Authors: Ben Tewey, Aman Garg
Published: 3/12/21
The Business
Salesforce is a global leader in customer relationship management “CRM” technology that brings companies and customers together. They offer a wide range of platforms and apps to help company’s increase efficiency in customer interactions. A customer subscribes to one of Salesforce’s applications/platforms so that they can connect with their customers in order to improve efficiency. Salesforce Customer 360 is the general application that includes the 4 main subscription based segments customers use.
The first of these 4 is Sales Cloud which is a true one stop shop for a company’s sales division. The application allows sales teams of companies to sell faster, smarter and in the way they want by storing data, monitoring leads, forecasting opportunities, gaining insights through analytics this segment makes up 27% of the Salesforce’s revenue. The second sect, Service Cloud, is an all in one for customer service and support. It enables companies to connect agents and mobile employees through one centralized platform, on which they can schedule work, and track and manage jobs in real-time. The Service cloud contributes 26% of revenue. The Marketing and Commerce Cloud increases engagement and efficiency in a company’s marketing team and optimizes commerce. This portion is slightly smaller than the other two adding about 15% of the company’s revenue in fiscal year 2021. Lastly, the “Platform and other category” makes up 26% of the revenue. This segment provides IT developers and business users with Platform-as-a-Service tools for building, securing, integrating and managing their own applications on the Salesforce platform.
All of these platforms and applications are subscriptions based meaning they provide recurring revenue for the company. In short, Salesforce provides platforms and applications to businesses to make the customer-management relationship more efficient. It is a testament to Salesforce’s diversification that no one of their customers accounted for more than 5% of their revenue in 2021, 2020, 2019 or 2018.
Leadership
Salesforce was founded in 1999 by Marc Benioff. Like all great ideas the company started in a one bedroom apartment. By the end of the year, there were already 40 employees and needless to say, a much larger office. In just two years, Salesforce was making 5.4 million in revenue. Their growth was exponential from there. They had their IPO in 2004 at 11 dollars a share raising 110 million dollars. By 2008, they had a billion dollar revenue. As they progressed, they acquired more companies and created a Salesforce eco-system allowing them to expand further. Salesforce introduced AppExchange, 575 apps from 250 independent software vendors, then Service Cloud, acquired Heroku, Radian 6, and kept going. They launched many cloud based platforms that worked together to provide a user intuitive experience that streamlined the customer business relationship. Recently, CRM became a DOW component, acquired Slack, Tableau, and Mulesoft – more on those later- and has a market cap of nearly 200 billion.
Back to Marc Benioff who is both, the CEO and founder, a huge positive as it demonstrates his capability as a leader to have an idea and build it from just that– an idea– to a 200 billion dollar enterprise. This is a real testament to his leadership and highlights his ability. As for the rest of the executives at Salesforce they are all incredibly able and qualified. The announcement of a new CEO at Salesforce that occurred as we were researching for this article is the ultimate non event. Benioff will move to executive chairman and Bret Taylor will step in as CEO. All of this is just formality– Taylor is already playing an important role at Salesforce and his day to day will not change all too much when he becomes CEO.
VestRule Growth Thesis
- International Expansion
- Further monetization of customer base through upselling and cross selling
- Mergers and Acquisitions will complete the ecosystem.
- Greater adoption of digitization in post-pandemic world will drive revenues
First off, Salesforce has a convincing opportunity for International expansion American revenue was up 22% year over year and 32% from the corresponding quarter last year. The Europe revenue was up 31% year over year and 47% from the same quarter last year. In Asian Pacific countries revenues were up 25% year over year and 28% from the same period in fiscal year 2020. In image 3-1 you can see revenue by location, year over year change and year over year constant currency change.
There is a convincing opportunity to upsell (get more products to customers), cross sell (get customers on multiple platforms and subscriptions), which will further monetize their existing customer base. Extending the range of customers from micro to large cap businesses alongside a greater adoption of digitization in a post pandemic world there is also opportunity for further expansion into new categories such as ecommerce and IoT.
Merger and acquisitions. Salesforce has acquired 20 businesses since the first quarter of 2018 including MuleSoft and most recently Slack. The MuleSoft acquisition (5.5 billion) in total was a great buy, the company offered a platform that was great for connecting apps, data sources, and devices as you can see this was very applicable to Salesforce’s business. In 2019 Slaesforce bought Tableau for 14 billion in CRM stock which specializes in data analytics- again very practical. With this track record of smart, effective buys we can presume the management will continue to grow the company through strategic acquisitions. Furthermore, the CRM market is projected to grow at a Compounded annual growth rate of 14.2% per year until 2027 according to Grand View Research giving Salesforce a perfect opportunity to continue to grow and dominate the industry. Lastly, let’s talk about the “slackquisition” Late 2020 CRM bought slack for 27 billion— a hefty price tag but it is key to significant new revenue growth and business opportunity because it enhances a prior acquisition of Quip. On its own Slack could not reach its full potential, but as a part of CRM’s ecosystem it will reach its full potential. Below is an image showing projected revenue from Salesforce through 2026 with Slack included although you will see we are much more conservative in our projections.
