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Vinay Singh
Vinay Singh
Articles (229) 

This Cloud Player Might Not Be Able to Make a Profit

May 31, 2014 | About:

The "cloud" is as big a buzzword as the "internet" was 15 years ago. Remember how that ended. It seems like any company which has anything to do with the cloud is trading at outrageous valuations, profits be damned. When people start talking about the price/sales ratio as if its important, something is seriously wrong.

Salesforce.com (NYSE:CRM) is a company which is growing revenue at an extremely quick pace. The company expects revenue to grow to around $4 billion this year, up from $3 billion in 2012. This new estimate comes as Salesforce announced the $2.5 billion acquisition of ExactTarget.

Remember when profits mattered?

ExactTarget provides software-as-a-service solutions that allow companies to communicate with their customers through email, social media, and other channels. In 2012, ExactTarget recorded $292 million in revenue and a $21 million loss.

The most recent quarter saw sales increase of 39% year-over-year. But costs increased 33% and operating expenses increased 51%, leading to a larger net loss. Salesforce paid $2.5 billion for this?

It seems to me that Salesforce could have spent far less to develop offerings of its own. It wouldn't be immediate like an acquisition, but it also wouldn't be a giant waste of $2.5 billion. If ExactTarget manages to grow its revenue by 35% per year for the next five years, the acquisition price is still about twice 2017 revenue. And profits will likely be nil.

The problems with Salesforce

When Salesforce announces earnings, they tend to emphasize non-GAAP numbers. In the most recent quarter, Salesforce announced adjusted EPS of $0.10, suggesting that the company turned a profit. But it didn't.

These non-GAAP numbers don't include stock-based compensation, which totaled a whopping $379 million in 2012 and $115 million in the first quarter of 2013 alone. That's a $0.20 charge for the quarter and brings earnings back into the red.

Many companies give stock options to executives, but the scope of the practice is staggering at Salesforce. Since the end of 2008, the diluted float has increased 17% due to the subsequent dilution.

Investors apparently don't care. The stock trades at 7.5 times sales and outfits like Goldman Sachs are touting the stock as a conviction buy.

Another problem is costs. While revenue increased 28% year-over-year, COGS rose 38% and operating costs rose 28%. This, of course, led to a bigger loss than during the same period last year.

Salesforce is growing largely through acquisitions, but they seem to overpay for unprofitable companies. From 2010 to 2012, the company paid $1.4 billion for acquisitions, and the most recent purchase brings that total up to $3.9 billion. This is about the same as the expected revenue this year.

This can't continue unless the company takes on more debt. And although borrowing costs are likely still low, Salesforce is using that money to add-on companies which are unprofitable. It's not exactly rocket science to figure out that this can't continue forever.

The big boys are getting real

Oracle isn't going to take Salesforce stealing its customers lying down. Oracle has been making acquisitions of late in an attempt to compete with Salesforce, and the $810 million purchase of Eloqua last year is a big one. Eloqua is similar to ExactTarget, offering many of the same types of services.

The question is: what is Salesforce doing that Oracle can't do? Sure, it's ahead of the cloud game a bit, but Oracle has vast resources to work with (since Oracle actually turns a profit). Is there any reason to believe that 10 years from now Salesforce will be a powerhouse in the industry? If Salesforce can't turn a profit now, when it has a lead, what hope is there that the company can turn a profit later when competition is more fierce?

The bottom line

Salesforce needs to prove that it can actually be profitable, including the effects of executive stock options. The stock trades at around 100 times adjusted earnings, which doesn't even include this cost. The valuation is insane, plain and simple.

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