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Investors have high hopes for Salesforce.com (CRM).  The company has championed the “death of software” offering clients an alternative to bulky programs typically run on centralized servers requiring constant maintenance and monitoring.  CRM instead offers clients an online solution where customers can set up and maintain business intelligence programs that are accessible from anywhere and are maintained and supported by CRM.  Customers appreciate CRM not only for the ease of use and the flexibility of the platform, but also for the cost savings.  Paying a fee for each user is often much less cost intensive than purchasing a software package, loading it onto a server, backing up the data, not to mention the personnel costs to maintain and upgrade both the hardware and the software.

The CRM solution is very attractive to small businesses who may purchase one or two licenses instead of a large expensive name brand package from People Soft or SAP.  At the same time, the company has been able to land several large customers such as Citigroup who typically purchase large numbers of seats.  These large clients are more likely to drive higher margins as there is less administrative work per user for CRM to take care of.  The diversified base of customers helps drive revenue stability and ward off weakness from any one sector in the overall economy.  Interestingly, the company has noted that business from its financial customers has held up relatively well despite challenges in that vertical.

The typical revenue model used revolves around user licenses.  A company will pay a monthly fee for each ID that is able to access the system.  This drives a stable cash stream as visibility into renewals is typically very strong.  At the same time, CRM is experimenting with the idea of charging for each time a user logs into the program.  This may help to land smaller customers who only need CRM for a small portion of their business and do not want to pay the full license fee for unlimited monthly access.  It will take time to see how many clients adopt this option and what the overall effect to margins and profitability are.  Analysts appear excited about the choices, but it is difficult to see how this will drive profitability enough to make a material difference.

Up to this point, CRM has enjoyed a relatively stable monopoly and has built quite a following being the only major player to offer this type of service with a strong quality and reliability approach.  Now that the market sees a profitable business operating in the space, competition is picking up and the heavy hitters are getting involved.  Deep pocket competitors such as SAP and Oracle could wring a substantial portion of the profit margin out of the businesses as the participants compete for customers.  CRM has stated that they are not concerned with new entrants because they have an eight year technology lead on the market.  However, it seems likely that that gap would be narrowed rather quickly if it became a strategic initiative of one of these larger firms.

The largest concern for investors is one that is currently being completely overlooked.  The stock is trading at 175 times NEXT year’s consensus earnings estimates.  Now the counter to this concern is that the company is growing revenue at geometric rates and it is only a matter of time until this revenue is translated to profitability.  This argument sounds reminiscent of the logic from the late 90’s when every growth company traded on a price to sales ratio regardless of whether the company earned money or not.  Now CRM is profitable and growing, but not nearly fast enough to make up for the price tag that is placed on this emotional name.

Shorting momentum stocks is very tricky because it is difficult to tell exactly when the market will finally begin to value a stock based on more traditional measures.  If it is overvalued at 175 times earnings, it doesn’t mean the market can’t push it farther towards 200 or 250 times earnings.  However, the unstable stock market, and the increase in risk aversion has begun to change the market dynamics.  As investors look for safer places to park their capital, names with hefty price tags will likely see multiple contraction and few growth stocks will escape unscathed.  CRM appears to be a good candidate for devaluation and may present an opportunity to capitalize by selling short.

CRM Notes

FD: Author does not have a position in CRM

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