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Morningstar | Salesforce.com Is Building an Empire; Our FVE Is $186

We believe Salesforce.com represents one of best long-term growth stories in software. We maintain our wide moat and positive moat trend ratings and raise our fair value estimate to $186 per share from $180 based on slightly higher long-term growth assumptions. Even so, this suggests 16% upside from the current price, and we therefore view the shares as modestly undervalued. Our fair value estimate implies a price/earnings ratio of 46 times fiscal 2021 non-GAAP earnings per share.

After introducing the software-as-a-service model to the world, Salesforce.com has assembled a front-office empire that it can build upon for years to come, in our view. The various cloud offerings encompass nearly all aspects of customer acquisition and retention. According to Gartner, the total addressable market will grow to $143 billion by 2022, which is impressive, given that it was less than $1 billion 20 years ago. We believe core growth will remain robust over the next five years supported by a large and growing opportunity, as we see compound annual growth rates ranging from 10% to 14% in the company’s individual underlying served markets. We think Salesforce.com should at least keep pace with the underlying markets, if not outgrow them, and easily achieve its $26 billion-$28 billion revenue target in fiscal 2023.

In our view, the company will benefit further from natural cross-selling of solutions among the clouds, upselling more robust features within product lines, pricing actions, international growth, and continued acquisitions. EPS should continue to grow faster than revenue as gross margins ramp across all clouds and the company further benefits from overall operating leverage.

Sales Cloud represents Salesforce.com’s original salesforce automation, or SFA, product. The company has gone from no product to 33% market share over the last 20 years. By virtue of SFA being its first product, Sales Cloud is the largest segment for Salesforce at 30% of revenue, growing at 13% in fiscal 2019. Customers and industry observers alike view Salesforce.com as the clear front-runner in the category, with Oracle and Microsoft being key competitors. We believe this segment enjoys a wide moat--indeed the widest moat as a stand-alone product among the company’s clouds driven by high switching costs. We note the importance of Salesforce’s SFA product given its role in moving the entire industry to the SaaS model, the recognized product strength, and the long-running market share consolidation. We believe the underlying market is approximately $12 billion currently and should grow by 10% or more annually over the next few years. We model Sales Cloud growth of 10%-11% in each of the next three years.

Salesforce.com has been very successful at penetrating its original client base with related solutions and has become the runaway leader with its customer engagement offerings. Service Cloud is the company’s second-largest segment, and despite generating $3.6 billion in revenues in fiscal 2019, the segment still grew 26%. Our analysis indicates Salesforce is a clear leader in this market as well, with Pegasystems, Oracle, and Microsoft being key competitors. We believe the market is approximately $18 billion and should grow by 12% or more annually over the next several years. We model Service Cloud growth of 18%-20% in each of the next three years.

Marketing and Commerce Cloud is Salesforce.com’s newest segment and therefore is the smallest offering in terms of revenue under the subscriptions and support umbrella. Marketing Cloud delivers marketing automation solutions while Commerce Cloud provides an e-commerce engine. In aggregate, this segment represented $1.9 billion in revenue in fiscal 2019 (14% of total) and grew 23%. In our view, marketing automation is another obvious cross-selling opportunity and fits in well with SFA and customer engagement. Together, Marketing Cloud and Commerce Cloud were assembled largely by acquisition, with ExactTarget, Demandware, Buddy Media, Radian6, and a variety of other smaller deals comprising the core functionality. This approach allowed Salesforce.com to quickly offer customers a complete solution in what has become the modern digital marketing platform. Here, Salesforce.com and Adobe have emerged as leaders in a relatively young and dynamic area, with Oracle, IBM, SAS, and SAP serving as notable competitors. We think the market is approximately $19 billion now and is also growing in the low-double-digit percentage area. Our model has segment growth slowing from 30% to 24% over the next several years.

The other growth leg that the company adopted about 10 years ago is the Salesforce Platform and other segment, which is not an obvious product extension of SFA. The Salesforce platform was the first true enterprise class application development platform, even if it was initially geared toward small and medium businesses and smaller commercial customers. By virtue of being a first-mover and with the AppExchange, Salesforce has been a leader in platform as a service for years. This is the company’s third-largest segment. At $2.9 billion in revenue in fiscal 2019, it grew 49%. Even backing out the MuleSoft acquisition in May 2018, the segment was growing faster than 30%. While we would share a consensus view that Salesforce.com paid a high premium for MuleSoft, we believe the strategic rationale for the deal is obvious. One of the pain points senior executives have in the digital transformation of their own businesses is the inability of legacy and existing applications to easily share data. MuleSoft develops APIs that help tie disparate systems together. According to Gartner, the market is approximately $25 billion and is growing at a 6% CAGR through 2022. We model 25% growth or more for the next several years, as Salesforce leverages its lead in digital transformation projects with MuleSoft and continues to enjoy above-market growth rates due in part to its extensive ecosystem.

Professional Services makes up 7% of revenue and has grown at 6%-8% in each year over the last decade. Through this segment, Salesforce.com offers strategic consulting on digital transformation projects, as well as training and certification on the company’s solutions. The company operates this segment on low-single-digit gross margins. We model 5%-6% growth in each of the next several years.

Salesforce has consistently chosen growth over margins--a strategy we take no issue with--and it seems to us that the company is ready to deliver more earnings growth to investors as well. Management seems committed to driving 100-150 basis points of operating margin annually. We think gross margins can expand by hundreds of basis points over the coming years as acquisitions are fully integrated and revenue scales and note that as recently as fiscal 2011, the company generated 87% GAAP gross margins. We believe the company should benefit from ongoing operating leverage as well.