The Case Against Salesforce, Even at the Lows

• CRM stock has hit a 52-week low amid decelerating growth and management departures
• The bull case looks attractive at a reduced valuation
• But Salesforce isn’t as profitable or as fast-growing as headline numbers suggest

At a 52-week low, it seems relatively easy to make the bull case for Salesforce Inc (NYSE:CRM). Yes, growth has slowed of late, but the macroeconomic environment is a factor. Over the long haul, this has been one of the greatest software companies in history.

Meanwhile, valuation looks attractive—and certainly more attractive than it has in at least a decade. Based on guidance for fiscal 2023 (ending January), CRM trades for just 27x adjusted earnings per share. Yet that same guidance implies a 30% increase in adjusted operating profit. (Adjusted EPS growth looks minimal, but that is because Salesforce.com booked over $1 billion in gains on strategic investments in FY22 that have not recurred this year.)

It’s a tempting case. But it’s a case that, looking closer, doesn’t look quite strong enough.

The Revenue Problem

The headlines portray that the drama surrounding Salesforce’s slowing growth is overblown. Q3 earnings handily beat expectations. The outlook for the fourth quarter was a bit disappointing but hardly disastrous. More importantly, Salesforce still expects revenue to grow 17% this year, and that’s with a 3-point headwind from the stronger dollar.

But in fact, the news is worse than those headlines suggest. As a provider of subscription software, Salesforce recognizes revenue over time rather than at the time a sale is actually agreed to. The length of time varies depending on the product, but the overall impact of this accounting treatment is significant: Salesforce closed the third quarter with more than $11 billion in “unearned revenue,” which will be recognized going forward.

In other words, some of the revenue behind the growth in fiscal 2023 comes from deals closing in fiscal 2022. That aside, growth has decelerated markedly. Billings—essentially the new revenue added in the quarter, whether that revenue will be recognized in the period or later on—increased just 5.7% year-over-year in Q3, according to figures from the company’s earnings release. Foreign exchange is a factor there, but hardly enough to suggest such a massive deceleration.

To put the 5.7% figure in context, billings increased by 20% year-over-year in Q1 and 19% in Q2. And the figure is likely to get worse in Q4. Salesforce itself is guiding for revenue growth of just 8% to 10%, roughly half the rate over the first three quarters of the year. A chunk of even that paltry growth will come from recognizing revenue billed in previous quarters.

The Profit Problem

This is a business whose growth has slowed in a hurry. Of course, the external environment plays a role. Salesforce prices much of its software on a per-seat basis, meaning layoffs at customers alone can pressure revenue. Executives at the company have noted elongated sales cycles and the need for approval at ever-higher levels of management as well.

Those headwinds will fade at some point, and as a result, even with slowing growth, a 27x earnings multiple does seem reasonable and maybe even attractive. Neither the results in Q3 nor the outlook for Q4 necessarily show a business that is losing market share or disappointing customers. Customers simply are tightening their belts.

The problem is that the 27x multiple isn’t necessarily real. Like most tech companies, Salesforce excludes stock-based compensation from its adjusted profit figures. Incredibly, stock-based comp accounts for more than half of adjusted operating profit. The company itself expects the exclusion to contribute $3.26 of the guided $4.92-$4.94 in full-year adjusted EPS—nearly two-thirds of the total.

And that comp is a real expense. In the quarter, Salesforce spent $1.7 billion buying back stock — yet executives admitted on the third quarter conference call that the spend would only offset a portion of the dilution created by equity and option grants to employees. Those buybacks are going to eat up a good portion of free cash flow going forward as well: on the call, Chief Financial Officer Amy Weaver estimated 30% to 40% of FCF would go to share repurchases.

Valuing CRM

To be sure, Salesforce is profitable (and free cash flow-positive) otherwise. And it’s not quite exact to argue that ‘real’ earnings per share are equal to roughly $1.70 (guided adjusted EPS less the impact of stock-based comp). Still, when accounting for the siphoning of free cash flow to offset dilution, the underlying valuation here seems likely to sit (roughly) in the range of 40x to 50x FCF.

That’s not a terrible multiple for this business, to be honest, even with near-term growth slowing. This still is a dominant player in software and a company that expects its operating margins to expand steadily in coming years.

But that is not quite the story that headline revenue and profit figures tell. That story is one of a dominant company whose stock is on sale and a potentially compelling opportunity. For CRM, even at the lows, neither appears true.

Disclosure: As of this writing, Vince Martin has no positions in any securities mentioned.