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Salesforce.com: Good Business but Pricey Stock

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, Co-Editor of Morningstar's OptionInvestor. Today, it's my great pleasure to welcome Sunit Gogia, who is Senior Analyst in charge of software companies here at Morningstar.

Sunit, thanks for coming.

Sunit Gogia: Thanks for having me.

Kobayashi-Solomon: So, just recently I wrote a bearish article or an article describing a bearish option strategy on a company that you cover Salesforce.com, and just want to ask you a little bit about that today.

So Salesforce.com is involved – they have a model called Software as a Service, people call it SaaS. So what is SaaS? Why should I care about it as an investor?

Gogia: So, software as a service is a delivery model where software is delivered online over the Internet and customers can access it typically using a web browser, without the need to install any software on their end. So most people are already familiar with this maybe without realizing it. Most people use a free email service like maybe Gmail or Yahoo! or Hotmail.

Kobayashi-Solomon: I was just going to say, so it's kind of the Gmail model versus Outlook and installing Outlook on your…

Gogia: Precisely. When you are using Gmail, you are just pointing your web browser to gmail.com, logging in and using the service, without installing anything. That is software as a service.

Kobayashi-Solomon: So I'm guessing it's probably most useful for kind of smaller businesses, businesses that don't have a huge budget for IT implementations or something?

Gogia: That's definitely a good starting point. Since we're talking about Salesforce.com, Salesforce.com software enables customers to manage sales leads, manage their sales pipeline. Now in the traditional model before Salesforce.com came along, customers that wanted to do that had to basically by, let's say Oracle Siebel software, maybe acquire a server from HP or IBM, hire IT people to install the software to maintain it.

Kobayashi-Solomon: So a ton of upfront investment, just to get up and running.

Gogia: Exactly. All of these are upfront capital expenditures. Now with Salesforce.com, the customer can simply point their web browser to Salesforce.com, login and start using the service. They don't have to acquire any software, they don't have to acquire any servers. But unlike for example Gmail, Salesforce.com needs to make money, so they charge an annual subscription fee.

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Kobayashi-Solomon: I was just going to ask you, because I know I have a Gmail account and I completely ignore all of their adverts that Gmail is giving me. So, but these guys are actually getting an upfront fee.

Gogia: Right. So they actually charge an annual subscription fee, which is a fee, but it's much lower than the CapEx you would incur to basically acquire software and servers.

Kobayashi-Solomon: So, is this really how – because Salesforce.com is not an enormous company and they are competing against enormous companies, Oracle, SAP, these kind of players, is that how they've been able to kind of sneak in under the radar?

Gogia: That's been a big key to their growth. Oracle and SAP, yes they are large, entrenched competitors, but they've mostly provided software to large businesses in the traditional packaged software model. Salesforce.com by virtue of providing a hosted service on an annual subscription basis, has been more affordable for many customers, who previously could not afford to acquire any solution to help them in this space.

Kobayashi-Solomon: So this is, your 10% manufacturing company or something like that who needs to manage their sales leads and their contacts and so forth?

Gogia: Sure. In fact, two-thirds of Salesforce.com's revenue base is from small and medium size businesses, and again, this was just an un-served market that even though Oracle and SAP were playing in this software space, they were not serving this segment of the market.

Now that said, Salesforce.com service is recognized as one of the best in the industry and like we said the economics are compelling for customers, so they have been able to gain share among larger enterprises as well.

Kobayashi-Solomon: So you've just said a couple of things. First of all, they offer compelling service, they've been able to grow rapidly, they are differentiating things through a niche. But I've got a bearish position on these guys. How do you kind of marry this kind of very bullish fundamental picture with a bearish position?

Gogia: So yeah, we are indeed very bullish we think on the company's prospects. We just think the stock is overvalued. So our assumptions for growth, for example, are over 20% growth per year for the next five years. Over this period, we have forecasted operating margins doubling to the high teens.

Kobayashi-Solomon: So you are not forecasting a complete fall off of business. I mean you are -- pretty robust growth, hugely robust profitability growth.

Gogia: Right. We absolutely see this – this model is here to stay. It's here to gain market share. That said, for the same reasons that we said, the economics are compelling to customers. We think the economics are not as compelling to Salesforce.com itself. These fundamental differences between this model and the traditional model, Salesforce.com has a primarily small and medium size business, customer base, which is fragmented and expensive to serve.

Kobayashi-Solomon: So just trying to first of all market to these customers; second of all, trying to keep them in the fold and keep them renewing and all of that stuff.

Gogia: Right. So customer attrition has been an issue. That said, we expect it to improve going forward. The company is making some of the right moves we think to improve customer stickiness and that is why we have operating margins doubling over the next five years, because we think they're going to get scale in that area.

But we think they are fundamentally, handicapped is a strong word, but we don't think they're going to get to the kind of margins that Oracle, SAP, Microsoft have enjoyed in the traditional model, where customers have basically paid more money upfront, and its always cheaper to support a smaller large customer base than a larger small customer base.

Kobayashi-Solomon: It makes a lot of sense. So just to summarize, you're bullish on the company itself, but it just looks like the stock price and the valuation has gotten ahead of it. Everybody is getting too excited about it.

Gogia: Exactly. Again, we think this company is going to do very well over the next five years, we just think the stock is overvalued right now.

Kobayashi-Solomon: You make a convincing case. Thanks for coming in, Sunit.

Gogia: Thanks for having me, Erik.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where you'll find many more investing ideas based on Morningstar's fundamental research.