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Shorting Salesforce (CRM)?

February 7th, 2011 · 3 Comments

Well, there are certainly arguments for that..

Is Salesforce.com Overvalued?

by: Frank J. Constantino February 07, 2011  | about: CRM
 

I invested through the internet boom and bust. I have seen, and unfortunately invested in, companies with astronomical valuations before. Many companies during that time never made a profit. Salesforce.com (CRM) reminds me of the internet glory days. The difference is that Salesforce.com does make money.

Salesforce.com provides customer relationship management software to businesses worldwide. The company offers unique solutions that can be customized to fit businesses needs. Salesforce.com provides many of its software applications through the “cloud”. The cloud refers to groups of servers from which software is hosted. Businesses can access their applications through these servers instead of installing software directly to their own network. This allows businesses to essentially outsource much of their information technology. Salesforce.com has turned this into a highly profitable business.

The stock is widely regarded as being extremely overvalued. It is easy to see why when you look closely at the numbers. Shares of the company have been the target of short-sellers for some time now. The shorts continue to get burned, as shares have continued to soar. Over the past twelve months the stock has risen 120%. Bulls argue that the short-sellers don’t understand the business and the growth prospects for the company. Bulls will point you to the 13.88x sales for which shares trade. Salesforce.com trades at a forward P/E of 118. The price to cash flow is even higher at 142x. Even though the company has an $18.1 billion market cap, it only generated $271 million in operating cash flow in fiscal 2010.

Here is a detailed look at the numbers for Salesforce.com

Metric CRM
Market Cap 18.1 B
Forward PE 118.33
Dividend Yield N/A
5 Year Div. Growth Rate N/A
Price/Book 19.16
Price/Cash Flow 142.22
Price/Earnings Growth 9.25
Return on Equity 7.64%
Debt/Equity 0.49
Revenue TTM* 1.55 B
Operating Cash Flow FYE 271 M
Capex FYE 54 M
Capex/Cash Flow FYE 0.2
5 Year Rev. Growth Rate 49.20%
5 Year Cash Flow Growth Rate 64.70%
Net Profit Margin 6.18%
Current Assets 1.19 B
Return on Assets 3.28%
Long-term Debt 466.85 M

Data provided by Charles Schwab & Co.
*Data provided by I-Metrix

Salesforce.com has a stellar five year revenue growth trend and cash flow growth trend. The problem is this is coming off of relatively small numbers for a company that the market has valued so richly. Salesforce.com by almost all metrics is extremely overvalued.

With 9.88 million shares short, Salesforce.com has 10% of its float short. I personally do not short stocks. As the old market adage proclaims, “the market can stay irrational longer than you can stay solvent”. Shares of Salesforce.com can stay irrational too. Although I don’t short stocks, I do occasionally buy put options on stocks that I feel the market has overvalued. By using put options, I can define the amount of risk I am willing to take. This is the only way that I would recommend attempting to capitalize on Salesforce.com’s rich multiple.

Salesforce.com is probably a great company. They have figured out a way to be very profitable in a competitive space. They may be the most promising company in the hot cloud computing space, but even stocks that survived the internet bubble saw their share of pain. I have a feeling investors that hold on too long in this stock will see their share of pain as well.

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The crucial point, according to us, is this. These trends are very impressive, but there comes a moment the company’s size relative to the market (and competitor’s adoption,copying of their business model) will start to limit the growth.

In that case, they will have to look for other growth opportunities in other markets. And here is where the resource based theory of the firm comes in handy. That theory considers the firm as a collection of resources and capabilities which can be applied in markets.

Salesforce seems to have a couple of so called ‘core’ capabilities, that is, capabilities on which their success is founded. One undoubtedly is their CRM software. The other is the way that’s delivered to customers, the SaaS (software as a service) model via servers in the ‘cloud.’

The SaaS model is extremely useful for many customers as they can save themselves the headache of running sophisticated IT departments and soldering together legacy applications, maintenance, etc.

The latter is already being copied by traditional CRM (customer relationship management) software like Peoplesoft, SAP, Oracle, Microsoft, Amdocs, etc.

Market shares (2008):

  • SAP 22.5%
  • Oracle 16.1%
  • Salesforce 10.6%
  • Microsoft 6.4%
  • Amdocs 4.9%
  • Others 39.6%

This includes traditional delivery (software run on servers of the client) as well as SaaS. The latter is the fastest growing segment:

  • 2007: 15%
  • 2008: 20%
  • 2009: 24%
  • 2010: 26%

We see that the SaaS model is taking share from the traditional model, but the rate at which this is happening is slowing. Now, that’s a bit worrying for Salesforce, because their growth heavily depends on SaaS, where they already have a 57% stake in that market (2010).

So, for the extreme valuations of Salesforce to be maintained, some stuff needs to happen:

  • The overall CRM software sales need to keep growing at a strong pace
  • the SaaS segment has to expand, that is SaaS has to grow faster than the overall CRM market
  • Salesforce has to expand its share of the SaaS market.

Growth/valuation
Why is this? Well, the overall CRM market is expected to grow about 10% a year (it’s an already relatively mature market), if Salesforce just maintains its share of the SaaS segment, and the SaaS segment just maintains its share of the CRM market, Salesforce would just grow with the overall CRM market at 10%.

This is nowhere near enough what’s needed to maintain the skyhigh valuation. 

So either SaaS grows much faster than the overall CRM market, and/or Salesforce grows much faster in the SaaS segment. Not impossible, but on present trends that seems quite improbable.

Trefis, a research outfit, has calculated that to maintain present valuation, Salesforce has to capture 30% of the overall CRM market (not only SaaS) in 2017.

With present growth rates in SaaS, that means that they will have to capture almost all of it by 2017. That seems quite unlikely.

SaaS could accelerate again, and grow much faster than the overall CRM market, but that will almost certainly be the result of increased competition from the likes of Microsoft, Oracle and other big tech outfits. Not only will that limit Salesforce growth, it’s also likely to put margins under pressure.

BaaS, PaaS?
There is, of course, an escape. Salesforce could expand in other markets. They’re already trying to do that with their Database.com product (an SaaS database), and a PaaS (platform as a service) product, which enables smaller companies to run (and develop) their applications on Salesforce servers.

Do they have more than generic capabilities to earn the kinds of CRM returns with these new products? We don’t think so. The Saas (and BaaS and PaaS) are rather generic strategies with low entry barriers. Oracle dominates the database market (>50% share), we can’t see Salesforce taking them on.

Conclusion
We think that Salesforce are richly valued and that sooner rather than later, growth will decelerate and valuations will have to come crashing down. It’s difficult to predict exactly when, but that it is going to happen seems quite sure.

Tags: CRM

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