Investing in Salesforce

Published on 04/11/21 | Saurav Sen | 3,657 Words

The BuyGist:

  • Why look at Salesforce?
  • What’s the Upside?
  • What’s the Risk?
  • Is it trading at a Comfortable Price?

Isn’t Salesforce played out?

Why are we looking at this behemoth anyway? Big companies imply small returns, right? That’s probably true in most cases, but it’s not a rule. We’ve been investors in household names like Microsoft and Apple for years; they’ve trounced the S&P 500 over that timeframe. Some of that may be over-valuation by the market. But mostly, we think, it’s because they make killer products that dominate their respective sports.

The other, subtler reason their stocks have done well is because they’ve transformed themselves. Apple realized that it simply can’t iPhone it in anymore. Microsoft made Cloud Computing its core business. Salesforce is the original Cloud-based software-as-a-service (SaaS) household name. But just when we thought they’ve captured whatever they need to capture, their management thinks they can double revenue in the next 5 years.

This talk of “doubling revenue” is serendipitous because just a couple of weeks ago, we estimated that we’d need to believe in a 100-ish percent revenue growth scenario for us to consider buying the stock. Here’s how we got interested in Salesforce – check out the last column:

But it wasn’t just that their “Revenue growth we need to believe” number was (gulp) palatable compared to other names in our AI & Big Data Watch List. We also looked at Scalability, or “Operating Leverage” as the sages of Wall Street would call it. So, to take both Believability and Scalability into account, we made a useful metric to prioritize our time called the Priority Factor. This was the result:

We’ve recently done a deep dive on Qualcomm – into its competitive advantage, moat, risks and valuation. Our subscribers know whether we bought or not. They have access to our Portfolio.  Adobe and Salesforce came in second. We decided to dig into Salesforce first.

In the sections below

  1. We’ll triangulate Salesforce’s “investability” among peers from a different angle.
  2. We’ll dig into the Salesforce story and how it’s likely to change going forward.
  3. We’ll discuss the main risk to the story.
  4. We’ll talk about price.

Ok. Let’s go. May the force be with us.

Salesforce’s other Peer Group

We updated our numbers and measured up Salesforce’s Priority Factor against some its closer peers. We were curious about how they stacked up against some other SaaS companies. Let’s start with Believability:

Now, let’s move on to Scalability:

Our Priority Factor is simply Scalability divided by Believability – more specifically, its (Fixed Costs as a % of Total Operating Costs) divided by (Revenue Growth we need to believe). Here’s how it shakes out:

Even in this comparison, Salesforce stacks up well. In other words, we’re on the right path. So far, so good.

Is the force with them?

Salesforce is already dominant. In their space, they are the biggest dog in town:

But we were surprised to see that their market share was only 20%. So, there is room to grow – not only in the current market environment but more so if the size of the entire CRM market grows. Salesforce Management has high expectations, especially because of high TAM (Total Addressable Market) growth.

What’s their pitch? In one(ish) word: Platform-as-a-Service. It’s a compelling story. They’ve got all the parts for this budding platform. Now it’s about execution.

Salesforce makes Customer Relationship Management (CRM) software. That means they sell software that collects and organizes data about customer interactions – meetings, marketing efforts, invoices, support etc. You can imagine that a CRM can have many layers – it could just be about maintaining a database of customers with some basic contact information and meeting notes. Or it could be something much more complex – like collating all complaints from thousands of customers and distilling it down to the top 3 product improvements the company must make. In other words, it could be kinda dumb or kinda smart. Over time Salesforce has become smarter.

Just a few years ago, Salesforce pioneered the Cloud-based SaaS model. We love this type of business model. If a company is dominant in its field and distributes its product over the Cloud, it has the makings of a Global Dominator. The theory is that Economic Moats widen dramatically – companies with deep wallets can continuously innovate and distribute at scale and speed, thereby making it very difficult for competition to ever catch up. Salesforce and Adobe are good examples of this. And in case someone does come along with a disruptive product, the Global Dominator can easily acquire them.

Salesforce has been on an acquisition spree. But their acquisitions have been lateral, not competitive or hostile. There are 3 high profile acquisitions that matter the most:

  1. Tableau
  2. MuleSoft
  3. Slack

The Slack deal is yet to be consummated. But for all intents and purposes, the deal is done. Slack CEO Stuart Butterfield was at the Salesforce Investor Day in December 2020. For our analysis here, let’s assume that Slack is fully integrated into Salesforce.

Together with the core CRM product, the 3 tack-on acquisitions can culminate into a formidable Platform-as-a-Service (PaaS). What would this look like? Imagine this:

Core database functionality of Salesforce + Data Visualization of Tableau + Messaging & Customer Service tech of Slack + All of it integrated with MuleSoft. So, imagine a small company using this PaaS. One of their customers buys their product. The PaaS will automatically attribute the sale to the reports, conversations, marketing plans and other KPIs. The attribution is seamless. Do that a few times over, and a pattern emerges. All this, by the way, is beautifully visible in Tableau’s awesome graphical charts. Disparate MARKETING COSTS are now perfectly attributed to the appropriate REVENUE line items. This is not as easy as it sounds, especially as the company grows.

