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AGB 2022.1 - Salesforce.com (CRM)
Highest Reinvestment Rate in Cloud Software
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“How do you achieve manifest destiny in the software market? It's all about distribution. Do you have enough sales people to cover the millions of companies in the world who need this product?... Our ability to invest and grow distribution, which is one of our core assets and I would say one of our core competencies at Salesforce, and the ability to consistently execute that in a public environment over so many years; 13 years of operating history now. This is what we bring to Buddy Media. It's a great product; this is the time in the market that people need this product. We are the ones who are able to operate the distribution channel; we need Michael and Marcel to deliver a world class offering and we will market and sell the heck out of it.” – Co-founder and Chief Executive Officer, Marc Benioff, on the Buddy Media Acquisition Conference Call, June 2012
Salesforce is the leading provider of cloud based software for enterprise and SMB customers. Founded in 1999, the company is considered to be one of the trailblazers for the SaaS model. While we all benefit from knowing how the story plays out over the next 20+ years, at the time the benefits of the SaaS model still had to be evangelized to customers. Luckily, the economics made sense for a lot of customers (especially smaller ones) to try the SaaS model, since the upfront costs and integration time were much lower than traditional on-premise software. This new software delivery model helped Salesforce take market share from software incumbents like SAP and Oracle (Siebel) over the years.
Salesforce developed its first SaaS offering of CRM software, which later became Sales Cloud (only 26% of revenues in FY21). But as the company scaled horizontally, most of the new product launches were either on the backs of a collection of small acquisitions or one large acquisition target. Salesforce used its scale and distribution advantage (relative to other SaaS companies) to grow quickly in adjacent areas of Enterprise software.
Here are the different cloud offerings in Salesforce’s product portfolio today:
Sales Cloud (launched in 1999) – makes sales teams mode efficient and productive. Key acquisition: Vlocity (2020).
Service Cloud (2009) – allows businesses to connect service agents with customers. Key acquisitions: Instranet (2008), Activa Live Chat (2010) and Assistly (2011), ClickSoftware (2019).
Marketing Cloud (2012) – allows digital automation for companies to marketing campaigns. Key acquisitions: Radian6 (2011), Buddy Media (2012) and ExactTarget (2013).
Commerce Cloud (2016) – delivers e-commerce solutions to brands and businesses. Key acquisition: Demandware (2016).
AppExchange (2005) – a platform where third party developers can create their own applications for Salesfore customers. Force.com was introduced in 2007 and Heroku was acquired in 2010.
Integration (2018) – helps customers migrate data onto other platforms. Key acquisition: Mulesoft (2018).
Analytics and BI (2019) – helps customers visualize and analyze data. Key acquisition: Tableau (2019).
Workstream Collaboration (2020) – helps customers communicate within the enterprise and with customers. Key acquisition: Slack (2020).
For the most part, Salesforce has emphasized growth above profits whether it’s investing organically into sales and marketing or making large acquisitions. This is evidenced by the company’s lower operating margins than other software companies of its size and even compared to other enterprise SaaS companies that generate ~1/5th of the revenues. For FY21 (close to calendar 2020), Salesforce generated revenues of $21.3B and non-GAAP OM of 17.7%. By comparison, Workday generated revenues of $4.3B and non-GAAP OM of 20.1% and ServiceNow $4.5B and 24.8%.
The company also prides itself as being the fastest growing enterprise software company ever across various revenue milestones. So far, Salesforce has outgrown Microsoft, Oracle and SAP on its way to guidance of $31.8B for FY23 by a wide margin. Salesforce even defines the different chapters of the company’s history by revenue demarcations. Chapter 1 was $0 to $1B in revenues (covered in Benioff’s first book, “Behind the Cloud”), Chapter 2 was $1B to $10B (covered in Benioff’s second book, “Trailblazer”), and Chapter 3 was $10B to $20B.
From here, taking a positive stance on the future of Salesforce may be distilled into three main things: (1) the continued growth in the overall enterprise software market, especially SaaS, (2) the company’s ability to meaningfully grow acquired assets through its distribution platform, (3) and the success of offering many clouds/products over others that offer best-of-breed point solutions.
While many business processes have been automated by software, there are other business processes specific to industry verticals that have yet to be addressed. Salesforce recognizes this and has participated in offering software specific to certain industry verticals like Financial Services and Healthcare. The company does this through its platform strategy as well, working with independent software vendors to build vertical specific applications. Salesforce gave out a statistic in FY16 that 35% of its vertical software customers were new to the company.
