price. Historically, if you held salesforce shares it would be your children, grandchildren or their descendants that would see the doubling or your investment. In 2008 the P/E ratio was 200 according to MSN Money. In 2009 this improved to 100. Today, according to MSN money, the P/E ration is 280.

So if nothing changes, it will take 280 years for a share buyer to get back the price in dividends or asset accumulation. Something has to change i.e. the ‘P’ or the ‘E’. ‘P’ is the price. for the ratio to come down to a ‘normal’ level, this would have to crash to about 1/20 of its current value i.e. $6-7 . The other option is a dramatic increase in ‘E’, the earnings (or profits). For comparison, the P/E of Microsoft is 10.

Revenue Growth

From 2005-2009, there was a clear pattern in the revenue growth of salesforce. This pattern being a deceleration in the growth (84%, 76%, 60%, 51%, 44% revenue growth respectively) of around 10% reduction in growth per year. In 2010, the revenue growth dropped more sharply to 21% but recovered to maintain the pattern in 2011 with a growth rate of 27%. It will be interesting to see if the growth rate drops below 20% in January next year.

Not surprisingly Microsoft’s revenue growth rate is much smaller than salesforce’s and in fact was negative in FY2010.

Margins

Salesforce has been dogged by small profit margins for years. Between 2005-2009 the profit margins were 4%, 5%, 9%, 3%, 6%, 8%. Salesforce managed to break into double-digits in 2010 with a margin of 11% but has dropped back again to 6% in 2011.

As a comparison, margins at Microsoft have sat around the 30-40% range for over five years.

Sustainable Growth Rate

This is the rate at which a company can grow its revenues without borrowing or issuing shares. This currently sits at 9%, well below their revenue growth rate of 27% meaning more borrowing or share issuing is on the cards.

Microsoft’s sustainable growth rate is, according to my calculations, around 23%, well below their current revenue growth rate of 7%.

Conclusions

Salesforce still has strong customer growth and subscriber growth but it is maintained through the collection of new customers and the upsell of low-value products. Obtaining new customers is an expensive exercise, compared to upselling existing customers and, with margins as low as they are, it may be time for salesforce to shift gears in this regard. It is true they appear to be upselling products like Chatter but really they should be looking to transition customers to the high-end Sales and Service cloud products. The numbers suggest this is not yet happening.

It terms of the P/E ratio it is the same old story. Conventional wisdom would suggest the P/E ratio is very high, meaning the market is very optimistic for the future of the product. It is not clear to me how the earnings are going to grow to such a level as to justify this optimism.

Revenue growth is, and always has been strong but is slowing. However, the growth is still larger than what the business can support meaning it will continue to raise debt and shares for at least a couple of years or until the banks and investors politely decline the opportunity.

My prediction is, with the strong push from Dynamics CRM in terms of pricing and incentive deals, the next quarter’s announcement on May 20 will show an impact on growth. This will frighten the market and we will again see the shares dip below $100. However, do not see this as advice. Benjamin Graham, the man that taught Warren Buffett everything he knows famously said “"In the short run the market is a voting machine. In the long run it's a weighing machine." What Benjamin did not tell us is how long a short run is. Based on the last four years, longer than I expected.