Financial Statement Analysis Assignment 3
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May the Force Be With You: Wide-Moat Salesforce.com Is the Newest Software Empire The market is discounting growth opportunities and operating leverage for this software leader.
Executive Summary
Salesforce.com has evolved from a salesforce automation point vendor to a full-fledged cloud-based
customer relationship management, or CRM, software behemoth. The company has been the key
forerunner for software as a service, or SaaS, and we believe the firm is among the most advantageously
positioned companies in software to capitalize on the ongoing secular migration to the cloud. We think
the market is underappreciating the opportunities Salesforce has to not only grow its business via its
existing products, but also through greenfield opportunities. Salesforce has generated consistent,
annual share gains across each of its product buckets, yielding leadership positions in salesforce
automation (45% share), customer service (18%), marketing (12%), and overall CRM spending (20%).
We believe enterprises will increasingly look to consolidate application spending around full-featured
suites, leaving Salesforce as the most likely beneficiary in the CRM market, propping up significant top-
and bottom-line growth for several years. Beyond growth opportunities, we revisit the economics of
software as a service (introduced in our 2015 Observer The SaaS Is Greener on the Other Side: The
Economics of Cloud Application Software Companies) and Salesforce.com’s path to operating leverage.
Key Takeaways
× Despite Salesforce.com’s abundance of success in the cloud-based customer relationship management
market, we believe the market underappreciates and underestimates the remaining CRM opportunity.
Salesforce has the most complete cloud-based customer relationship management suite to date,
including a network of applications around salesforce automation, customer service, digital marketing,
and e-commerce (via the recent $2.8 billion Demandware acquisition). This breadth should only
propagate the firm’s ability to land large, multiapplication deals.
× We are encouraged by the steps Salesforce has taken to add functionality to its applications. The firm is
also branching out into new verticals, and we see ample opportunity for the firm’s platform-as-a-service
offerings in addition to newer products around the “Internet of Things” and artificial intelligence,
including the firm’s recent announcement of the Einstein AI platform.
× Although many of Salesforce.com’s new initiatives contribute minimal revenue today, we believe the
connected device boom and the secular trend toward machine learning and intelligent applications
should yield ample opportunity for the firm’s Internet of Things and Einstein offerings.
Companies Mentioned
Name/Ticker
Economic
Moat
Moat
Trend
Currency
Fair Value
Estimate
Current
Price
Uncertainty
Rating
Morningstar
Rating
Market
Cap (Bil)
Salesforce.com CRM Wide Positive USD 98 75.06 High QQQQ 50.98
Morningstar Equity Research
25 October 2016
Contents
2 Overview of Salesforce’s Moat
3 Sizing Up the CRM Opportunity
9 Sales Cloud
14 Service Cloud
19 Marketing Cloud
24 Commerce Cloud
29 Summing the Parts
30 PaaS and Beyond
34 SaaS Economics and Valuation
Rodney Nelson
Equity Analyst
+1 312-244-7298
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Wide-Moat Salesforce.com Dominates in CRM
Salesforce.com has evolved from a salesforce automation point vendor to a full-fledged cloud-based
CRM software behemoth. The company has been the key SaaS forerunner, and we believe it is among
the most advantageously positioned companies in software to capitalize on the ongoing secular
migration to the cloud. In our view, Salesforce.com has established a wide moat based on two sources:
customer switching costs and network effect. Given the proximity to revenue-generating activities and
the interconnectedness of its products, we believe CRM applications have a high degree of switching
costs, while the use of multiple applications from the same vendor can have network-effect-like benefits.
We believe the Sales Cloud for salesforce automation bears the greatest degree of switching costs, a
market in which Salesforce boasts upwards of 40% market share. Sales are the lifeblood of any
organization, and Salesforce.com’s best-in-breed solution allows representatives to manage and track
their activity within their deal pipeline, while the product helps automate activity while dictating the
best course of action with a given prospect.
We also believe the service (for multichannel customer service management), marketing (for
multichannel campaign management, targeting, and analytics), and commerce (for business-to-
consumer digital commerce platform build-outs) clouds each bear a meaningful degree of switching
costs, particularly as vendors look to take a unified approach across multiple channels to engage and
retain customers. To this end, 70% of Salesforce.com’s top 200 customers use four or more of its cloud
products, up from just 13% of its top 40 customers four years ago (Salesforce also offers several
products geared toward application development and greenfield opportunities, housed under the App
Cloud). We believe this growth in attach rates also serves as evidence for our positive moat trend rating,
as we believe customers are increasingly locked in to the platform as they adopt additional products.
