As always, below represents my opinions and should not be construed as financial advice. Always do you own due diligence. I welcome your feedback of my opinions and hope to have a civil discussion.
· Company Description
o ELI5 the company’s business model
§ Salesforce is the leading provider of Customer Relationship Management Software. Most of their software runs through their Customer 360 platform which serves as a single source of truth across an array of applications.
· Company Soundness
o How does the company collect revenue? Does the company have a good or services that is purchased frequently or a regular interval?
§ Salesforce receives cash for cloud services and software licenses. Often time contracts are paid in advance and costs to service those contracts are amortized over time. This results in receiving cash up. As a result, salesforce typically has strong positive cash flows while their business overall operates at near breakeven levels. Since the positive inflows are sustainable, I view this as a positive dynamic.
§ The nature of their services results in highly recurring revenue.
o Do they operate with significant leverage?
§ Not really. They have $0.24 of debt for every $1 of equity on the balance sheet. Additionally, they have 6.3 billion of operating cash flow compared with interest expenses of only $297 million over the last 12 months ended 09/30/22.
o Is their balance sheet will suited for a downturn and why?
§ Yes, Salesforce has highly recurring and sticky revenue which should help to insulate their balance sheet in a downturn. As of last 09/30/22 they have nearly $12 billion in cash, $4.3 billion in receivables and a $3 billion line of credit if need be. If anything, they have too much cash on hand given their very negative Cash Conversion Cycle.
o Is there evidence that market power is growing and that this will lead to strong financials?
§ Salesforce has consistently turned 20% of revenues into free cash flow while growing revenue per share in nearly every quarter over the past decade. Having said that in recent Cash returns on invested capital have fallen from ~20% to ~9%. I do expect this to move back up toward 20% over the coming years as Salesforce removes excess capital on its balance sheet though a $10 billion buyback. Additionally, management has guided to 30-40% FCF margins over time up from their trending average of 20%. I feel this is likely achievable as the sales growth pace will likely slow in the coming year from 20% to the teens. Slower growth is typically met with wider margins. Additionally as I write salesforce announced a 10% layoff to staff furthering the case for higher margins.
o What is the competitive advantage?
§ The competitive advantage of salesforce is they are the hub of much of their customer needs. Salesforce has developed an iPhone like Appstore to allow third parties to integrate into their products. Additionally, many of their products are highly customized to allow for workflows and automation for their users. The exit costs for leaving salesforce are likely to be steep for their major revenue generators as this means migration costs, development costs of new customizations and integrations on a new CRM provider and retraining costs for staff. All of this to leave the number 1 provider of CRMs for over 20 years seems like a difficult decision to leave them.
o Are their major company specific risks?
§ Salesforce is losing their Co-CEO Bret Taylor at the end of January this year leaving founder Marc Benioff to run the firm. While this is great short term as Benioff has overseen a great rise in Salesforce, it may indicate some transition issues over time.
· Can the company be replicated?
o Is there evidence that the company has defended its market position in the past?
§ Yes, Salesforce has been the leading provider of CRMs basically since its inception as measured by revenue. Additionally, through their acquisition of Slack, they now have all the pieces to operate their business anywhere at any time.
o Is technology likely to serve or harm the company?
§ When you’re in tech, changes can be a problem. It is not clear that changes in technology will benefit them.
o Would $10 billion of capital be enough to re-create the company?
§ No, Salesforce operates in too many businesses across the CRM spectrum for $10 billion to make a massive dent. In addition, since salesforce is the hub of so many companies’ operations, many software engineers have specialized in CRM services. This would be difficult for a smaller player to re-create as it generates a small network effect.
o Are there structural reasons why the supply of new competition is likely to be limited?
§ No. Despite my above comments, thanks to cloud-based servers, access to computing is becoming cheaper and more abundant and thanks to advancements in coding, building applications is becoming faster. This creates a recipe for lower barriers of entry for competition.
o Are there structural reasons why customers are likely to stay with the company?