Here’s the thing: Salesforce sells better Attribution. Why is this important? Because Attribution is problem. Let’s tweak that. Bad Attribution is a pervasive problem.

Companies don’t talk about Attribution enough. But they do it all the time. And they do it badly. That’s because they operate in complex-adaptive systems - Causes & Effects have reflexive, feedback loops. Excel can’t make sense of it. “Circular Loop!”, it screams. In Investing, Business, Marketing, Economics or Policy decisions, Attribution is murky. It's easy to build a model to explain an effect, after-the-fact. But that requires companies to pick the “cause metrics” in the first place. This is a problem.

Attribution is basically Deductive Reasoning – it tests an existing theory. The existing theory is that Sale X was made because of Action Y. A CRM makes that link. A firm does that many times over, and then it has a lot of data. Gaining insights from data requires Inductive Reasoning – reaching a conclusion based on available data. Inductive Reasoning means making an inference. The best type of Attribution occurs when Deductive and Inductive Reasoning meet. Then something close to the truth shakes out. This is complicated. Most Analytics tools can't do this. Yet. This is where AI (we realize it’s a buzzword) can make a massive impact – matching up Deductive and Inductive Reasoning.

Salesforce has another thread that it hopes will run through the gamut of its products. It’s an AI engine called Einstein. Salesforce hopes that Einstein will be the cherry on top of a layered cake with core CRM software, Tableau, MuleSoft and Slack. If Salesforce can actually achieve this, it’s hard to imagine competition ever catching up. CRM + Tableau + MuleSoft + Slack may become the Competitive Advantage. Switching costs + Einstein would be the Moat.

Maybe we should call this story: SlackForceoMuLeaustein. For simplicity, let’s call the “new Salesforce” Layer Cake. Marketing is not our strength.

So, what’s the problem?

Nothing major yet. Obviously, a lot of the thesis hangs on execution. But the main risk is market saturation. We’re just not sure whether Management estimates of TAM (Total Addressable Market) expansion are realistic. We don’t have the data to confirm this. The subsequent question then is: Will Salesforce be able to double revenue in the next 5 years?

If the last 5 years are any indication, then we should give Management the benefit of the doubt. Marc Beinoff – Founder and CEO – is still at the helm. Maybe he’ll be right again. Here’s what happened the last 5 years:

For most of that time, there was no Tableau, no Slack, no MuleSoft and no Einstein. With these 4 boosters in place now, will Salesforce repeat its stellar run-up? Or will they need more boosters?

Acquisitions can be a drag. Unless there are real “synergies”, they tend to be dilutive – Free Cash Flow can decrease in the long-run, especially if too much debt was used to acquire a company that doesn’t generate enough cash to cover the cost of that extra debt. Otherwise, if equity is used, as it has been for the Slack deal, then it could dilute valuation – Free Cash Flow per share could decrease. How have these metrics behaved in Salesforce’s rather acquisitive past?

It appears that, going by past records, we needn’t be worried about Value-Dilution. Apart from our characteristic skepticism about TAM, the only other risk we can think of is Institutional Lethargy that can creep into big, bloated, successful companies. Unfortunately, there is no way to quantify that either.

There are no riskless stories in equity investing. And these risks are digestible. So far, so good.

Price Talk

Let’s do some reverse engineering - Expectations Investing in action.

CRM (Salesforce’s ticker) trades at roughly $228 per share. That’s a market capitalization of around $210 billion. Now, we always like to buy something at a 30% Margin of Safety. If we tack on 30% to $210 billion, we get $269 billion.

Now, if we use our standard 20X multiple on this market cap, we arrive at about $13.4 billion in Free Cash Flow. That’s how much Free Cash Flow Salesforce would need to generate – or have a good chance of generating – for us at The Buylyst to consider buying the stock at its current price. This is a massive jump.

Hard to digest. But let’s keep going.

So, what does $13.4 billion in Free Cash Flow mean in terms of Revenue? Now, we need to make some more assumptions to back-solve.

  1. We’re not including Slack’s revenue in these calculations because it doesn’t really move the needle. Slack’s revenue over 12 months ending January 31st, 2021 was about $900 million. Salesforce’s revenue was $21 billion. So, about 4%.
  2. We won’t factor in any Slack costs either. So, essentially, we’re saying that the net free cash flow impact of Slack will be a wash. As a sanity check, Slack’s free cash flow during the 12 months ending January 31st was roughly $50 million. Doesn’t move the needle.
  3. We will however factor in the share dilution that will occur if the Slack acquisitions deal closes. So, Salesforce’s shares outstanding will increase from 921 million shares to roughly 1,000 million shares (rounded up).
  4.  We’ll need to make some cost structure assumptions: 
    1. Let’s assume Gross Margin will remain the same – so Costs of Goods Sold proportionately increase with revenue.
    2. Let’s assume Fixed Operating Costs will remain the same.
  5. Let’s assume that capital costs remain the same. So, Capital Expenditure and Cash Interest remains the same.
  6. Cash Tax Rate assumed at 20%.

