What is the Value of Top Line Growth?

By Tom Gibbs - March 2, 2012 | Tickers: IBM, MSFT, ORCL, CRM | 0 Comments

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Firms are often put into precarious situations when it comes to fulfilling the wants and needs of its individual constituents.  Customers, suppliers, investors, employees, and management teams, although all working towards similar end results on the surface, each have different motivations that may eventually prove to be conflicting.  This especially holds true for those enterprises that have previously unveiled their ability to grow rather swiftly.

Investors are undoubtedly motivated by growth, and are, for the most part, willing to ante up for the opportunity to participate in the potentially lucrative undertaking.  In keeping up the growth, really through most means necessary, a firm can maintain the confidence of the general investing population.

Management teams, once a firm has showcased its ability to grow by several multiples every year, are put under pressure to maintain the above-average performance.  Through the unlocking of different performance metrics – assuming that their pay is tied to the overall success of the firm – managers is also inherently motivated to grow a firm (although not always through the most ethical means).

Competitors, suppliers, and customers also need to have their fingers on the pulse of a given enterprise as it progresses through the growth phase of its life cycle.  Swift growth, fueled through product and service price cuts, say, can have a direct impact on different competitors in the field.  Game theory suggests that these incumbent competitors, assuming that their product and service offerings are characterized by rather inelastic demand, will likely reduce prices in turn.  For suppliers and customers – when the firm exits its growth phase (can that time frame be estimated?) will it still be a solvent enterprise?  Growth does not affect all corporations in the exact same manner, and such swift growth, especially when handled the wrong way, can leave a company in less than full health.

This proposes the topic of growth and the value of growth.  With several different constituents to whom a management team needs to answer, it is not surprising that unhealthy growth scenarios are often played out during a company’s growth phase.

Salesforce.com

Salesforce.com (NYSE: CRM) is a leading provider of enterprise cloud computing applications – sounds exciting enough – that provides customer and collaboration relation management (CRM) services to businesses worldwide.  With the advent of cloud computing, the entire infrastructure of servers, storage, network devices, operating system software, and development tools is managed by third parties who specialize in infrastructure management.  Accessing the various material is as easy has having an Internet connection.

Salesforce.com’s CRM application is targeted towards companies, both large and small, that seek to better record, track, manage, analyze, and share information regarding sales, customer service/support, and marketing operations.

The inherent characteristics of the industry make it a perfect environment to incubate rapidly growing players – high fragmentation, ever-evolving technology, and shifting customer needs act to open unique niches to which different companies can target.  Microsoft’s (NASDAQ: MSFT) Microsoft Dynamics CRM Online offers customers full integration to Microsoft Office tools to contribute to training cost efficiencies and user adaptability. 

Oracle (NASDAQ: ORCL), another Salesforce.com competitor in the cloud space, seems to be perturbed with the inroads the smaller competitor has made into the industry, and anted up nearly $1.5 billion in late 2011 for an acquisition of a provider of sales force automation and customer relationship management services. 

Especially when facing head-to-head with these incumbents – who are better funded and have an existing base of close followers – chipping away market share and attacking an unfilled niche is of utmost importance.  However, despite its swift growth and impressive (is it?) performance over the past several years, Salesforce.com presents a prime example of the healthy/unhealthy growth choice. 

When examining a corporation’s growth practices, an investor should, among other things:

• Consider Producing Pricing Trends

Discounts are a natural tool to effectively manage supply and demand dynamics.  Used effectively, a firm can maximize traffic even during periods of downturn (whether cyclical economic downturns or perennial downturns that come with different selling seasons).  However, does effective use constitute the use of deep discounts to report short-term top line growth at the expense of long term company image?

Salesforce.com has made it known that deep discounts – in excess of 50% -- have recently been offered to customers willing to sign up before year end (fiscal year end January 2012).  The company has also guaranteed these new low rates on future renewals and for additional users.