Salesforce also has many partnerships with the large software vendors like Microsoft, Google, IBM, Amazon and Workday. Each of these relationships are different but most cover some type of integration arrangement with each other’s products and/or infrastructure expansion (with the public cloud providers). Interestingly, the company mentioned that integration with existing software is the 2nd highest cost for implementation of new software, so these partnerships are reducing costs/time for customers.
The long-term operating model for the company (and other SaaS vendors) is still uncertain because of the differing cost structure vs. the traditional on-premise software model. Furthermore, most SaaS companies including Salesforce are still in growth mode, when margins are compressed to grow the top line. Analysts have tried to solve for steady state operating margins based on a breakdown of new business growth, renewal rates and cost structures at steady state and have generally arrived at margins estimates of 35%-40%.
This coincides nicely with the company’s internal analysis of unit economic margins. Salesforce lays out economic margin by key its product lines. The formula for Economic Margin is:
(Lifetime Revenues – Cost to Book – Cost to Serve) / Lifetime Revenues
Economic margins can differ depending on deal sizes, attrition, cost to book and costs to serve. It’s no surprise that marketing has the lowest economic margin due to its high relative attrition rate at ~15%. Service Cloud and Integration have the highest economic margin due to low attrition rate and relatively low COGS.
Over the past 4 years, Salesforce’s cost to book increased by 3% annually while the attrition rate declined by 7%, leading to improving economic margins. On average, the company’s economic margins are in the low-to-mid 40s%, which implies that at steady state, the company should be able to achieve operating margins slightly below this range, assuming the key variables don’t change much.
Why is it a good business?
When Salesforce was starting out, the company benefited from counter positioning. Other software companies that were early adopters of the SaaS model also had this advantage vs. legacy on-premise software vendors. SaaS was a better value proposition for customers in many ways: (1) high upfront costs could be avoided and customers had more predictable expense structures going forward, (2) implementations were much shorter and less costly, and (3) there were no more upgrade cycles to the software.
As the company grew larger and commanded more market share in its key product categories, Salesforce benefited more from its customers increasing switching costs. The switching costs go up in two ways. First is the increasing knowledge base (and habits formed) and data generated by customers that use Salesforce’s software each year. Second is the adoption of additional cloud products that Salesforce offers through its platform.
Typically a customer will become a Sales Cloud or Service Cloud customer first. Then the customer adopts the other cloud offerings over time, as it becomes easier to manage its front office software and data on one platform. At the company’s 2018 Analyst Day, Salesforce revealed that of the company’s 150k customers, over 38% were subscribed to multiple clouds. These multi-cloud customers spend up to 10x as much as single cloud customers and contributed to over 90% of the company’s revenues. As of FY22, multi-cloud customers represent 95% of the company’s revenues.
And at Salesforce’s 2020 Analyst Day, the company showed that the FY17 cohort of new customers moved from subscribing to 1.8 clouds to over 3.6 clouds over 4 years. This cohort also increased ARR by 2.1x over that time period.
Salesforce has a higher attrition (or gross churn) rate compared to the other large SaaS companies. This metric is important because a high churn could mean low returns on sales and marketing spend, no matter how large the average lifetime value of the customer. As we know from our write-ups on other best in class SaaS companies like Workday, Veeva Systems and Atlassian, the formula for LTV/CAC is:
(Δ Subscription Gross Profit Dollars / Incremental S&M expenses) x
(1 / Churn x Discount Rate) x (New Customers / Total Customers)
This higher churn rate can be partly explained by two factors: (1) Salesforce has a higher mix of SMB customers and (2) the attrition rate for Marketing Cloud is higher than the rest of the company. At the company’s 2020 Analyst Day, Salesforce stated that its FY15 cohort of SMB customers (20 or fewer employees) had an attrition rate close to 20%. That compares to an overall attrition rate of ~9.5% for the company in FY15, which implies that the attrition rate for Enterprise customers is less than half of that of SMB. Even with that high attrition rate, the FY15 SMB cohort collectively increased ARR by a 4-year CAGR of +36% due to the 19x higher ARR per customer that stayed with Salesforce during that period.
Of the different product categories, the company’s lowest attrition rates are in Service Cloud, Commerce Cloud and Integration at ~5%, followed by Sales Cloud and Platform near ~10%. Marketing Cloud has an attrition rate above 15%. The overall attrition rate has decreased over the years from 21% in FY10 to under 8% as of the latest quarter. Part of the reason for the decline in attrition is the increased contribution from Service Cloud, Platform and Integration, which have lower attrition rates than Marketing. The other reasons for the lower attrition are that more customers are adopting more than one cloud product and Salesforce has focused more on developing vertical cloud applications, especially for Financials and Healthcare companies.
