What Happened?
The short version is that Salesforce missed revenue, and then gave weak guidance. They said that their customers are pulling back on spending.
This resulted in the stock dropping roughly 20%.
Is this an opportunity? Maybe. Let’s take a look.
The Company
Salesforce is a cloud-based software company that specializes in Customer Relationship Management (CRM). Notice the abbreviation is the same as the ticker. Clever, Salesforce. CRM tools help businesses manage their customer interactions and data. Here's a rundown of what Salesforce offers:
Centralized platform: Salesforce puts customer data from different sources into one system. That gives each department like sales, marketing, and customer service a unified view of each customer.
Salesforce for Sales Teams: This feature allows sales teams to manage leads, track deals, automate tasks, and measure performance.
Marketing Automation: These tools create and run targeted marketing campaigns, personalize customer experiences, and track marketing ROI.
Customer Service: Salesforce also helps manage customer support inquiries and provides self-service options.
The Moat
Once you know what Salesforce does, the moat should be fairly obvious. They do have a brand moat, but the most powerful moat Salesforce has is the high switching cost. Once Salesforce gets into a company, it’s hard to get it out.
Growth
Salesforce has seen fast growth in revenue and earnings in the past.
Revenue Growth (CAGR)
3-Year: 16.94%
5-Year: 20.6%
10-Year: 23.29%
EPS Growth (CAGR)
3-Year: 5.7%
5-Year: 30.59%
10-Year: 29.09%
Let’s take a look at their margins.
Let’s take a look at their margins.
The gross margin is pretty stable at around 75%.
The operating margin does raise my eyebrows a bit.
A good operating margin for a Software as a Service (SaaS) company typically ranges between 20% to 30%. However, this can vary depending on the company's stage of growth, market conditions, and business model.
Early-stage SaaS Companies: Might have lower operating margins, often below 20%, as they are investing heavily in growth, marketing, and customer acquisition.
Mature SaaS Companies: Usually have higher operating margins, sometimes exceeding 30%, due to economies of scale, higher customer retention rates, and more efficient operations.
The question is - where does Salesforce land in that spectrum? It’s hard to call a company with a $220 billion market cap and $35 billion in revenue early-stage. Only getting to an operating margin of 17% in the past year does concern me.
Continuing on with profitability, let’s look at revenue and free cash flow growth.
Here we can see the declining growth rate of revenue that the market is concerned about. At the same time, we can see the effects of the improving operating margins on free cash flow.
I view this picture as mixed. Salesforce does have a high gross margin, but that’s expected with a software company. The very low operating margins in the recent past and declining revenue growth are concerning. However, the improving profitability is a good point.
Let’s look at some more of my concerns.
Stock-Based Comp
Oh boy, this one’s a doozy. Here’s the chart.
Growing profitability doesn’t help a lot if the company gives away more than 40% of the earnings in SBC.
We also have to consider the growth of the company when we look at SBC. The faster the company is going to grow; the worse SBC is.
Buffett on paying with stock:
Warren Buffett calls his purchase of Dexter Shoe in 1993 his most gruesome mistake.
Not because the business didn’t work out, but because he paid for it with Berkshire Hathaway stock.
‘I gave away 1.6% of a wonderful business ... to buy a worthless business’
— Warren Buffett, 2007 Berkshire Hathaway Shareholder Letter
Those shares are worth more than $15.8 billion today.
Giving away shares of a growing business is expensive.
The market obviously expects Salesforce to grow.
Even after the 20% drop, Salesforce is trading at a P/E of more than 40. Of course, this looks cheap compared to previous multiples:
Notice the scale on the right - in 2023 Salesforce traded at a P/E close to 1000x. Then it came down to a much more reasonable 500x. It continued descending to the dirt-cheap 42x earnings today.
Capital Allocation
Besides the egregious SBC, Salesforce has pitiful returns on capital. Here’s ROIC, but if you look at ROE or ROA, they look equally low:
If reinvesting in the business only gets you 6% returns, what do you do with your capital?
Buy back some of the stock you gave away to your executives of course!
Salesforce has actually managed to reduce its share count slightly.
I’ll give credit where credit is due.
Staffing
Salesforce supposedly has a switching moat. That should give it relatively sticky and stable revenue. But Google “salesforce hire” and “salesforce layoff” and you’ll get lots of stories from the last few years.
Salesforce has repeatedly done significant layoffs, followed by hiring sprees not long after. If your revenue base is so sticky, how come you can’t staff correctly?
Salesforce Welcomes 1,800+ New Employees, Expects to Hire More Months After Mass Layoffs
Salesforce to hire 3,300 people after layoffs earlier this year, Bloomberg reports | Reuters
All kidding aside, considering the growth of Salesforce in the past, it could be interesting at the right price. What price is that? Let’s do some quick valuation and see.
Valuation
We’ve already seen that Salesforce is near the lowest non-negative P/E it’s traded at. We can also look at a forward P/E that takes into account growth expectations:
Again, at the low end. But just because something is cheaper than it used to be, that doesn’t mean it’s a good investment.
Reverse DCF
I’d like to run a DCF on Salesforce, but I don’t know what kind of growth rate to put on the company. They’ve grown quickly in the past. They’re improving their operating margins and FCF. But their ROIC is low, and their revenue is slowing.
Instead, I’ll run a reverse DCF to see what kind of growth the market is expecting.
If I want a 15% return, Salesforce will have to grow FCF by 23% per year for the next decade. That’s not a low hurdle. For reference, I used the estimated 2025 FCF of 11,730 million and subtracted the SBC of 2,841 as my starting point.
FCF Yield
Another way we can look at Salesforce without putting a growth rate on it is FCF yield.
Using the same 2025 estimate and subtracting the SBC, we get a FCF yield of 3.9%. Is that enough? It all depends on the future growth rate.
And that’s the problem, isn’t it?
Returns are going to come from earnings growth, and not much else.
Salesforce has a very low dividend yield of 0.68%. At 42x earnings, it’s hard to argue that there will be a lot of multiple expansion to benefit from. That leaves earnings growth.
Conclusion
This one winds up in the “too hard” box for me. It’s grown like a weed in the past and it seems like it should have sticky revenue. Yet the ROIC is very low and revenue growth is slowing. Management seems to have no idea how many employees they’ll need, which tells me the revenue base might not be as sticky as one would think.
I hate the SBC, and the valuation doesn’t scream “obviously cheap”. It could end up being a great investment. But I don’t have enough conviction in the business, and I definitely don’t have enough confidence in the management to buy it.
This is not a one-foot fence with obvious, big rewards on the other side for me.
Awesome write up! Thanks.