We are also heartened by Salesforce.com’s thought leadership, yielding constant upgrades to its CRM
solutions and innovative features such as intelligent lead scoring and predictive analytics, making it far
more difficult for customers to abandon its products. Further, as more users come into the Salesforce
network, both Salesforce and its users benefit. In the case of the former, Salesforce receives more
feedback and data to improve all of its products, while more application developers in Salesforce.com’s
App Cloud yields a greater number of useful business applications in the firm’s AppExchange, which we
believe is the largest online enterprise application software marketplace live today.
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Sizing Up Salesforce.com’s Core CRM Opportunity
Customer Relationship Management Market Overview
CRM software is vital to both revenue-generating and customer interaction activities for businesses of
all sizes. As enterprises look to become more tactical in their sales, marketing, and customer service
practices, firms are turning toward innovative software platforms to track and gather insight into not
only their customers, prospects, and deal pipelines, but to also understand best practices for providing
service, extracting maximum value out of its relationships by upselling and cross-selling to additional
products and services, and creating, targeting, and managing marketing campaigns. As a result, the
CRM software vertical received an overwhelming share of the $156 billion spent on application software
in 2015, excluding the highly fragmented vertical-specific software market.
Exhibit 1 CRM and ERP Dominated the $156 Billion Application Market in 2015
Source: Gartner, Morningstar research
While the market outlay exceeded $25 billion on customer relationship management software in 2015,
we think this market opportunity is still several years from reaching its peak spending levels. There are
three key waves propagating growth rates for CRM spending, including:
Business Intelligence
and Analytics 11%
Customer Relationship
Mgmt. (CRM) 18%
Digital Content Creation
2%
Enterprise Content
Management 4%
Enterprise Resource
Planning (ERP) 19%
Office Suites
11%
Other Application
Software 23%
Project and Portfolio
Management 2%
Supply Chain
Management 7%
Web Conferencing,
Collaboration/Social Software Suites
3%
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1. Enterprises moving away from internally developed CRM systems.
× The source code for proprietary, internally developed CRM systems can date back multiple
decades, and they generally lack crucial functionality including modern, intuitive user
interfaces, built-in analytics, and the ability to tap into CRM data from other applications via
APIs. We suspect this wave will fully play out over the next several years as enterprises
address points of weakness in the IT infrastructure.
2. Software as a way to improve business processes.
× Small businesses frequently retrofit generic business applications (such as Excel) for other
uses, including customer relationship management. These processes are generally
completed via manual data entry and updating, costing businesses valuable time that could
be spent engaging its customers. While this wave is a much more fragmented opportunity,
we expect small and midsize businesses to continually look to software for operational
improvements as growth materializes, while larger enterprises turn to software as a means
of improving the customer experience and capitalize on greenfield opportunities.
3. Software as a way to save costs via the cloud.
× Beyond improving business processes, cloud computing has allowed enterprises to eliminate
costly infrastructure (in the form of underutilized physical hardware, maintenance, and IT
management headcount). Despite torrid growth for many cloud vendors, this wave remains
in the early stages, particularly in international markets where cloud adoption has lagged
North American markets. We estimate that shifting to the cloud can save customers as much
as 30% on their total IT costs over the long run, largely derived from downsizing on-premises
data center hardware and IT staffing required to run and maintain legacy software
applications.
These three waves largely underpin our expectations for application software growth over the next
several years. Further, organizations are increasingly embracing the value of each step of the customer
relationship journey, which has yielded CRM growth well above the overall application market growth
rate for several years, a trend we expect to continue for several years. Research firm Gartner estimates
that the CRM market (which covers most of Salesforce.com’s core products, including salesforce
automation, customer service, marketing, and digital commerce) will grow at a compounded annual rate
of just over 14% through 2020, well ahead of the broader application market (8.6%), making CRM the
largest application spending category.
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Exhibit 2 Midteens Growth Will Make Customer Relationship Management the Largest Application Vertical by 2020
Source: Gartner, Morningstar research
At a midteens growth rate, Gartner estimates that spending on customer relationship management will
exceed $50 billion in 2020, or roughly one fourth of its global enterprise application spending estimate of
more than $215 billion. However, exhibits 1 and 2 do not delineate between cloud and legacy on-
premises applications. While organizations have been more hesitant to move some applications to the
cloud (such as financial management applications within the ERP suite, though this trepidation is
gradually abating), Salesforce has helped lead the migration to the cloud for CRM applications, making it
the most heavily deployed application vertical in cloud-based environments today. Of the nearly $31
billion spent on software as a service in 2015, 39% was allocated toward CRM applications, a number
Gartner expects to inflate to 43% by 2020.
