With Salesforce (CRM-NYSE) finally releasing company-wide dollar attrition last quarter, we can now launch coverage of CRM being more confident in our relative and historical valuation as well as our target price. This is the first in an ongoing series of research examining Salesforce’s business and share price. Salesforce has a number of diverging elements including:
– Trading patterns
– Relative valuation, growth
– Profitability
– Competitive position
Over the last few years, there has been one steady method of valuation that has been a strong predictor of its share price: an enterprise value based on its trailing 12-month customer lifetime value added over trailing 12-month customer growth costs. We have tracked this over time and believe it is the best way to value CRM.
OVERVIEW OF MAIN PRODUCT
The best place to start is listening to their Investor Day (November 2017). The presentation is available here.
Salesforce is primarily a Customer Relationship Management (CRM) company, hence its CRM ticker. 62% of its revenue comes from its CRM service, segmented as ‘Sales Cloud’ (before sale) and ‘Service Cloud’ (after sale).
Sales Cloud is a whole-package solution that enables more efficient selling, process management, forecasting, and tracking versus competing products and Excel. Its modules include:
– Contact, Task, and Schedule Management.
– Channel Integration and Activity Logging.
– Custom Dashboards.
– Pipeline Management.
– Sales Automation.
– Funnel Analysis and Sales Forecasting.
When using Sales Cloud to close a deal, customers enter Service Cloud where they are taken care of in a variety of ways.
Brief Pros of Sales and Service Cloud
User friendly – The user interface is simple, intuitive and easily customizable in comparison to Microsoft Dynamics CRM.
More complete ecosystem – Salesforce covers all aspects of CRM, from marketing to sales and customer service. Their sales and service products are well integrated.
Main Cons of Sales and Service Cloud
Specialized development necessary – Salesforce uses its own proprietary programming language – Apex, instead of common, universal web standards such as Java, .Net and HTML.
More difficult set-up – For SMBs, Microsoft Dynamics CRM ratings for ease of use were twice that of Salesforce. In general Salesforce’s set-up is not intuitive.
In the cloud only – While likely obvious to most reading this, CRM only offers their software in the cloud. Most competitors offer both on-premise, hybrid or cloud solutions. Much of salesforce’s growth is being driven by companies increasingly comfortable with moving internal data to the cloud. Salesforce has no plans to offer on-premise solutions.
More expensive for key features – While offering a free trial and low standard package costs, Salesforce has a lot of hidden costs including higher than average storage costs. Most large organizations looking for robust features and functionality will find themselves being upsold to the Enterprise Edition, which starts at $125 per user per month. Microsoft offers much of the same features of Salesforce’s Enterprise Edition for $65 per user per month.
Increasingly Diversified Enterprise Products – About 70% of new business comes from their five core products: Sales, Service, Marketing, Commerce and Platform. 10 other add-on products make up the remaining new business.
HOW THE STOCK TRADES
High R-Squared to the NASDAQ – While we don’t normally emphasise trading patterns, it is interesting to note that over the last 12-months, CRM’s share price has moved almost in lock-step with the NASDAQ composite. The r-squared between the closing price of each was 0.95 with CRM’s beta being just over one. CRM has moved up and down with the market, with the ups being higher, pushing the stock up over 46% year-to-date.
Exhibit 1 – CRM Versus NASDAQ Composite
Source: Perspectec, Company Reports
Trading at its historical valuation – CRM continues to trade at or slightly above its historical SaaS growth valuation. While it trades at a premium to peers, its historical valuation has been a closer proxy for its share price than a comparable valuation.
Exhibit 2 – CRM Share Price vs. Valuation
Source: Perspectec, Company Reports
SaaS Metrics
Customer Lifetime Value TTM: Customer Lifetime Value (CLTV) = Gross Margin of Subscribers / Churn
Customer Growth Costs TTM: Customer Growth Costs (CGC) = R&D Expense + S&M Expense
Trading at a premium to its peers – We have conducted a SaaS comparative graph comparing Salesforce with other enterprise cloud services. The stock continues to trade at a premium to peers using both growth and overall SaaS Valuation metrics.
Exhibit 3 – SaaS Metrics vs. EV/EBITDA – Salesforce Appears to be Relatively Expensive with a Lower Margin Profile than its Peers
Source: Perspectec, Company Reports
Exhibit 4 – SaaS Growth Metrics vs. EV/EBITDA – Salesforce also Appears to be More Expensive Relative to its Current Growth Profile. In a year’s time we see it’s relative valuation becoming more reasonable.