How does all this shake out?

Now, let’s answer the big question on all our minds: how long will this take? Salesforce says that they expect to double revenue in 5 years. To believe that, we’d have to believe the Layer Cake story. Then the stock looks quite attractive. It’s not so far-fetched.

But there is a snag.

It’s hard for us to believe that Salesforce’s Fixed Costs will stop growing. This upends our “revenue growth we need to believe” number. Womp. Check out their growth in Fixed Costs (R&D, Cost of Labor, Sales & Marketing) next to revenue growth:

How does this flow down to the most important metric of all – Free Cash Flow? In the previous section, we had charted out Free Cash Flow per share. Even with acquisitions, Free Cash Flow per share increased. But did it keep up with Revenue growth?

Not as fast as we’d like, especially in recent years. It turns out that over the last 3 years, while Salesforce’s revenue doubled (approximately 100% growth), Free Cash Flow per share grew by just 40%. If this continues, it becomes harder to believe that Salesforce’s stock is reasonably priced.

Why did this happen? Well, Salesforce issued a lot more shares to fund their acquisitions. This dilutes existing shareholder. And it makes valuation harder. Check out their how their number of outstanding shares grew:

So, let’s say revenue doubles over the next 5 years – so a 100% increase just as Management would have us believe. If the past is prologue, then Free Cash Flow per share would grow by 40%. Tack on a 40% increase on current Free Cash Flow per share of $4.06, and we get about $5.7.  

At The Buylyst, we use a 20X multiple on Free Cash Flow (FCF) or Free Cash Flow per share to estimate a “comfortable price”. 20X on $5.7 is about $114 per share. Salesforce stock trades at $213 as of editing this analysis piece. $114 is not even in the vicinity.

But wait. Over the last-five-years timeframe, things look better. Revenue grew by 218%. FCF per share grew by 201%. That’s more like the 1:1 proportionate growth that we’d like to see over the next 5 years. So, what do we believe?

To buy Salesforce at its current price, we’d need to believe that:

  1. They won’t issue more shares to fund more acquisitions.
  2. Their Fixed Costs won’t grow at the same rate as it did in the past.
  3. The Layer Cake story outperforms Management expectations.

If these 3 assumptions pan out, FCF per share can grow at a similar pace as revenue. Then our original estimate that we need to believe that Salesforce’s revenue will grow by about 100% to buy the stock would hold up.

So, what should we do?

We started this analysis hoping that Salesforce is a comfortable business at a comfortable price. We’re not so sure. There are 2 main risks:

  1. Fixed Costs keep growing as fast as revenue.
  2. Management makes more acquisitions by diluting shareholders.

If these 2 scenarios take place, that “revenue growth we need to believe” number spikes up a lot. Then Salesforce becomes more speculative, and we’re better off looking at other companies on our AI & Big Data priority list – Adobe, Infosys or Wipro.

It’s risky to invest in stocks that heavily valued on Sales Growth – it’s impossible to predict when Mr. Market will suddenly turn its attention to actual earnings – net cash generation. Salesforce may enjoy a big premium now because revenue is expected to double. But if those dollars don’t flow down to Free Cash Flow, at some point the market will stop paying a premium. To bet that the market will keep valuing Salesforce predominantly on Sales growth is Speculation, not Investing.

We’ve learned one thing from this analysis. We need to adjust our Watch Lists. Investing is a life-long learning pursuit. Giants of investing like Buffett and Munger keep hammering that point. So, our Watch Lists need to be more accurate at singling out viable opportunities. We’ve got some pointers from this analysis on how to do that.

The main metric we need to incorporate into our Watch List is this: Does Free Cash Flow per share Growth keep up with Revenue Growth?

As for Salesforce, we’ll borrow a term from Buffett and put it in the “Too Hard” pile. It’s a comfortable company at an uncomfortable price. Incidentally, that’s his second largest pile, after the “No” pile. Salesforce is not a “No”.

There are 2 scenarios in which we’ll buy Salesforce: 

  1. We gain confidence that the cycle of capital-raising to fund growth acquisitions is tempered.
  2. There is a market crash/correction, at which point a lower price will make the risks more palatable.

If we factor in a 50% probability for this combination of scenarios to play out, a “comfortable price” would be somewhere between $114 and $213 (current price). Let’s call it $165. We’d probably pounce on Salesforce stock at that price.

In the coming days, we’ll do a similar analysis on Adobe.

Many Happy Returns.

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