Business Intelligence
and Analytics 11%
Customer Relationship
Mgmt. (CRM) 24%
Digital Content Creation
2%
Enterprise Content
Management 4%
Enterprise Resource
Planning (ERP) 17%
Office Suites
10%
Other Application
Software 21%
Project and Portfolio
Management 1%
Supply Chain
Management 7%
Web Conferencing,
Collaboration/Social Software Suites
3%
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Exhibit 3 In 2020, the $75 Billion SaaS Market Will Still Be Dominated by CRM
Source: Gartner, Morningstar research
While enterprises are all at different stages of the cloud migration, we believe that the IT community is
generally in the early stages of moving legacy workloads into the cloud. Even with torrid growth through
2020, Gartner estimates that just 5% of total IT spending worldwide will be geared toward cloud-based
services. Admittedly, certain data stores and application workloads will need to stay out of multitenant,
public cloud infrastructure because of regulations around security and data sovereignty, but we believe
most core enterprise applications will eventually migrate to the cloud.
We think it is important to distinguish between SaaS and on-premises CRM spending growth for that
reason, at least as a point of reference, particularly since Salesforce.com offers its products only via the
SaaS delivery model, while legacy vendors such as Oracle and SAP scramble to reconfigure legacy
applications for the cloud. Over the next five years, we expect the mix between on-premises and SaaS
CRM spending to increasingly tilt toward the cloud, with the SaaS spending growth rate coming in well
above that of on-premises expenditures. Specifically, Gartner estimates that SaaS CRM spending will
grow at a compounded annual rate of 21% over the next five years. We believe that Salesforce.com’s
best-in-breed CRM portfolio will be the largest beneficiary of this growth, which could make our base-
case estimate of 19% compounded annual revenue growth over the next five years for the firm’s core
CRM applications (including Sales, Service, Marketing, and Commerce clouds) look conservative. Given
the mission-criticality and revenue-generating functions to which these applications are tied, along with
dollar attrition rates across the entire Salesforce.com portfolio of less than 9%, we believe these factors
in totality support our belief that Salesforce.com’s customers bear a large degree of switching costs,
underpinning our wide moat rating.
Business Intelligence
Applications 6%
Customer Relationship
Management 43%
Digital Content Creation
3% Enterprise Content
Management 2%
Enterprise Resource
Planning 13%
Office Suites
4%
Other Application
Software 13%
Project and Portfolio
Management 2%
Supply Chain
Management 7%
Web Conferencing,
Teaming Platforms, and Social Software Suites
7%
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Exhibit 4 Gartner: CRM SaaS Spending Will Grow at a 21% CAGR Over the Next Five Years Versus Just 7% for On-Premises Spending and 18% for Salesforce
Source: Gartner, Morningstar research
Note: “M* Salesforce Sales” includes our subscription revenue forecasts for the Salesforce.com’s sales, Service, Marketing, And Commerce clouds only; does not include App Cloud/other sales.
Leaders in this space include most of the usual suspects in the software industry, such as Microsoft,
Oracle, and SAP. However, many of the application vendors that once dominated the CRM vertical
largely rely on legacy on-premises applications. Vendors such as Oracle and SAP are racing against the
clock to retrofit these solutions and mash them together with acquired SaaS technologies to create a
complete cloud-based offering, but so far we believe those organizations are taking a back seat (from a
revenue and technological reliability and scalability perspective) in the SaaS wars versus cloud-native
firms such as Salesforce.com, particularly at the high end of the more than $25 billion market.
0%
5%
10%
15%
20%
25%
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
CY 2014 CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Salesforce Sales* Cloud-Based CRM Spending On-Premises CRM Spending Salesforce Growth Cloud-Based CRM Growth On-Premises CRM Growth
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Exhibit 5 Salesforce.com’s CRM Success Has Come at the Expense of Its Rivals
Source: Gartner, Morningstar research
Based on Gartner’s estimates, just 22% of application software expenditures were allocated toward
software-as-a-service solutions. While this number should surge in general across software, we suspect
that the migration of CRM suites could accelerate even beyond Gartner’s expectations, particularly as
application software vendors like Salesforce.com look to build new functionality into its products such as
embedded analytics, artificial intelligence, and use cases around the Internet of Things that could help
further consolidate IT spending. We believe this type of thought leadership can provide greenfield
opportunities for Salesforce.com’s products, ultimately creating the potential to expand its total available
market beyond Gartner’s estimates. Over the next several sections, we explore these themes, along with
the state of each of Salesforce.com’s existing CRM products and their respective opportunities and
challenges.
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
CY 2010 CY 2011 CY 2012 CY 2013 CY 2014 CY 2015
Salesforce.com SAP Oracle Microsoft IBM Adobe
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Parting the Clouds
Sales Cloud
Sales Cloud is Salesforce.com’s flagship salesforce automation application, or SFA. Introduced in 1999,
the product is the firm’s most mature offering. Sales Cloud allows salespeople to track deal pipelines,
manage interactions, and gain access to contact information for customers and prospects alike. Over the
years, Salesforce.com has added increased functionality to the platform via both internally developed
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