There’s a lot of speculation floating around about a potential acquisition of Salesforce.com (CRM) by multiple companies, which has sent the stock on a tear. As I’m writing this, the stock is currently trading at roughly $74 per share; on the company’s 624.15 million fully diluted shares outstanding as of their most recent 10-K, the market is valuing CRM at more than $46 billion. It’s likely that any deal would value CRM at $50 billion, $55 billion, or even more.
What would buyers be getting for their $50 billion investment? Well, they’d be paying nearly 10x trailing revenues ($5.37 billion in 2014) for a company that has grown per share revenues at a rate of 27% per annum over the past three years. According to Bloomberg, analysts believe that the overall growth rate will slow to 21% in the coming year – and likely below 20% after accounting for share issuance (I think this is a logical way to view a serial issuer like CRM). Over the course of the company’s history, they’ve reported a retained deficit of $605 million.
But let’s look at this question a different way: what else could a potential acquirer – say, Microsoft (MSFT) – do with $50 billion? What’s the opportunity cost associated with acquiring CRM?
Well, for one, it could announce a large tender offer to repurchase their shares. For Microsoft, that might be at $50 per share; that would enable it to repurchase nearly one billion shares, reducing the number of diluted shares outstanding at the company by more than 12%. Revenues per share would increase from $10.70 per share in the most recent fiscal year to $12.20 per share – well ahead of the $11.40 per share Microsoft would report if it paid cash for CRM.
At Microsoft’s corporate gross margin rate of ~70%, the incremental $1.50 per share in sales would add $1.05 in gross profits per share; on the other hand, in the scenario where Microsoft acquired CRM, the shares would add roughly half that amount (80% gross margins for CRM).
Microsoft has other options, too: it could try and re-create CRM in-house. They could commit to spending by all means necessary to hire CRM’s top employees, develop technology that is more attractive than what their competitors can match, etc. For the sake of argument, let’s say that with five years of concentrated effort they would be able to do this successfully. What would the financials look like in this scenario?
Well, we can see that Salesforce.com had total operating expenses of $4.2 billion last year. The company isn’t profitable because they continue to ramp Marketing & Sales spending. Oddly, the company has not seen any leverage in this line item: despite the fact that sales have more than tripled since 2011, Marketing & Sales expense has increased from 48% of sales to 51% of sales.
Microsoft could match CRM’s R&D spend (~$800 million a year) and commit to comparable Marketing & Sales investments, which would put it in a $4.2 billion in the hole for the year –Â assuming it was a new entrant with no sales. In reality, Microsoft is already a large vendor in the ~$23 billion CRM software market: Dynamics has ~7% market share last year according to Gartner, compared to ~16% for industry leader Salesforce. If they were intent on taking share at any cost, Microsoft could also commit to pricing their product offering at a 50% gross margin (or lower), as opposed to the ~80% CRM has reported in recent years; if they did so, they should be able to substantially undercut their competitor on price.
In this case, it’s hard for me to see how Microsoft could even reach $3.5 billion in net outflows from the business each year. Gartner data from 2013 already had Microsoft’s CRM Software business at $1.4 billion in annual sales, growing more than 20% a year. With 50% gross margins, that provides us with $700 million a year, assuming revenues at 2013 levels (likely much higher now). Remove this from the $4.2 billion mentioned above and we’re at $3.5 billion in net cost.
By my math, even under the assumption that the net loss rose in line with sales growth (~20% a year), Microsoft would be in the hole for ~$25 billion after five years. That includes some extremely aggressive assumptions on what it would take to replicate CRM’s success – and still suggests the total cost would be less than half of what Microsoft would spend in a takeover.
Assuming Microsoft can acquire similar talent and can afford to invest substantial sums of money if necessary (it can), $50 billion or more looks like a big price tag to pay for a deal relative to trying to rebuild the business internally.
This is before considering potential regulatory issues, integration costs (including diverted attention from other important areas by top management), technological issues, and so on. While I think Oracle’s Safra Catz was speaking her own book, there’s also some truth in what she said about a potential deal last month between Salesforce.com and another Oracle competitor:
“It would cause a lot of disruption in that market and so I would view that as something that would be helpful to us, especially in the short or medium term, dependent on who it was.”
An approved deal would also provide cover for further consolidation in the space – potentially diminishing the share advantage a CRM acquirer would gain in relatively short order.
As it relates to the benefits of owning Salesforce.com, I was under the assumption that the “strategic partnership” these companies announced last October was pursued in order to ease the burden of businesses that used both vendors (this is far from my area of expertise, so I could be dead wrong). Here’s what Satya Nadella said at the time:
“Working together we’ll deliver new solutions that connect the customer insights of Salesforce to the cloud productivity of Office 365, the cloud platform of Azure and the mobility of Windows, so our customers can do more.”
Of course, analysts / bankers are tripping over themselves to explain why a company like Microsoft should do a deal. One of the most frequently cited justifications? They can afford to; and since a company like Microsoft is earning very little on many billions in excess cash, the thinking is that as it relates to near term earnings, the deal might make sense.
That says a lot about how analysts think about capital allocation and per share intrinsic value. With that logic, Microsoft could justify buying CRM at just about any price; the analysts don’t care if they price tag is $30 billion, $40 billion, or $60 billion. As long as it makes “strategic sense” and doesn’t materially impact near term EPS, any deal would be given two thumbs up.
I think a more logical test is opportunity cost; what else can Microsoft do with the money? As a shareholder, there’s simply no question that I would rather own more of Microsoft at its current valuation than all of Salesforce.com anywhere near its current market valuation. Small bolt-on acquisitions that allow the company to leverage its influence with enterprise customers is another avenue that I think makes more sense than large scale M&A at sky high valuations.
An announced deal would make me seriously question management’s ability to intelligently allocate capital going forward; as a result, I would start reducing my position materially if Microsoft attempted to acquire CRM. Thankfully, reporting from Reuters on Friday morning (here) suggests that Microsoft is unlikely to pursue a deal at the current valuation.