Returns on incremental capital?
Over the past 10 years, Salesforce has spent 13% of its capital on capex, 44% on R&D and 43% on acquisitions. Including stock used for acquisitions, the number skews much higher to 70% for acquisitions. Capex spend is mostly for computers, servers and software related to the company’s cloud service. Remember that since Salesforce was founded years before many of the public cloud offerings became mainstream, the company has hosted its cloud on its own for the most part. The company did announce that through a new infrastructure architecture called Hyperforce, customers are now able to choose which public cloud provider (AWS, Azure, GCP, etc.) to host their data generated on the Salesforce platform.
R&D spend as a % of revenues has been very steady at the company, ranging between 13%-17%. As we noted in our Workday write-up, Salesforce has lower R&D spend (as a % of revenues) when compared to Workday and ServiceNow. This makes sense given that Salesforce has been much more acquisitive than these other two companies. The company has essentially chosen to outsource a lot of its R&D efforts in the form of acquisitions. The benefit to this is that it’s much quicker to scale up a product or a series of products this way. But the drawback is that there are integration costs and many technology acquisitions result in a poor return on capital due to their lofty valuations.
On the acquisition front, Salesforce has done 5 large deals in the past decade. The first was Exact Target in 2013, which makes up most of the company’s Marketing Cloud. At the time, Salesforce’s CEO talked about needing to acquire big to quickly build up Marketing Cloud meet the growing market opportunity.
“But we found through this process is that there is this tremendous next generation opportunity in marketing and that is what motivated us initially to acquire Radian6, to acquire Buddy Media, to do more in building out a marketing suite. But what we realized is we didn't have all the pieces that we wanted. There were some big pieces that were missing. And if we were going to make an acquisition, we can't just keep making these small acquisitions. That strategy was just taking, honestly, too long. We needed to do something of consequence and we needed to do something strategic and we needed to do something now.” – Co-founder and Chief Executive Officer, Marc Benioff, on the Exact Target Acquisition Conference Call, June 2013
It’s difficult to outline the returns for each of the 5 large deals because most of these targets were trading at such lofty valuations at the time (valued on EV/Sales). We can, however, analyze how much each acquisition has grown since being on the Salesforce platform (in this section below) and we can also try to back into what the steady state earnings could look like (in the last section) making some assumptions to get a feel for which of the deals were better than the others.
Exact Target (in 2013) was acquired for $2.5B at 9x trailing EV/Sales. At the time of acquisition, Exact Target was #1 in email marketing and had recently expanded to lead nurturing. Since the acquisition, Exact Target’s revenues have increased to $2.3B (8x in 8 years), implying a 1x EV/Sales on purchase price.
Demandware (in 2016) was acquired for $2.8B at 12x trailing EV/Sales. At the time, Demandware was growing +27% y/y and competing with others like SAP, Adobe, Oracle and this market is still very competitive. Since the acquisition, Demandware’s revenues have increased to $880M (~4x in revenues in 5 years), implying a 3x EV/Sales on purchase price.
Mulesoft (in 2018) was acquired for $6.5B at 23x trailing EV/Sales. At the time, Mulesoft was the leader in integration software and had a 60% customer overlap with Salesforce. The company quickly benefited from joint engagements, which improved ASPs by 1.3x and converted deals at a 1.9x higher rate. Since the acquisition, Mulesoft’s revenues have increased to $1.5B (5x in 3 years), implying a 4x EV/Sales on purchase price.
Tableau (in 2019) was acquired for $15.7B at 12x trailing EV/Sales. At the time, Tableau was a leader in data visualization and analytics. Since the acquisition, Tableau’s revenues have increased to $1.7B (1.5x in 2 years), implying a 9x EV/Sales on purchase price.
Slack (in 2020) was acquired for $27.7B at 21x trailing EV/Sales. At the time, Slack was a leader in enterprise collaboration, competing with Microsoft Teams. Salesforce expects Slack to grow to $4B in revenues by 2025 which would imply almost a 40% CAGR. Since the acquisition, Slack has outperformed expectations, improving billings growth back to mid 30%s to low 40s% range.
We estimate that Salesforce has generated returns on incremental capital between 17%-24% over the past 5 years. Including the acquisitions that used stock as currency, that number drops to 9%-17%. The offset is the reinvestment rate (if you include stock issued for the large acquisitions), which is very high for a software company. Salesforce’s reinvestment rate has been consistently ~100% for many years, a result of its aggressive acquisition strategy.
