Salesforce.com - The Next Billion in Revenue

The future of Salesforce.com

Salesforce.com (CRM) is trying to move beyond its success as a SaaS provider of sales force automation to a broader role of a key supplier of SaaS application development tools and hosting services. While the market potential is enormous, CRM’s strategy for translating this opportunity into shareholder value is still work-in-progress.

Salesforce.com (CRM, MGI-X: 1,302; MGI-CV: +4%) has achieved an unqualified success in becoming the leading provider of Software-as-a-Service (SaaS) solutions for Sales Force Automation. The company is now attempting to broaden its strategy by aiming at the market for SaaS application development tools and services, essentially marketing an integrated suite of development tools and hosting services. CRM has recently hosted a widely successful user event - Dreamforce 2009 which played to capacity crowds listening to company presentations delivered by management with a visibly renewed sense of confidence. Management seemed very pleased with the Q3FY2010 results and indicated that they “signal the company has regained not just its sea legs as evidenced in Q2, but is now in a growth stance”. At the conference CRM has renewed its marketing push of the Force.com development tools suite and hosting platform.

Force.com is a tightly integrated suite of development tools which include database, user interface, and transaction management. Force.com services abstracted at a high level to deliver functional blocks that make up modern web applications. It is designed to specifically take advantage of the Salesforce.com hosting environment and development tools suite which are used internally by CRM to develop its own line of SaaS products. In targeting rapid applications development requirements, CRM is addressing the needs of small and medium-size organizations without or with limited IT resources as well as tactical/functional needs of larger organizations that are willing to largely bypass corporate IT. While our initial user checks corroborate the company’s claims with regard to time and cost benefits of the Force development platform in our view it is too early to judge the long-term staying power of these early adopter applications and too early to dramatically revise near-term revenue projections for CRM based solely on Force.com. While CRM is the first large company on the starting line for SaaS development services, this race is a 2 to 3 year marathon which just started and more competition will be forthcoming much of it based on open source tools re-packaged for specific hosting environments.

At the same time, Force.com is a meaningfully-sized long-term opportunity for CRM and could be up to 5X the size of CRM’s primary market for sales and support apps. It is not unusual for a Fortune 500 company to have thousands to tens of thousands of internally developed applications – with the high majority written in pre-internet technologies (e.g., mainframe and client-server development tools), and a sizeable percentage waiting for a technology upgrade. If Force.com is able to become the default cloud development platform for the thousands of departmental and tactical, functional applications, it could over the next 2-3 years generate up to $1 billion in incremental revenues for Salesforce.com.  Today, Force.com is gaining a base of reference accounts, with some existing Salesforce.com customers building pilot apps with Force.com and some seriously evaluating expanding their investment in the platform going forward.

The State of the Core Business

While there is no question that CRM’s business has notably strengthened as evidenced by improvements in attrition, net customer additions, gross margin and operating cash flow, the deceleration in deferred revenue growth has continued. Borrowing an analogy from the semiconductor industry, the book-to-bill ratio is slowing down at a pace that should give pause (perhaps seasonal) to investors looking at 2010. Management’s comments call for a further recovery in top-line growth and acknowledge the prospect of a more moderate future growth as compared to the pre-crash levels.   Q4 is traditionally the strongest seasonal quarter for CRM and typically results in a large jump in deferred revenues thus likely to provide much more clarity as to the real long-term growth and retention trends for CRM. On top of deferred revenue, the company has accumulated a significant amount of cash and so far has not clearly articulated a plan for how to deploy this resource optimally.

CRM Business Efficiency Metrics are Stable

Salesforce.com MGI scores are among the highest of all SaaS/Cloud applications vendors but way below those of leading enterprise software providers such as Oracle. CRM’s current MGI scores are virtually unchanged from the July 2009 quarter, with MGI-X at 1,302 and the MGI Change Vector still positive at +4% vs. +21% in July and +5% in April. Aside from the quantitative MGI scores, the business in our view has notably strengthened in terms of stabilized attrition rates, net customer additions, gross margin improvements and cash flow. Furthermore, as we mentioned above, we are heading into Q4 which is traditionally CRM’s strongest quarter.

Competitive Outlook

The competitive gap between CRM and its nearest competitors remains wide and deep. Salesforce.com today is the clear leader and the largest (by revenue) independent vendor of SaaS and cloud computing applications. SAP, Oracle, and even Microsoft are far behind Salesforce.com in terms of their knowledge and experience with on-demand enterprise applications. None can claim even $100 million in SaaS revenues, let alone $1 billion+. None have SaaS applications which achieved comparable dominance in its product category. SAP appears trapped in its own cloud-based quagmire (aka Business-By-Design), while Oracle founder Larry Ellison is outright incredulous (See YouTube.com: “Why Larry Ellison Hates Cloud Computing?”) of the cloud computing model. While it is easy to poke fun at the Cloud Computing model and many application types may never fit into the SaaS model, it is hard to argue with over $1Bill+ in SaaS revenues that CRM generates annually and its meaningful continued growth.

Challenges Ahead

Counter-balancing the upside potential of CRM is pragmatic reality – the growth in its core business is slowing down, the next big market opportunity will require change and will increase risk. The company has gotten to its current size by largely by-passing corporate IT departments and cherry-picking amongst business processes that can operate with minimal integration. A move into tools that help develop any corporate application will put pressure on CRM to provide additional integration middleware as well as support. A typical budget of implementing a corporate application is comprised of 40% application cost and 60% integration, implementation and training cost. Achieving long-term success and high retention in the internally developed applications market would require Salesforce.com to build a sales and support channel focused on selling into the IT organization – the very same organization that Salesforce.com has outmaneuvered while selling its core CRM application directly to the business function (i.e., the sales organization).  Salesforce.com motto – “No Software” is not exactly a welcome message inside of mainstream IT departments.  Force.com has a massive opportunity with software application developers and applications vendors. However, similar to the challenge in selling to IT, creating an effective channel to sell into the ISV (independent software vendor) community requires a focused effort with domain and, often, vertical industry expertise. To date, Salesforce.com has not committed meaningful headcount or sales and marketing resources to attack this market.

Stock Outlook

CRM shares are not cheap but price has rarely been a good indicator for Salesforce.com stock. MGI Change Vector (MGI-CV) scores have been a very accurate indicator for CRM shares mid- to long-term direction and in the past we have made both Long and Short recommendations on the stock. Valuation aside, CRM has become a core holding in the emerging cloud computing software sector. Longer term we are bullish on the company’s prospects and competitive positioning. In the short-to-medium term, the continuing slowdown in deferred revenues coupled with lofty valuation leads us to re-iterate a NEUTRAL rating on CRM. 

Bottom Line

Salesforce.com remains the leading application cloud provider with competition far behind. Company is entering new, potentially larger markets that could meaningfully grow the business but will also require changes in channels and the operating model thus increasing the overall risk profile. We see the long-term risk/reward ratio as attractive for CRM but in the short term, given the deceleration of the core business, limited visibility on the new opportunity and pricey valuation, we remain NEUTRAL on the stock.