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Morningstar | Always Be Closing: Salesforce.com Executes Another Successful Quarter; Raising our FVE to $175

After transferring coverage of Salesforce.com to a new analyst, we are raising our fair value estimate to $175 per share from $158 and maintaining our wide moat rating, positive trend, and medium uncertainty ratings. We continue to believe Salesforce benefits from strong switching costs and a network effect in terms of its platform offerings. The firm's acquisition of MuleSoft (acquired at an expensive multiple of 22 times revenue) and incremental investments in its AI tools (Einstein) embolden our confidence in Salesforce's increasing switching costs. With shares trading at a discount to our fair value estimate, even after an impressive year-to-date run, we still anticipate additional upside for Salesforce and still see this as an attractive point of entry. The firm's prospects are buoyed by salient trends, such as a shift to cloud applications and enterprises undergoing a digital transformation. These trends, coupled with robust aggregate CRM spending growth, will propel Salesforce's top line, in our opinion.

The firm reported second-quarter 2019 earnings on Aug. 29. Salesforce's second-quarter revenue of $3.3 billion and diluted GAAP EPS of $0.39 per share sat at the upper end of our expectations. Our estimates for fiscal 2019 revenue are now $13.2 billion, targeting the high end of management's guidance range. We attribute shares selling off to muted third-quarter EPS guidance, but we were impressed with full-year targets.

MuleSoft and verticalization remained the story during the quarter. MuleSoft's Anypoint Integration Platform allows Salesforce to essentially become the glue behind the entire IT systems of major enterprises, while concurrently strengthening the interconnection between Salesforce's various clouds. Our fair value increase is largely based on greater expectations for MuleSoft's growth, which we model on a standalone basis. Second, we see vertical products, like Health Cloud, as crucial to the firm's long-term growth story.

In terms of our long-term thesis, we believe that after starting as a trailblazer at the genesis of the software-as-a-service, or SaaS, movement, Salesforce.com has expeditiously transformed into a modern software heavyweight. We think Salesforce benefits from secular tailwinds, as enterprises utilize cloud applications for rapid deployments, instant updates, and to lower the total cost of ownership for their software applications. At Salesforce's founding, its total addressable market, or TAM, was a mere $750 million. Today. it is nearly $100 billion. The firm's ability to continually target behemothic TAMs through new product launches is remarkable. Even with over $10 billion in revenue, Salesforce has bucked the law of large numbers in recent years by continuing to grow at 20%-plus, and we don't foresee the firm's high growth slowing any time soon.

Salesforce's products run the gamut of customer relationship management, or CRM, an overarching term for functions fulfilled by several applications. Salesforce's goal is to be the one stop shop for CRM. The firm's Salesforce automation services, which is now Sales Cloud, its oldest and best-known product, is now supplemented by Service Cloud, Marketing Cloud, and Platform, each generating in excess of $1 billion in annual revenue. Commerce Cloud, IoT Cloud, AI/Einstein, and MuleSoft remain nascent offerings, that give us confidence in Salesforce's long-term growth runway. Salesforce is the largest pure-play SaaS vendor and we expect additional product launches ahead.

Despite expanding into new verticals (largely through acquisitions such as MuleSoft, Exact Target, and Demandware) and a growing customer footprint, the firm's customer and dollar attrition rates have declined into the single digits, supporting the stickiness of Salesforce's applications. 51% of enterprise customers were multi-cloud in fiscal 2018 and utilized more than one product. While the firm faces entrenched competitors, we expect Salesforce to surpass $22 billion in revenue by fiscal 2022.

In March 2018, Salesforce acquired public company MuleSoft for $6.5 billion. We believe MuleSoft is independently moat-worthy, benefiting from switching costs and additive to Salesforce's aggregate moat. To contextualize MuleSoft's appeal, we need to establish that when many IT departments choose software applications for their company, they adopt the pre-eminent application for its respective function (Salesforce in CRM or Workday in human capital management, or HCM), rather than using a single vendor, such as Oracle for CRM, HCM, and enterprise resource planning, or ERP. MuleSoft's Anypoint Integration Platform can connect data across both on-prem and cloud environments and the firm already maintains a large enterprise footprint with customers such as McDonalds, Coca-Cola, and GE. For example, MuleSoft's tools can pull data from SaaS applications, mainframes, legacy on-premises offerings, and databases, Thus, a theoretical customer can use MuleSoft to help connect Salesforce's CRM data, SAP's billing data, and the data in that enterprise's in-house e-commerce application. The benefits of this are multifold in our view. First, we believe this eases the burden for cloud transitions, especially for enterprises that have held out on cloud migrations. MuleSoft refers its functionality as API-led (application program interface) connectivity. Thus, it accelerates a new customer's ability to adopt Salesforce's cloud platforms. Second, MuleSoft allows Salesforce to be the backbone of major enterprise's various IT systems. Ripping and replacing MuleSoft would be burdensome and laborious, keeping customers tied to the Salesforce ecosystem.

This is Salesforce.com's first quarter with the dual CEO structure. For background, President and COO Keith Block was promoted to co-CEO at the beginning of August 2018, joining co-founder and chairman Marc Benioff in the CEO suite. Block joined Salesforce in 2013, after serving a long tenure at Oracle, once serving as the VP of Oracle's North America sales and consulting operations. We certainly have our trepidations regarding the inefficiencies inherent in a dual CEO structure. Ben Horowitz, of Andreesen Horowitz, has discussed the topic extensively stating the numerous problems that can typically result from this structure. Horowitz has asserted that Workday has been one of the few successful examples of this in the past, as Aneel Bhusri and David Duffield both had their circles of competence, in that they were solely responsible for certain parts of the business. Throughout Block's tenure at Salesforce, Benioff has credited Block with his relentless attention to salesforce execution, his enterprise focus, his verticalization strategy, and his ability to spearhead M&A initiatives. We certainly believe Block has been instrumental to Salesforce's growth story, as evidenced by the firm's ability to hit its $10 billion in revenue goal by fiscal 2018, adding to our confidence that the firm will surpass $22 billion in revenue by fiscal 2022. We posit that Salesforce's structure may be more like Workday and less like Oracle (With two CEOs and founder and chairman Larry Ellison serving as the CTO). While Block has, and will continue to be responsible for global sales, the industry strategy, and growth targets, Benioff is the head of product, technology, and culture.

