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Salesforce: This Stock Flattened for a Good Reason

Cloud-based services, particularly enterprise solutions following a subscription model, attract a high premium when it comes to stock price. The market tends to value these companies higher than most other sectors because of the strong dependence of clients on these products, which results in revenue stability. This often makes it difficult for investors to understand whether a given stock in this sector is overvalued or not. A classic example of a company creating such a dilemma in the minds of its investors today is Salesforce (NYSE:CRM).

What does Salesforce do?

Salesforce is one of the market leaders in the cloud-based customer relationship management (NYSE:CRM) systems across the globe and also one of the leading software-as-a-service (SaaS) providers. The California-based company has multiple cloud-based solutions that help companies store customer data, monitor leads, do complex analysis to gain insights, forecast revenues, track customer communication and deliver services and support to clients. While a majority of its revenues are from North America, the company's client base is spread across the globe, and it has acquired a double-digit market share in the global SaaS industry in its 20 years of operations.

Strong results but dull outlook

The market has now grown accustomed to the idea that the Salesforce results will beat expectations on all fronts. The management has been consistently beating analyst estimates for almost all quarters over the past couple of years, and third quarter of 2019 was no exception. Salesforce reported a top-line of $4.51 billion, which was yet again above the analyst consensus estimate of $4.45 billion. This was nearly a 33% increase compared to the corresponding quarter of the previous year, and the growth was largely driven by core subscription and support revenues.

On the earnings front, the company's earnings of 75 cents per share were above the analyst expectations of 67 cents per share. However, the problem with the result was a lower earnings outlook projected by the management. For the next quarter, the Salesforce management kept their revenue expectations aligned with the market expectations at around $4.74 billion, but their projected earnings per share of close to 54 cents per share were well below par. Analysts expected this number to be around 61 cents per share, which resulted in the stock price taking a hit as soon as the outlook was announced.

Growth strategies from management

The Salesforce management has been actively expanding its customer base abroad and building partnerships with international giants such as British Airways, Siemens, Australia and New Zealand Banking Group, EON and Panasonic. With the launch of its Customer 360 product, the company now has a larger addressable market, though it is now in direct competition with the Open Data Initiative, an alliance of Microsoft (NASDAQ:MSFT), Adobe (NASDAQ:ADBE), and SAP (NYSE:SAP). Salesforce management is broadening its offerings by making strategically relevant acquisitions like Tableau (a $15.7 million deal to increase the company's digital transformation capabilities) and MuleSoft.

The Salesforce stock might not rebound too soon

Salesforce was once considered a stock that had the capability to generate multi-bagger returns. However, that stage is long gone accourding to one interesting statistic: the stock price of Salesforce has appreciated 122% over the past three years, but only 12% in the past year. While a 12% appreciation may not seem too bad, it shows a marked decline in growth for a company like Salesforce.

The above chart shows that the company had a topsy-turvy ride throughout 2019 despite the strong demand for cloud services. There has been a sharp decline in the enterprise value-to-Ebitda multiple, though it has stabilized now. This is a clear indicator that a future jump in the stock price will be driven by improved profitability, which is why the stock has plunged after the weakened outlook. With a three-year annualized revenue growth rate of 19.4%, some promising acquisitions and strong international expansion efforts, the top-line is not the problem. However, a net margin of 4.64% and a return on equity of 3.79% are certainly low for a company that is trading at a price-earnings ratio of 166.38. The management needs to improve the bottom-line in order to continue creating shareholder value.

Key takeaways

Salesforce is definitely not a bad company to have in one's portfolio, but the stock is going through a tough phase now. The consistent insider selling has not helped the company, and its price (which is more than 8 times its revenues) is definitely on the higher side. The valuation seems even higher when one figures that Salesforce's operating margin is below that of industry peers. All these factors indicate that the company's stock is best avoided until the management is able to show some significant improvement in its profitability.

Disclosure: No positions.

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This article first appeared on GuruFocus.