Description

Salesforce.com (CRM) has been the scourge of short sellers for some time and I guess it’s now my turn to get burned.  I believe that CRM’s revenue growth rate is slowing to somewhere in the teens (%) – a far cry from the 30+% growth that most analysts talk about.  It might take a few quarters for people to catch on, but when they do they’ll have much more concern with a bottom line that is not only failing to show any operating leverage, it’s actually going the wrong way (i.e. into the red on a GAAP basis).

Full disclosure: I’m actually long January 2014 puts, not short stock.  I do think a short will work eventually, but keep in mind that I expect management’s shenanigans (described below) to produce the same sort of artificially inflated yoy comps for the next three quarters. 

The market freaked out in 3Q12 (ended Oct 31, 2011) when deferred revenue growth (adjusted for FX) came in at “only” 31% yoy and management guided to 30% yoy growth for 4Q12.  Analysts had been hoping for something closer to 35%.  Management offered all sorts of reasons why deferred revenue growth isn’t such a great metric but, judging by the stock price, folks weren’t buying it. Realizing they couldn’t spin it the way they wanted to, I believe management basically tried to juice deferred revenues by pushing even harder to sign longer-term deals and discounting their prices like never before. And voila! 4Q12 billings miraculously shot up 58% yoy, including a record number of large deals in the quarter.  The numbers are as follows (in $millions):

Billings = subscription revenue + change in deferred revenues
4Q12: 1,057 = 594 + 462
4Q11: 669 = 429 + 240

Keep in mind that this isn’t traditional enterprise software where customers pay for license fees upfront. It’s software-as-a-service, with subscription revenues recognized ratably over the term of the license, hence the attention paid to deferred revenues.  But they aren’t the whole story.  Since a large chunk of them come from renewals, deferred revenue growth is a bit of a lagging indicator.  We’ll want to look at growth in new business.

To get a sense of where the top line growth rate is headed, we’ll want to calculate new business by stripping out the renewals.  Per the 4Q12 call: “we continued to benefit from a sustained decline in dollar attrition, which fell for the tenth consecutive quarter to end the year still in the mid-teens percentage range.”  So let’s assume that attrition was about 15%:

Renewals = (1 – attrition rate) * billings in year-ago period

568 = (1 – 15%) * 4Q11 billings of 669

New business = total billings – renewals

489 = 1,057 - 568

Repeating the exercise to get 4Q11 new business:

413 = (1 – 15%) * 486 

256 = 669 – 413

So, 489 vs 256 is a 91% yoy increase, which would be fantastic if it was an apples-to-apples comparison.  But it isn’t.  Last quarter’s numbers were boosted by some incremental acquired revenue and a whole lot of revenue essentially borrowed from the future (i.e. pulled forward by extending the average invoicing period).  We need to strip out both of these factors to get a more relevant comparison.

We can estimate incremental acquired revenue as follows:  total revenues recognized in FY12 (subscription + support) were 2,267, versus 1,657 for FY11, which equals growth of 37%. On the call, management tells us that growth would have been 30% if we exclude the impact of the 11 acquisitions done over the past two years.  So,

1,657 * (1 + 30%) = 2,154 pro forma for no acquisitions

2,267 – 2,154 = ~113 of FY12 revenues from acquisitions.

Though management hasn’t given us any other numbers to work with on this topic, we do know that Jigsaw and Radian6 were probably the only ones with meaningful revenues.  We can safely assume that their revenue growth is accelerating.  Finally, we know that Radian6 didn’t get consolidated until partway through 2Q12.  So all things considered, these ~113 of FY12 sales were probably weighted heavily to the back end of the year.  It’s hard to imagine incremental acquired revenues in 4Q12 being much less than 30, especially considering 4Q11 didn’t have Radian6.

We can estimate the revenue borrowed from the future because management tells us on the call that deferred revenues would have increased “approximately 31%” for FY12 were it not for the shift to longer invoicing periods.  Reported growth was 47.6% for the year, so the difference (16.6%) is the growth due to this change.  Taking FY11 year-end deferred revenues of 935 and multiplying by 16.6%, we see that the move to longer invoicing periods boosted deferred revenue by about 156.