Source: Perspectec, Company Reports
Transitioning from high growth to low growth – Salesforce has maintained a growth rate of about 25% Y/Y over the last few years, right in the middle of its 20% to 30% guide. At its current growth rate, Salesforce is seeing the lifetime value of its customer gross margin being added representing only 70% of its costs to acquire and grow new and existing customers. Rarely do enterprise cloud SaaS companies spend more to acquire customers than they are worth. It is just not a sustainable business model and spending on sales and marketing as a percentage of gross margin will need to come down.
We see Salesforce missing its four-year goal – Another way to look at it is that the company looks to grow from just over $10 billion in revenue in fiscal 2018 to $20 billion over the next “three or four years” as a soft goal. We believe this is more likely to happen after five years as revenue growth from new customers decelerates due to competitive pressures.
Competitive sales cloud market will increasingly force Salesforce to move to higher margin customers – The sales cloud market for SMBs remains competitive as can be seen with SMB focused HubSpot spending 2x the value of a customer in order to acquire, maintain and grow their base. Salesforce’s gross margin growth will increasingly come from these higher margin larger businesses and increasingly from service integrators, which help reduce S&M costs.
Improving operating margins is next – Salesforce indicated at its last investor day that they will begin to slow down their sales team expansion. We may have seen a little bit of this with Q1 with sales and marketing growing by the lowest amount ($14 million) in 6 quarters. Increasing operating leverage from this strategy will be the first steps towards a very long-term target of 35% EBITDA margins by the time they reach zero growth. We remain more conservative and forecast revenue growth of 23% in 2019 with EBITDA margins rising to 15% from 14% in fiscal 2018.
Exhibit 5 – Financial Fiscal Q3 Results and Q4 Guidance.
Source: Perspectec, Company Reports
Exhibit 6 – Salesforce Versus Guidance and the reaction of the stock
Source: Perspectec, Company Reports
Comparing their competitive positioning –
We evaluate salesforce’s four major segments and their products, Within each segment we rank Salesforce against major competitors using four factors that we believe will impact a product’s competitive position and sales. The factors we use are price (35% weight), popularity (ratings/reviews, 35% weight), funds spent on advertisements (15% weight) and money spent on R&D (15% weight).
The higher the average output, the easier we believe it is for a sales person to sell a product. This translates to higher leverage for sales and marketing costs, which represented 34% of revenue in fiscal 2017. We will update this metric every time we release a new report. If the score falls, we will reduce the impact of sales for a given segment produced from R&D and S&M expenses.
Exhibit 7 – Salesforce’s Competitive Position by Segment
Source: Perspectec, Company websites
Below are the historical financials, our forecasts and our DCF.
Exhibit 8 – Historical and projected Income Statement
Source: Perspectec
Exhibit 9 – Historical and projected Cash Flow Statement
Source: Perspectec
Exhibit 10 – Historical and projected Balance Sheet
Exhibit 11 – Discounted Cash Flow
Valuation
Increasing profitability appears to be accounted for in the share price at the moment – Over the next four quarters with the focus on improving operating leverage, we forecast EBITDA growth of 31%. The increase in EBITDA and EPS is the primary reason we see the share price moving higher. Our target is based on a valuation method that has typically held true for Salesforce’s share price over the last number of years and is similar to how we value other enterprise SaaS companies.
Our target is based on an EV/TTM EBITDA multiple of 37x based on trailing 12-month results ending in fiscal Q1/19 (April 30, 2018). The 37x multiple is based on the multiple the company has historically traded at. This multiple more closely follows CRM’s share price while a 33x multiple would be what enterprise cloud SaaS company’s with similar growth metrics would typically trade at. 37x CRM’s TTM EBITDA of $2.05 billion equals an enterprise value of $76 billion. Adding net cash of $3.8 billion gets us a market capitalization of $79.8 billion. Dividing this by an anticipated 745.3 million diluted shares outstanding gets us to our target of $108.
Based on the current share price of $104, we believe the shares are slightly undervalued.
In one year’s time however, we see the share price moving to $131 primarily driven by trailing 12-month EBITDA increasing to $2.5 billion. Because of this, we believe investors should buy the shares now.
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For the purposes of complying with NYSE, NASDAQ and all Self-Regulatory Organizations, Perspectec Inc. has assigned the following rating system BUY, HOLD/NEUTRAL, SELL for the securities which are the views expressed by an analyst, Independent contractor, and or an employee of Perspectec Inc. The information and opinions in these reports were prepared by Perspectec Inc. or an analyst, independent contractor. Though the information herein is believed to be reliable and has been obtained from public sources believed to be reliable. Perspectec Inc. makes no representation as to its accuracy or completeness.
