Description

I believe CRM stock (~$214) can compound at between 15-24% over the next five years, for a mid-point IRR of 20% using conservative assumptions.

CRM was previously posted by Condor; it's an excellent write-up with a lot of useful background.

Here I'm going to focus on the recent price decline and why this creates an interesting set-up for future returns.

Share Price Decline

Yesterday Salesforce reported earnings and slightly lowered guidance for the year. The stock declined 21% to $214. Over the last several quarters, Salesforce has been talking about a "measured buying environment" for its software. 

Part of this is cyclical: companies bought a lot of software during Covid and are now rationalizing it by consolidating vendors and cutting costs. Deal cycles are elongated and there are more approval layers before enterprise customers pull the trigger on new software purchases.

Part of this is self-inflicted, with changes to the go-to-market organization. Here is the relevant bit from yesterday's earnings call:

COO Brian Millham then elaborated that these changes should result in productivity improvements in Q2 and beyond:

Core Business Remains Strong

Here is a disaggregation of revenue over the last several quarters:

Integration and Analytics, while only 15% of total revenue, continues to grow strongly.

Benioff also called out growth in Data Cloud, which isn't a reporting segment but rather Salesforce's own data lake and a precursor to generative AI features. Brian Millham explained this clearly in June of last year at the Jefferies conference:

Salesforce Isn't Going Anywhere

Salesforce was founded in 1999 and was the original SaaS business, showing customers that moving from licensed software to software as a service was a good idea. The company has grown organically and through acquisitions over the years. Recent acquisitions include Mulesoft, Tableau, and Slack. 

It has been building a bundle of products and services, starting with customer relationship management (CRM), and spanning sales, marketing, collaboration, finance, customer service and support, data and analytics, and more.

The company rarely raises prices (the most recent price increase was ~9% in August 2023; they hadn't raised prices in 7 years despite adding dozens if not hundreds of new features and updates).

Attrition is about 8% per year, which means retention is 92%. This isn't as high as ServiceNow, but it's pretty good. 

Salesforce has a lot more SMB customers, and as is the rule in enterprise software, the bigger the customer, the lower the average attrition. The more products and solutions the customer buys, the lower the attrition.

Here is CFO Amy Weaver talking about lower attrition from customers spending more with Salesforce, from the 2023 Investor Day, and the accompanying slide:

This is what Salesforce has been working on: building more products and services to keep customers happy, spending more, and with greater stickiness.

The Margin Opportunity

In 2022 ValueAct put out an interesting slide deck on Salesforce pointing out how low its margins were compared to peers. Afterwards, several other activists took positions in the stock, and Mason Morfit ended up taking a board seat.

I've rarely seen a CEO pivot so quickly as Benioff did from the mantra of "growth at all costs" to "let's lower our costs." He really lived up to his personal belief that "In the beginner’s mind there are many possibilities, but in the expert’s there are few," approaching Salesforce with a beginner’s mind.

This has been the result:

GAAP operating margin, which had been choppy and even negative despite Salesforce’s increasing scale, exploded higher. The company has committed to keeping margins up and increasing over time.

There has been a persistent gap between GAAP and non-GAAP operating margins (non-GAAP is simply GAAP operating margin, with SBC and amortization of intangibles added back (and, in recent quarters, restructuring charges from all the layoffs, more about this below)).

As GAAP margins have increased, so have non-GAAP margins:

Non-GAAP operating income has closely tracked free cash flow (defined simply as CFO less capex):

Therefore, as GAAP margins expand, non-GAAP margins and FCF margins should expand at a similar pace.

How high could margins go?

Here are some comps sorted by revenue. CRM sticks out like a sore thumb, with G&A and S&M costs significantly above the adjacent peers Oracle and SAP.

If we take an average of Oracle and SAP’s G&A, S&M, and R&D intensity as a percentage of revenue, we end up with 3.8%, 23%, and 18.8% respectively. 