Competitive Moat
- Once integrated into a work environment not worth the effort or time to switch
- AI intelligence and access to data allows more informed decisions to be made by Einstein
- Economics of scale allow for more operating leverage
- Pure focus on CRM while competitors have other endeavors
Moats in the software application industry are hard to dig– part of the reason why I am falling out of love with the industry (we will talk more about this in the Negatives and Risks section.). Salesforce held 19.8% of the CRM market in the first half of 2020, reference image 4-1, and has been the market leader for seven straight years. For reference SAP, Adobe, Microsoft, and Oracle held a combined 17.8% market share. Let’s face it Salesforce is the only large company that is solely focused on developing CRM software. Every other company on this list has numerous other focuses and CRM makes up only a small portion of their business.
Secondly, once on the Salesforce network it would be an incredible hassle and remarkably expensive to switch an entire company off of the software. Dozens to thousands of employees relearning a new interface is just not worth the time or effort because a company would be sacrificing valuable time therefore CRM has a high customer retention rate– once installed companies rarely switch.
Third, Salesforce has tremendous economics of scale meaning because of its size and market share they have more operating leverage which lowers costs.
Lastly Salesforce’s system of intelligence: Einstein. A system of intelligence is an application that crosses multiple data sets such as web analytics and customer data to serve timely content and predict user behavior. This way the more people use their software the more data they accumulate and operating knowledge increases as their AI learns more. In turn, this makes the customers’ experience better as time goes on. It also acts as a moat against smaller startups that simply do not have access to the raw amount of data that Einstein does ensuring that Salesforce will be a better product.
Financial Statement Overview
Balance Sheet
- Strong balance sheet
- Well capitalized.
Salesforce has a strong balance sheet and is a well capitalized business. Over the three year period from fiscal year 2019 to 2021 Salesforce has consistently improved their current ratio from 0.94 in 2019 to 1.07 in 2020 to 1.23 in 2021. Ideally we look for a current ratio of 2:1, however we would like to note that contributing to this ratio is a line item “unearned revenue” that salesforce counts as a liability. If this line item were to be ignored, in our eyes it reasonably can be because unearned revenue represents amounts that have been invoiced in advance of revenue recognition but will be recognized as revenue when transfer of control to customers has occurred or services have been provided. If this 12 billion dollar “liability” is ignored the current ratio would jump to nearly 4:1. Salesforce has been improving their cash and cash equivalents steadily and were up 2 billion year over year.
To look at some long term trends: current assets have been increasing year over year consistently from 6 billion in 2017, to 9.5 billion in 2018, 10.6B in 2019, 15.9B in 2020 and 21.8 billion in 2021. Of course the story with total assets has been the same with a 370% increase in the same 5 year period. On the flip side current and total liabilities have increased over the same period but not nearly at the same rate. In fact, the current ratio has increased year over year for the last 5 years as we mentioned earlier. In the same period as the 370% increase in total assets total liabilities have increased 240%. Now for the beautiful part– shareholders equity has experienced a 550% increased over the last 5 years from 7 billion to 41 billion. Book value per share has increased 450% in 2017 to 45 dollars a share. Total debt has increased to 6.35 billion and stalled year over year, however net debt has significantly dropped.
Income Statement
- 80% gross margins in the subscriptions and services segment (this segment makes up 94% of revenue
- High operating expenses which eat up 72% of the 75% gross margin
Revenues have been building year over year from 8 billion in 2017, to 10B in 2018, 13B in 2019, 17B in 2020 and 21 billion in 2021. Gross profit, of course, has increased alongside revenue and consistently remained in the range of 73% to 75% margin. However, total operating expenses have increased as well from 6 billion in 2017 to 7.3B in 2018, to 9.2B billion in 2019 to, 12.3B in 2020, finally to 15.3B in 2021. These expenses have substantially eaten up Salesforce’s gross profit, averaging about 72% of the 75% gross margin, leaving them with an income from operations margin of about 3%. However, as the company matures we will see these expenses naturally cut down because word of mouth advertising will work its magic. Revenue per share has steadily increased year over year and basic EPS jumped this year due to the high net income. EBITDA has continually grown. As expenses from sales and marketing are cut back (which occurs as the company matures) net income margins will continually increase and salesforce has incredible opportunity for high net income margins.
In 2021 Salesforce derived 19.976 billion of its revenue from its subscription and support segment and 1.276 billion from its professional services and other categories for a total revenue of a record 21.252 billion, over a 21% increase from fiscal year 2020. The subscription and support section is broken down into 4 segments as we mentioned in our opening. Sales which was 5.19 billion, service which was 5.37 billion, platform and other which was 6.2 billion and marketing and commerce which was 3.13 billion all increased year over year from 2020 to 2021. The subscription and revenues segment has a mouth watering, 80% gross profit margin. For a total total gross profit of 74%, the professional services sector operates at a loss.
