JCL Blog

One Example of Irrational Exuberance Meets the Cloud

Disclosure:  My company competes with Salesforce.com from time to time, but our product is a niche extension of what SFDC does and we have never claimed to be a replacement for their product.  I doubt Mark Benioff has ever even heard of our 150 person company.  This post can be read as negative on Salesforce.com -- buy my point is on the irrationality of the stock market more than on the performance of the company.  Salesforce.com has done a great job blazing a trail in our industry.  

Salesforce.com recently released their earnings and the trends I pointed out in my posting: Sales vs Engineering continue.  In short it is another impressive performance.  Growth, profits, and one amazing P/E!  At Friday's close the stock was trading at a price earnings ratio of 114.5!  Yow!  The industry is listed at 21.8 and the S&P 500 at 20.5.  I know there are some irrational investors out there but I just don't get this -- Salesforce.com trades at five times the P/E of the rest of the industry.  No less than 14 analysis have the stock at a strong buy, 4 at moderate, and 14 at hold.  Not a single analyst in the sell column.  

I suppose the logic must be to pay in advance for growth.  A quick look at the articles referencing Salesforce.com from this last week alone and you would think CRM was just getting started and the buy ratings are based on the incredible growth.  I just don't see that either.  It is true that salesforce.com is highly scalable because it offers hosted software and adding a new customer does not cost them much in terms of manufacturing cost.  However, the thought that this cost is lower than other software companies is not true.  Sure they don't have to ship anything -- but neither do any other software companies.  The cost in added bandwidth required for a new customer of a hosted solution like Salesforce.com probably exceeds the cost of delivering an executable over the web as typical software companies do now.  The whole industry operates on a very low marginal cost for adding another customer.  Once the software is developed all software companies (yes Salesforce.com is a software company) keep 90%+ of each additional dollar.

What matters then is the cost of selling.  When your product is nearly free to produce, the biggest expense is either R&D or Sales.  And Salesforce.com takes the cake in high sales cost.  Salesforce.com spends 50 cents of every dollar it takes in on selling costs.  This has been the case from the very beginning.  The fans must argue that awesome growth costs money and when Salesforce.com decides to slow growth, they will be able to radically reduce sales spending and the profits will skyrocket.  So let's dig into that thought a bit.  Over the past three years the company has had an impressive growth rate.  Even now, growing at over 20% per year is impressive.  But 2008 was 50% over 2007 and the deceleration is steady however you run the numbers.  All the while the sales spending is keeping pace with the growth -- last quarter it was 48%. 

Here are some other interesting ratios:

  • Salesforce.com spends 5 times as much on sales as it does on research and development.
  • Salesforce.com spends $2.50 on sales for every $1 increase in revenue.
  • Salesforce.com spends $170,000 on sales per employee per year -- that is every single employee in the whole company.

In the last earnings release conference call Salesforce.com indicated that growth will be declining further to 17% and they are continuing to hire more salespeople.  So the cost of new business acquisition is going up even further.

So here is what I conclude.  High sales cost is heroin.  If you stop doing it there will be serious consequences.  The only logical explanation for the steady investment of 50% of revenue on sales is that no economies of scale in selling have emerged.  This company sells to the enterprise and enterprise selling is hard and expensive work.  It is not like consumer companies that go viral and all of the sudden the product starts selling itself.  They spent $600M last year to produce 20% growth and in 2008 they spent $375M to grow 50%.

So while it is possible that no new competitors will come on the market, no setbacks to cloud computing in general will occur, and Oracle and Microsoft will continue to give up marketshare, I have to think that this valuation is about as good as it is going to get for Salesforce.com. I think even Salesforce.com agrees in that last year they took advantage of their incredible market cap to raise $500M in debt and now sit on a $1.7B pile of cash.

More on Disclosure of my interests:  I do not hold and of Salesforce.com's stock nor do I hold a short position.