Competition Limits Growth
CRM helped pioneer the SaaS model, which allowed it to deliver business applications and software to customers in a new, more efficient manner. In many ways, CRM has a great deal in common with Netflix (NFLX). NFLX pioneered a new way of delivering content to consumers, but the barriers to entry were not enough to keep Amazon (AMZN), Hulu, and others from following in their footsteps. To protect its market share, NFLX has had to keep its margins low and attempt to differentiate with original content, which threatens to further erode its already thin margins because it is so much more expensive than the used content NFLX peddles now.
Similarly, CRM helped popularize the SaaS model both through its own software and its mobile app development platform. Long term, I don’t see any more value in the cloud platform for CRM than I do the streaming delivery system for NFLX. Once competitors can replicate the delivery system, the only differentiation becomes the content being delivered. CRM now has to rely on offering superior quality products, and while its current offerings still beat the competition, there’s no guarantee that it will hold on to that top spot in the future. Companies like ORCL or SAP could leverage their existing franchises and large installed bases of customers to create a competitive product, or smaller companies like SugarCRM could succeed through the open source software development model.
As of 2012 Salesforce had a 14% market share in the global CRM industry, which made it the industry leader. However, SAP and Oracle still have double-digit market shares, and small, fast growing companies like Sugar CRM and Zoho make up almost 40% of the market. As the market leader, Salesforce is in an enviable position, but there are too many competitors for it to achieve the market domination that its stock price implies.
Priced For Perfection
Salesforce could absolutely grow into a profitable company in the future. After all, it does have the largest market share and most advanced set of products in a rapidly growing industry. However, the massive revenue growth and margin expansion that its stock price predicts seems unlikely.
CRM’s current valuation of ~$51/share implies 30% compounded annual growth in revenue for 13 years with an average pre-tax margin of 7.5%. Under that scenario, CRM would have $95 billion in revenue in 13 years, which is about how much IBM generates today.
Even if we give CRM credit for more significant margin expansion, the required revenue growth is still staggering. If CRM’s pre-tax margin expands to 15 percent, the company would still need to grow revenue by 20% compounded annually for 15 years, at which point its annual revenue would be $55 billion, or around what Intel generates today.
Simply put, a $30 billion market cap for a company with negative profits does not make sense. There are too many competitors out there for CRM to grow revenue and expand margins simultaneously to the extent that the market valuation already implies. Too much downside risk is in this stock.