Such a pricing strategy raises questions about the corporation’s offerings.  Does management have confidence in the product, especially when compared to the offerings of competitors like Microsoft, Oracle, and IBM (NYSE: IBM)?  Is the company attacking the correct niche, and is it effectively catering to the wants/needs of customers that define that niche?  Are customers simply willing to buy the product to satisfy their own short term desires to cut costs? 

In the long run, price competition is not a sustainable way to captivate customers.  And, in the long run, without captivated customers a company does not have control on a sustainable competitive advantage.  What will Salesforce.com’s customer profile look like in the future if it can only compete on price?  Likewise, one needs to consider the perceptions of product’s inherent worth to previous customers, who are now seeing competitors purchasing the same goods for half the cost.  Will these clients sign up for renewals when the time comes?

• Consider Stock Compensation

Many corporations, especially start-ups with relatively little cash remaining after reinvestment for growth, tend to use options to compensate employees.  The ability to continue to do this relies on a corporation’s continued swift growth – how else will the non-cash payments unlock their value? 

Over the past four years, Salesforcce.com has awarded more than a half of a billion dollars in stock-based compensation, which has taken a huge cash payment burden off the company as it has grown.  However, what will Salesforce.com’s employees demand for payment when the enterprise’s growth begins to slow?  It is difficult to believe that the 30% year over year projected growth rate is sustainable too much longer, as huge competition by firms with a deep financial backing are intent on killing Salesforce.com’s threat. 

• Consider Goodwill

An outsider also needs to determine how a firm is growing.  If an organization’s operating strategy is sound – it has a high quality product/service that is in high demand, it has control over the price it can charge customers, it has a deep moat that can fend off competition, etc. – it can generally grow organically through the reinvestment of free cash flow that is generated each period.  Of course, strategic acquisitions, even for these aforementioned enterprises, can be accretive to operations if they complement a firm’s future strategy.  The most important metric to analyze, however, is the purchase price of the acquisition.  Even an acquisition that will perfectly fit into a corporation’s strategy will not be accretive if it is too expensive – an investment made at fair value will only earn at the required rate of return. 

A firm that largely grows inorganically through strategic acquisitions will have an extremely difficult time generating meaningful return on core assets if it pays too much for those acquisitions.  Over the past four years Salesforce.com has spent more than $865 million on business combinations, and in looking at the goodwill balance of each individual acquisition, there can be no question that the firm is paying too much for top line growth.

Acquisitions in 2011:

• Jigsaw
• Purchase Price: $161.9 million
• Amount added to Goodwill: $133.3 million (82% of purchase price)
• Net Tangible Assets of Acquired Company: $4.3 million
• Price/Tangible Assets: 37.7x
• Heroku
• Purchase Price: $216.7 million
• Amount added to Goodwill: $181.3 million (84% of purchase price)
• Net Tangible Assets of Acquired Company: $5.4 million
• Price/Tangible Assets: 40.1x
• DimDim
• Purchase Price: $37.1 million
• Amount added to Goodwill: $23.4 million (63% of purchase price)
• Net Tangible Assets of Acquired Company: $1.9 million
• Price/Tangible Assets: 19.5x

Putting a value on a technology company is a rather difficult exercise because intangible assets are essentially worth what someone will pay for them – they do not have values that are estimable with close certainty as do tangible assets like inventory, buildings, or even better, cash.  However, when looking at the premium that Salesforce.com has paid above and beyond these three acquired companies’ “fair value,” there can be no doubt that the corporation has a very challenging task ahead of itself in generating meaningful returns on these investments. 

Investors love to see top line growth because it is one of the primary drivers to a higher level of profitability.  In growing its top line at more than 30% per year, on average, over the past several years, Salesforce.com has become the “sweetheart” of those looking to cash in on the growth of cloud computing (I’m not sure what else to call a 160x enterprise multiple).  However, top line growth is but one of the key drivers of profitability.  Investors in Salesforce.com, and any other corporation growing with the same strategy, need to consider the future implications.  As mentioned, a corporation has many different constituents that it needs to please on its way to the top.  As the corporation grows, is it considering your needs and desires as an investor?

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