Now for the expenses. Research and development has increased year over year which we see as a good thing considering the nature of the industry– the company has to reinvest in order to maintain its moat. Marketing and sales also increased to a 9 billion dollar expense,(up from 7 billion the year prior, leading to a total increase in operating costs of 25% from 12 billion to 15 billion. Net income for fiscal year 2021 was 4.072 billion which is significantly up from 126 million in 2020 and represents a net margin of 19%. This section deserves some discussion. Gross profits are substantially eaten up by total operating expenses leaving Salesforce with income from operations of 455 million in 2021 and 297 million in 2020 to be clear this 53% increase is astounding, but it leaves the question of how did they sport a 4 billion net income in 2021? These gains come from a 1.5 billion dollar benefit from income taxes and a 2 billion dollar gain in strategic investment. We feel the net income margin for this year is misleading and prefer to look at the income from the operations line for true growth.
Sources ibid balance sheet section.
Cash Flow Statement
Net cash provided by operating activities improved year over year from 2020 to 4.8 billion. Capital expenditures totaled 710 million in 2021 up from 643 million in 2020. This leaves Salesforce with a free cash flow, for our purposes defined as cash from operation- cap ex, for 2021 at 4.091 billion which is an increase from from 2020 and 2019.The only notable changes in cash from investing were an increase in business acquisitions because of the slack deal and an increase in purchase of marketable securities which left with an outflow of 3.9 billion. Well covered from operating activities. Cash provided from financing activities was 1.2 billion led by only a 4 million repayment of debt, a 500 million outflow ,last year and a 1.3 billion cash infusion from employee stock plans. In all, Salesforce increased their cash position by 2 billion dollars in 2021 to 6 billion. This has been a steady trend for the last 5 years along with a steady increase in cash from operations. Cash from investing has been sporadic but always negative much the same as cash from financing which has been sporadic but always positive. Finally cap ex has consistently increased, but so has cash from operations as we mentioned which has led to an increase in free cash flow.
Sources ibid balance sheet section.
Valuation
According to our conservative discounted free cash flow salesforce shares are currently undervalued. We believe this is a conservative estimate because of the growth rate we are assuming. For reference we have Salesforce revenues growing at 20% for the next two years and a 15% growth for the year after that. Salesforce themselves have projected revenue in 2026 of 50B this would be a CAGR of 19%, our estimates have a CAGR 15%. We have revenues after 2025 growing at 3% terminally, but naturally built into this would be a steep drop from a 15% growth from 2024-2025 to only a 3% growth from 2025-2026. On other metrics such as price to free cash flow, EV/EBITDA, EV to Revenue, Forward P/E and Trailing P/E and P/S salesforce is also modestly cheap. The fair value according to our model is $230 a share, but being value investors we would want to buy this stock with a considerable margin of safety.
Negatives and Risks
- Formidable competitors such as Microsoft and Oracle
- Microsoft especially because of the growth of Dynamics 365, the financial security of the company, and ubiquitous use of Office makes for natural gravity
- Slack acquisition will turn EPS negative for 2022.
It’s not all good. Rising interest rates are putting pressure on the stock price, to be clear the interest rates are not pressuring the business, the stock price will be affected but the business itself will not. As interest rates increase the stock price may have near term headwinds because investors will have to discount future cash flows at a higher interest rate to warrant the additional risk they are taking on by buying stock as opposed to a bond.
Secondly, difficulties with expanding out of CRM such as Analytics and integration, we’ve already seen an effort to do this with the Tableau acquisition in 2019, if these efforts to expand were unsuccessful that would negatively impact the business. Salesforce will have to continuously spend on R&D and S&M to stay ahead of their peers Net Suit, Nimble, and Microsoft’s Dynamics 365. This increased expense or failure to reduce sales and marketing expenses in the future would adversely affect the business and continuously eat up gross profit.
CRM has been a serial acquirer of other businesses if, in the future, these investments,or any future investment, don’t realize the potential Salesforce thought they would have, it would negatively impact the business.
Salesforce is in a competitive field with other large companies such as Microsoft, Adobe, Oracle and SAP, if these companies begin to focus on CRM, salesforce would be hurt. These companies are already established, securely financed, and have plenty of capital to attack CRM’s market share. Microsoft by far is the most formidable opponent–so let’s talk about it. Dynamics 365 has seen growth rates that have outpaced Salesforce over the past few quarters, including 39% in the most recent quarter. This means Microsoft has captured an increase in market share. With the full offering of IaaS, PaaS, and SaaS for CRM, ERP, Service, and Customer Data, Microsoft will continue to rise and provide a significant challenge to Salesforce’s ambitions. Microsoft saw its Teams solution expand by more than 100 million users in 2020 and, given the ubiquitous use of Office and Office 365 by enterprises, Microsoft Teams has a natural gravity.
Lastly, the Slack acquisition will significantly negatively impact earnings for at least the next two years.
Disclaimer
I am not a financial advisor. These articles are for educational purposes only. Investing of any kind involves risk. Your investments are solely your responsibility and we do not provide personalized investment advice. It is crucial that you conduct your own research. I am merely sharing my opinion with no guarantee of gains or losses on investments. Please consult your financial or tax professional prior to making an investment.
Bibliography
BamSEC SEC filings directory CRM
Learn to Invest CRM Stock Analysis