We hypothesize that the promotion could be indicative of two things. First, Block's sales contributions and M&A leadership have been noticed and other firms were attempting to poach him for CEO positions. We suspect that Benioff may have given Block the co-CEO promotion to ensure he stays at Salesforce for the long haul. Second, Benioff has been leading Salesforce for nearly 20 years and it is within the realm of possibility that he is intent on setting up his successor in order to eventually have a more hands-off role or focus on other ventures, such as philanthropy or politics. Either way, we continue to believe that Block is crucial to hitting the ambitious long-term sales targets of the firm, particularly the $20 billion by 2022, $40 billion by 2028, and $60 billion by 2034 goals.

In terms of valuation, for the consolidated business, our five-year CAGR is 20% and our 10-year CAGR is 15%. We utilize a bottom up valuation for Salesforce, estimating a 14.5% five-year CAGR for Sales Cloud, a 20% CAGR for Service Cloud, a 20% CAGR for Platform, App Cloud, and Other, a 18% CAGR for Marketing Cloud, a 57% CAGR for Marketing Cloud, a 43.5% CAGR for MuleSoft, and an 11% CAGR for Services revenue. We find these assumptions reasonable when contextualized around the expected double-digit CAGR for the CRM industry. We model that Salesforce achieves its $40 billion by 2022 targets. We expect subscription revenue to outpace the lower gross margin services revenue, thus enabling gross margins to steadily approach 80% by the end of our explicit forecast period.

In terms of MuleSoft, we model the recently acquired business separately and believe that by Salesforce's fiscal 2023, MuleSoft can surpass $1 billion in revenue and will produce positive operating margins on a standalone basis by 2022. We believe MuleSoft's product is sticky can accelerate cloud migrations, creating synergies with Salesforce's core business.

We expect Salesforce's margins to trickle upwards over the next decade as the firm begins to benefit from operating leverage. Our thesis is that Salesforce is heavily investing in new product launches to amplify its TAM and that the firm's SaaS deployed business model likely understates normalized operating margins. Marketing and Commerce Clouds, IoT Cloud, Einstein Analytics, and Vertical Specific Clouds have all required immense investment, but have driven the top line and allowed the firm’s TAM to approach $100 billion.

As growth slows, Salesforce will benefit from diminishing commission expenses leading to declining SG&A costs. We think SG&A as a percentage of revenue, which sat at 54.6% in fiscal 2018, can reasonably move toward 32.5% by 2028. We model midcycle GAAP operating margins of roughly 35%.

Salesforce's muted operating margins have been pointed out as evidence that this name is overvalued, but we refute this supposition for several key reasons. Our long-standing thesis around Salesforce and its cloud peers has been that the ratable revenue recognition likely understates long-term profit potential. In terms of the financials of Salesforce, pure-play SaaS businesses typically recognize revenue ratably, meaning if a customer pays for a year of Salesforce's CRM tool, Salesforce only recognizes a portion of that on their income statement at quarter-end, while the rest sits as deferred revenue as a liability on its balance sheet. This differs from the historical precedent of on-prem rivals who recognize the vast majority of revenue for a multiyear licensing deal upfront, with a very minor maintenance or service component over the ensuing years. In contrast, the vast majority of Salesforce’s expenses associated with the deal are incurred up-front. Certain sales and marketing expenses, the cost to develop the software, and infrastructure costs are not recognized over time with the revenue, although we note that sales commissions are deferred. Therefore, the faster Salesforce grows, the more money it loses. If we were to look at the cash flows of a single deal, Salesforce would be in the red immediately because of the incurred expenses, with the cash flows progressing toward breakeven and then positive over time. A single deal for Salesforce might not be cash flow positive until a year or two after a customer implements a product. However, as time progresses, Salesforce becomes increasingly profitable. Thus, as Salesforce's growth begins to slow, we project a swift uptick in margins. For a historical precedent, around the financial crisis, Salesforce's SFA offering began to mature leading to slowing revenue growth, but briskly expanding operating margins. As revenue growth slowed, Salesforce began reinvesting in the business, launching new products (such as Service Cloud which was launched in 2009) to reaccelerate growth and enter new markets. Thus, we believe management has worked to expand Salesforce's TAM at the detriment of near-term margins.

Taking a long-term view and due to our understanding of SaaS unit economics, we expect as current products to mature, Salesforce's operating margins will briskly trickle upwards over the next decade. We find it prudent to evaluate Salesforce financially from a free cash flow perspective and want to contextualize our view on Salesforce around the simple fact that while Salesforce's penetration of enterprise customers is strong (well over 80% of the Fortune 500), potential wallet share is much higher. Salesforce's TAM is expected to surpass $100 billion in the next few years and the estimated CAGR for the CRM industry over the next five years is well above the respective CAGRs for other application software industries (Gartner estimates a 13.8% CAGR for the aggregate CRM market between 2017 and 2022). Our confidence in long-term operating margin expansion, cash flows, and valuation is grounded in our assertion that Salesforce possesses a wide economic moat supported by switching Costs and a network Effect.