Can Salesforce.com Deliver on its Promise?

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As a value investor, it has become mind-boggling to see how irrational investors in technology have become. It seems when the market is searching for growth stories, high expectations are the norm - to the extent that they will push multiples and valuations to grossly absurd levels. This has been my chief concern with cloud giant Saleforce.com (NYSE: CRM) -- a company that I’ve always wanted to like, but just can’t.

While Salesforce.com is as dominant as any other, both in cloud computing and the now-popular software-as–a-service (SaaS) market, I don’t see how the company can produce the long term growth that its current valuation presumes. While it is providing exceptional growth today, at some point, “growth” will have to cross paths with “execution.” The likelihood that these two will shake hands is just not that great.

Nothing but cumulus clouds ahead
While Salesforce.com has a meaningful lead in its market, it is not going up against a bunch of “no-names.” There are several within the space which includes Oracle (NYSE: ORCL)IBM (NYSE: IBM) and Microsoft (NASDAQ: MSFT) who are all trying to put it out of business – with varying degrees of success. Though Salesforce.com is maneuvering pretty well at this point, these dominant rivals will eventually catch up.

Despite its tough competition, Salesforce.com hasn't been able to develop internally through its own R&D. Consequently, it has spent close to $1 billion buying up niche cloud/social media names such as BuddyMedia, on which it spent almost $700 million. This deal came shortly after Salesforce acquired Radian6.

Salesforce.com was pressured into these deals to compete more effectively with Oracle, which has been on a shopping spree of its own, most recently buying Vitrue. Likewise, I don’t see how Salesforce.com can realistically match Google (NASDAQ: GOOG), which just acquired Wildfire, in any cloud-based social media initiative. Even more concerning is the idea that a model that is strictly focused on acquisitions for growth can be sustainable.

The company will find that it is spending more of its time trying to integrate these businesses as opposed to growing what it already has. What’s more, its significantly increased spending on its marketing and sales efforts, as evidenced by the 34% increase in the second quarter, mean that Salesforce is having a hard time establishing any meaningful stronghold in its revenue growth. In other words, it is being forced to spend for growth, which will only impact its margins.

Valuation still a concern
In the opening, I mentioned that Salesforce's growth and execution must one day come together if the stock is going to work for the long term. This seems to be true even on the most bullish assumptions. Many analysts have placed enormous price targets on the company. Merrill Lynch currently has a target of $200 – essentially assigning Salesforce a multiple of 8.6 times its enterprise value and recurring revenues.

Meanwhile the company has been given a target of $165 by Roth Capital, which thinks that the company can trade at 31 times its free cash flow and 83 times its fiscal 2014 EPS estimates. These are pretty outrageous assumptions considering the presence of Oracle, Microsoft, and IBM, and virtually anyone else within the space. These projections assume that the rivals to Salesforce.com are just going to bow out and concede the market.

Even more remarkably, analysts continue to make these enormous projections, even though Salesforce.com already trades almost at 200% of its industry averages for enterprise value and unlevered free cash flow. These forecasts project revenue growth that is 175% higher than the industry average.

Bottom line
While it is understandable that analysts and investors have become enamored with the company’s 30% revenue growth of today, it’s an uncomfortable feeling falling in love with a stock that consistently demonstrates that conventional rules of valuation don’t apply. For Salesforce.com to support its current valuation -- a current P/E of 76 -- it must perform perfectly for at least the next two years. The returns investors are betting on just don’t match the company's risk.


rsaintvilus has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines, Microsoft, and Oracle and has the following options: short JAN 2013 $150.00 calls on Salesforce.com and long JAN 2013 $150.00 puts on Salesforce.com. Motley Fool newsletter services recommend Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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