Applying this to CRM’s numbers results in an uplift of 12.8 percentage points to its GAAP operating margins, from 17.2% last year to 30%:

Note that this would result in CRM spending much more in R&D. If it turns out that they don’t need that much R&D, there’s an additional 4.7 points of margin to pick up.

Free Cash Flow, Multiples, and Valuation

Salesforce’s recent focus on margins has exploded its already prodigious free cash flow generation:

Over the years, CRM has traded at median free cash flow multiples of between 36x at the low end and 43x at the high end.

Currently, the stock is trading at just 18.8x TTM FCF.

This is an entry yield of 5.3%.

It does not take much to get to a mid-teens IRR from here. We can assume no re-rating of the shares and perpetual FCF/share growth of 10% and the IRR would equal 15.3%.

For context, FCF per fully diluted share has compounded at 24.9%, 22.8%, and 24.4% over the last 10, 5, and 3 years.

I believe that a business with ~75% gross margins and free cash flow margins of ~32% currently should be able to demonstrate high incremental margins. Therefore even if growth remains subdued, FCF/share growth of 10% is not a big ask.

Now, let’s do a bit more complicated valuation work.

I have two scenarios below showing the possible IRRs over the next five years. 

The LOW scenario just assumes a flat 8% YoY revenue growth. It assumes a total margin expansion of 13 points by year 5. Share count is held flat. Dividends (yes, Salesforce pays a dividend) grows in line with free cash flow per share growth. The exit multiple is 20x. The resulting IRR is 15%.

The HIGH scenario assumes revenues grow inline with consensus; margins also expand a total of 13 points. Share count is reduced by 0% in FY 2025 but by 1% thereafter (they have been buying back stock, and that should increase with the increase in FCF). The dividend payout ratio increases gradually to 25% and the exit multiple is 25x. The resulting IRR is 24%. 

The midpoint IRR is 20%.

Upside to These Estimates

What could go right? 

Revenue could reaccelerate and outperform my low case or even consensus. Salesforce will almost certainly continue to make acquisitions, both small and large, to continue building its bundle.

Gen AI, which right now seems like a nothingburger, could actually generate incremental revenue over time.

Bear Case on Gen AI

One bear case on Gen AI I’d like to address is “Gen AI will allow anyone to build software and therefore replace customer relationship management software and everything else they sell”.

The best refutation of this was articulated by Marc Andreessen recently:

“Falling costs for building new software companies are a mirage. The reason for that is this thing in economics called the Jevons Paradox. I'm going to read from Wikipedia: The Jevons Paradox occurs when technological progress increases the efficiency with which a resource is used, reducing the amount of that resource necessary for any one use, but the falling cost induces increases in demand. 

You see versions of this, for example, you build in your freeway and it actually makes traffic jams worse, right? Because basically what happens is, oh, it's great. Now there's more roads. Now we can have more people live here, we can have more people, we can make these companies bigger and now there’s more traffic than ever. 

The classic example is during the industrial revolution, coal consumption: as the price of coal drops, people use so much more coal that the overall consumption actually increases, but people get a lot more power. The result was the use of a lot more coal.

The cost of developing any given piece of software falls, but the reaction to that is a massive surge of demand for software capabilities. The result of that actually is although it looks like starting software companies, the price is going to fall, actually what’s going to happen is it’s going to rise for the high quality reason that you're going to be able to do so much more right with software.

The products are going to be so much better and the roadmap is going to be so amazing of the things you can do, the customers will be so happy with it that they're going to want more and more and more. 

And by the way, another example of Jevons paradox playing out in another related industry is Hollywood. You know, CGI in theory should have reduced the price of making movies; in reality it has increased it because audience expectations went up. And now you go to a Hollywood movie and it's wall to wall CGI.”

Catalyst

- Cyclical issues abate and organic growth re-accelerates

- Shares could re-rate although that isn't part of the thesis

- Continued margin expansion, incremental buybacks