Salesforce.com: Great Growth, Now 'Show Me the Money'

NEW YORK (TheStreet) -- "Shares of Salesforce.com.com (CRM) are just too expensive. With rivals such as Oracle (ORCL), Microsoft (MSFT) and SAP (SAP) trying to put the company out of business, it's hard to see how Salesforce.com can ever grow into its enormous valuation. Not only does the company lack operating leverage, it also has no profits."

For years, this has been a popular bear argument against Salesforce.com -- except the company has not cared to listen. Instead, each quarter, Salesforce.com has taken the "us against the world" approach by seeking to prove doubters wrong with its eye-opening growth performances.

Remarkably, while one might expect standing ovations for these accomplishments, instead bears contend "I bet you can't do it again." In fairness, the company does deserve credit for its ability to grow revenue -- particularly in such tough enterprise spending environments as we've seen. On the other hand, it's hard to argue with analysts who wish to see more growth where it matters most -- on the bottom line.

Solid Q3, But Bears Are Still Hanging Around

Salesforce.com had an impressive quarter, one the company considered "record-breaking." This is despite the fact that 35% revenue growth (only) met expectations.

The company earned 33 cents per share on revenue of $788 million -- helped by better than expected showing in the company's services support and subscription business which grew 35% year-over-year.

Equally impressive was Salesforce.com's 20% year-over-year growth in operating income, which surged 20% as the company continues to grow various business segments such as professional services at an annual rate of more than 30%. So, what's the problem?

While that level of growth speaks to excellent execution, it means nothing if it doesn't translate to profits. In other words, what's the point? This has been an area where the company continues to struggle. During the quarter, gross margin shed more than one point. Likewise, operating margins dropped by 500 basis points.

Although the company saw an 18% jump in operating income, analysts were not pleased that margins declined year-over-year by 1.5 points and dropped by almost 3 points sequentially. This was an area where the company attributed the poor showing to its acquisition of Buddy Media earlier this year.

Moving Forward

As understandable as this may be, the company has to do much better in terms of profitability if it truly wants to keep the bears in hibernation. Regardless, the company seemed pleased with its performance and nothing was going to ruin a good growth party. CEO Marc Benioff offered the following:

"Salesforce.com.com is the first enterprise cloud computing company to exceed $3 billion annual revenue run rate, with outstanding third quarter revenue growth at 35% in dollars and 37% in constant currency. Given the strong customer response to our next generation social and mobile cloud technologies, I'm delighted to announce that we expect to surpass a $4 billion annual revenue run rate during our fiscal year 2014."

Surpassing $4 billion in revenue, up about a billion from fiscal year 2013, is certainly an aggressive goal and I get very uncomfortable whenever management think it's necessary to make such bold predictions. What it says is that "we have this thing figured out." But on the other hand, Salesforce.com has met its earnings targets time and time again. The question is, will the competition just roll over and surrender the market? Evidence suggests they won't.

Meanwhile, names such as IBM, F5 and Red Hat have been making significant investments in the popular SaaS (software as a service) market to position themselves for the opportunities that lie ahead. Although Salesforce.com enjoys a good chunk of the market today, it will eventually find that it has to spend more on sales and marketing, plus other acquisitions in order to preserve its current market share. Still, that does not speak to other investments that it might have to make once growth starts to slow.

Bottom Line

As "the cloud" and "big data" markets become more defined, this is only going to heighten the demands on Salesforce.com to perform. Seeing as the company already struggles with operating leverage, I question why it needed to put such undue pressure on itself with such bold projections. What it also means is that the company's execution is more geared towards revenue growth than profits. But how long can this work?

For now, we have to appreciate that what Salesforce.com has been able to do is nothing short of impressive. As a value investor, I ordinarily would stay away from stocks that carry a price-to-earnings ratio of more than 20, must less one that is close to 80 as Salesforce.com.com. However, not only has the company proven that it can grow into its valuation, but as Benioff noted, the company is raising the bar. Perhaps the bear concerns about profits just might be overblown -- at least for now.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a private investor with an information technology and engineering background and has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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