§ Yes. Despite an environment that is likely to increase competition, customers are likely to be sticky giving the switching costs involved with leaving them.
o Are parts of the company not able to be recreated with capital? Which parts and why?
§ The brand, which is that of an industry leader.
§ The network of third-party support and engineers that are proficient in rolling out their software packages. It takes users for engineers to want to get trained in a new software and takes engineers to roll it out. A startup may struggle to gain traction given the maturity in the market of Salesforce, Microsoft and Cisco.
o Are there competitive threats on the horizon?
§ Nonapparent other than what is listed above. Having said that, I speculate if Apple will enter the market. Many people every day use their mail, calendar, contact, and messaging app daily. Throw on an admin page and charge a subscription and you have a CRM already installed on most employee devices that they are comfortable using with engineers who are trained on their software. Wouldn’t be a silver bullet but may be a concern.
· Growth
o Is there a 90% chance that earnings will be up 5 years from now?
§ Yes, mid teen revenue growth rates with guidance of margin expansion for a firm that has grown revenue per share in 38 of the last 40 quarters suggest a good trend.
o Is there a 50% chance earnings will continue to grow in excess of 7% per year after the 5 year period?
§ Yes, longer than 3 years out, salesforce will still likely be growing low double digits.
· Watch List Decision
o Do you honestly know enough about the industry and company to make an investment decision?
§ I feel I do
o Bottom Line: Based on your answers is the company well insulated from economic and competitive shocks while able to grow for many years to come?
§ Given their massive customer based and ability for customers to add-on higher value services, salesforce seems poised for growth going forward.
· Valuation
o Value the company
§ Shares outstanding have been growing by nearly 2% per year over the past 1.5 years. This period represents the post Slack acquisition dilution. Management has announced a $10 billion buyback and has begun executing on it. All in all, I still expect shares will increase over time despite the buyback. To that end, I will forecast shares increasing by 1 to 2.5% per year
§ In terms of revenue, my analyst data from Finbox estimates revenues to grow to $44.475 billion over the next 3 years which implies a CAGR of ~13% per year. 3 years after that analysts expect revenue to grow at roughly the same rate. Salesforce has extremely sticky and consistent revenues. To that end, for the 3-year projection, I will assume 12.5% premium and discount to revenue estimates for my bear and bull case.
§ Free cash flow margins have stubbornly stayed flat for much of the last 5 years and averaged around 20%. In their recent investor day presentation, they announced they plan to get Non-GAAP operating Margins up to 25%. This is a crude measure of FCF. I will forecast a 18% to 24% FCF margin for a midpoint of 21%, up slightly from the longer term average. They are a show me story for now, so I have not paid much mind to their more aggressive guidance.
§ Putting the above together I get 3-year FCF per share estimates of $6.32 to $11.78 for the bull and bear scenarios.
§ Historically, Salesforce traded at far lower FCF yields, but I feel those days are over as this company is in transitions from 20%+ growth to a more moderate level. As a result, higher valuations are likely a thing of the past. Historically FCF yield have hovered around 1.2 to 3.0%. Currently they stand at 4.0% and for the forecast I will assume FCF yields are between 2.75% to 5.75% at the end of the 3-year period for a midpoint of 4.25%
§ Using the forecasted FCF yields and FCF per share I get a 3-year valuation between $204 to $229 per share. This implies a ~15% rate of return from these levels at the midpoint.
o Would it be a prudent investment to buy the company at current levels?
§ For me, Salesforce represents an established company with a strong brand with maybe a slightly bit higher than average risk given the uncertainty around management transitions and bloat that has occurred over the last few years. To that end, I would want to earn about 11% return on an investment in Salesforce. Given the midpoint offers a 15% ROI at these levels, Salesforce might be attractive. This valuation implies salesforce would yield 11% or more from price level purchased under $158.
Sources:
Aggregated Data: https://finbox.com/FINBOX:CRM
Company Data: https://investor.salesforce.com/overview/default.aspx
Author is long at the time of the writing
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