There are a few different ways to analyze the reinvestment runway for the company. Since Salesforce is a large enough software company, one could take a top down approach and look at projected growth rates for software as a category. Software has been gaining share as a percentage of global GDP, reaching almost 0.6% by 2020. It’s uncertain where that can get to eventually, but one could look at this ratio in the U.S. Total software spend in 2020 was $232B in the U.S., which was 1.1% of GDP.
Another way would be to look at the projected growth rates for Software by industry analysts. According to Gartner, U.S. software spend is projected to be the fastest segment of IT spend, growing from $232B in 2020 to almost $400B by 2025, which implies an ~11.5% CAGR.
Salesforce addresses its projected TAM at its Analyst Day each year. At the 2021 Analyst Day, the company expected that Sales Cloud and Platform would grow at +11% CAGRs through 2025, Service Cloud and Data at +12% and Marketing and Commerce Cloud at +16% to reach a 2025 TAM of $248B.
That’s up materially from a 2024 TAM of $175B from the 2020 Analyst Day and a 2023 TAM of $168B from the 2019 Analyst Day. The growth assumptions by cloud/product hasn’t changed much year to year, but the groups tend to change each year as new acquisitions come into the fold.
Though the company’s internal estimate of its TAM is already a large part of global software spend, it has the potential to move higher if Salesforce acquires software companies that address other enterprise applications. For the front office applications, Enterprise Content Management could be an area that the company has yet to address fully. And since Salesforce has entered the collaboration and communications space with Slack, it could also be an area in which the company can further invest or do more M&A.
With a reinvestment rate between 90%-110% and a return on incremental capital between 17%-24%, we estimate that Salesforce has increased its intrinsic value between 18%-22% over the past 5 years. This reinvestment rate (and intrinsic value calculation) is on a company basis. We do point out that due to the dilution from the acquisitions of Mulesoft, Tableau and Slack, the per share calculations are much different. The shares outstanding of the company has increased ~40% from FY16 to FY21 and this doesn’t include the dilution from the Slack deal.
What else is important?
What to make of these larger acquisitions?
Because the company has put revenue and product growth above other considerations like profitability and returns on capital, it makes sense to determine whether these large acquisitions are accretive or dilutive to intrinsic value growth. While calculating exact returns aren’t possible without the proper disclosures and until enough time has passed, it may be beneficial to see what type of growth rates these acquisitions need to achieve for prices that were paid.
Salesforce has made larger acquisitions as the company has gotten larger. Part of that has to do with increasing valuations for software companies over the past decade. We’ll do the math for the latest three large acquisitions since the company used stock as part or all of the purchase price.
Mulesoft in 2018 was $4.9B in cash + $1.5B in stock. At the time, Salesforce’s market cap was $85B, which implies that Mulesoft was 7.7% of the size the company and the new stock issued was 1.8%.
Tableau in 2019 was an all stock transaction valued at $15.7B. At the time, Salesforce’s market cap was $125B, which implies that Tableau was 12.6% of the size of the company.
Slack in 2020 was $16.3B in cash + $11.4B in stock. At the time, Salesforce’s market cap was $220B, which implies that Slack was 12.5% of the size of the company and the new stock issued was 5.2%.
If we assume that long-term margins for each of these businesses is 35% (this is likely low for Mulesoft as the unit economic margins are higher, but it’s uncertain for Tableau or Slack), we can back into the revenue number that each of these acquisitions would need to achieve to get to return on capital of 15%. (This is not cumulative returns, but rather last year returns).
Mulesoft would need to generate $2.8B in revenues, which is a 10x since it was acquired and only a 2x from today.
Tableau would need to generate $6.7B in revenues, which is a 5x since the time of acquisition and 4x from today. Keep in mind that only the Platform segment has revenues even close to that today.
Slack would need to generate $11.9B in revenues, which is a 12x from today. $11.9B in revenues is almost 2x the size of Salesforce’s largest segment and multiples of Slack’s estimated TAM today ($3.2B estimate for 2020 by Gartner).
Looking at these acquisitions from this lens, it makes sense why the market wasn’t too optimistic about the Slack deal.
Acquisitions are the largest source of optionality for Salesforce. However, the main concern would be that the company has been making larger acquisitions at higher valuations in recent years. Even with higher market multiples for software (aside from the recent drawdown for the past 3 months), the company continues to be very aggressive with M&A.
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