So, 489 of new business less 30 for acquisitions and 156 for longer billing periods gets us to 303 of true “apples-to-apples” new business in 4Q12, which is 18% growth over the 256 in 4Q11.  18% would be great for a lot of companies, but not for one as richly valued as CRM.  It’s even less impressive when you consider how much discounting and how many new salespeople CRM had to hire just to generate this slowing new business growth (enough to push GAAP EPS into the red).

Repeating the exercise for previous quarters, CRM’s adjusted yoy new business growth is as follows:

2Q10 -10% (quarter ended 7/31/09)
3Q10 25%
4Q10 47%
1Q11 100%
2Q11 71%
3Q11 63%
4Q11 66%
1Q12 73%
2Q12 34%
3Q12 2%
4Q12 18%

So what’s driving this slowdown? My guess is some combination of market saturation and heightened competition.  Frankly, I have a hard time estimating saturation.  Some people talk about an addressable market of $18 billion, others say $5 billion … the numbers are all over the map and I’m not sure what goes into them.  Let’s just say that this could be an important factor.  And to the extent they’re sacrificing price for volume, they’re getting even closer to saturation than the $ figures imply.

I have a better feel for the competition effect.  Management began to tweak the incentives for their sales team a little more than a year ago so as to push for longer invoice terms.  We also know that they began a big hiring spree for new salespeople starting around 2Q11 (spring of 2010).  Yet despite all that, 3Q12 numbers still came in light.  In response, I’m guessing they pushed the sales team even harder to sign longer-term deals and also discounted pricing to new lows.  Apparently, a recent Sanford Bernstein channel check found anecdotal evidence of discounting as severe as 80% off list.  I wish I could look at revenues per customer, but CRM stopped reporting its customer count in 2Q12 … which just happens to be when my analysis shows new business growth slowing down.

When Salesforce.com first pioneered SaaS it really caught the competition off guard.  Today, however, is a different story.  Oracle, Microsoft, and SAP are totally engaged and typically pricing their SaaS offerings at about half the price.  

Meanwhile, open source provider SugarCRM is selling a pretty good lower cost product aimed at the low end of the market.  The average customer uses less than 20% of the functionality in the product, meaning it’s probably not all that tough to switch.  Pushing small customers from monthly bill to paying for a whole year upfront might just upset some folks and push them into the arms of SugarCRM and others.

Valuation:

I think a really generous valuation would be net cash plus 30X TTM cash from operations less stock comp less capex, which works out to $57 per share.  Considering that growth is slowing significantly despite management throwing everything they can at the problem, and considering the lack of operating leverage, I’m pretty sure it’s not worth more than that.

Risks:
1) The same dynamics will likely play out for the next three quarters.  This is the only risk I really worry about.  Frankly, I just can’t say if the market figures it out before then.  Eventually, though, what goes up must come down.  This pull-forward of billings will create a shortage of customers up for renewal beginning in 4Q13 (i.e. a year from now), unless management can extend invoice periods even further.

2) Other product lines could take off, but enterprise collaboration is hard to monetize (no network effect) and PaaS is rapidly becoming a commodity.

3) More acquisitions could boost revenues, but to make a big impact they’d have to come with low EV/Sales multiples, and those types of companies are not going to be very exciting (i.e. high growth). Remember, the last 11 deals combined barely moved the needle on FY12 revenues.

4) Could get acquired (in theory), but who would be willing to do a non-accretive deal in the ballpark of $25-30 billion?

5) Operating leverage might actually materialize, but I really doubt it. Consider slide 56 from their 8/31/11 presentation, which lists 3 scenarios:
a. "high growth" revenue growth >30%, operating margin flat to slightly down, cash from operations growth < sales growth
b. "growth" revenue growth of 20-30%, +1-3% boost to operating margin, cash from operations growth = sales growth
c. "maturity" revenue growth <20%, +2-4% boost to operating margin, cash from operations growth > sales growth.

In other words, according to management, we can expect as much as a 7% boost to operating margins as the business matures … which would be just enough to get it to GAAP breakeven.  Whoopee!

Finally, note that CEO Marc Benioff hasn’t sold any shares since 2010 (although he sold a ton in 2010 and his colleagues have certainly not stopped selling).  Could this mean he really believes his own spiel?  Maybe.  But I can’t help wondering if he’s hedged out the risk with some fancy derivatives he got from some Swiss bank.  I’d love to hear others’ thoughts on this.

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