, Inc. (CRM) In The Danger Zone

buyers and sellersDavid Trainer:, Inc. (NYSE:CRM) is in the Danger Zone this week. The cloud-based customer relationship management (CRM) provider has helped pioneer the software as a service (SaaS) model, but the first-mover advantage can be short lived. CRM differentiated its services by delivering them through the cloud, but as other companies develop their own cloud platforms, CRM will be hard pressed to continue its spectacular growth. CRM’s strategy of acquisitions to grow revenue at the expense of profits raises questions over whether the company can achieve the profit margins necessary to support its expensive valuation.

Acquisition Strategy Hurts Profits And Strains the Balance Sheet

CRM has spent aggressively on acquisitions in recent years, including a $2.6 billion purchase of ExactTarget, a provider of digital marketing software, this past July. These acquisitions have kept the top line growing at the expense of profitability.

CRM’s cash operating profits (NOPAT) had been growing at an accelerating rate until 2011, when the company’s growth strategy shifted its focus to acquisitions and revenue growth. Over the next three years, the company spent (in millions) approximately $400, $420, and $580 respectively. As Figure 1 shows, these acquisitions have been good for revenue but bad for NOPAT.

Figure 1: Revenue vs. NOPAT


Sources:   New Constructs, LLC and company filings

The ExactTarget acquisition appears to continue this pattern. In 3Q13, ExactTarget added roughly $81 million to revenue (accounting for 28% of CRM’s year over year revenue growth) and lost about $68 million (accounting for 55% of CRM’s reported pre-tax loss for the quarter).

While CRM has managed these acquisitions without overly straining its finances so far, the balance sheet is beginning to swell. At the end of its most recent fiscal year CRM had over $2.3 billion in adjusted total debt, which includes $1.1 billion in off-balance sheet debt due to operating leases. That number has increased significantly in 2013, as CRM took on an additional $1.9 billion in debt and capital lease obligations. At the end of 2010, the company had under $780 million in total debt.

Salesforce is competing with giant companies like Oracle (ORCL), Microsoft (MSFT) and SAP (SAP) in the CRM industry. If it tries to outspend those companies it will have to run up even more serious debt or dilute equity holders. Oracle recently bought Big Machines, a company that Salesforce had previously invested in.

Buying up smaller companies to hit revenue targets and keep the stock price up is nothing new. Recent Danger Zone calls Tangoe (TNGO) and InnerWorkings (INWK) followed the same strategy. Those two stocks are down 37% and 29% since I put them in the Danger Zone.

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