Salesforce: software service with a smile

Not too long ago, a company would buy software on a disc and install it on its own computers. These days, they rent their software on the internet, or in the "cloud". This is more secure and cheaper than maintaining hardware on the premises, while the software is automatically updated no more having to go and buy the latest version. This concept is called software as a service (SaaS), and one of the industry pioneers was Salesforce.

Founded in a one-bedroom apartment in 1999, it is now the world's largest pure-play SaaS vendor. Salesforce's SaaS fits into a broader approach called customer relationship management (CRM), which covers a company's relationships and interactions with customers and potential customers. The goal is to stay connected to clients, streamline processes, drive business growth and improve profitability. Salesforce was one of the first companies to offer SaaS CRM, and "CRM" is itsticker on the New York Stock Exchange.

Salesforce now aims to be a one-stop shop for all forms of CRM. Its products include Sales Cloud (which manages sales leads), Service Cloud (customer support), Marketing Cloud (digital marketing campaigns), Commerce Cloud (e-commerce management), Quip (a tool for organising company-wide projects) and Salesforce Platform (where customers can build their own apps). And there is a series of new initiatives to help companies maximise their potential, such as Einstein, an artificial intelligence tool, and the group's Internet of Things (IoT)facility.

Plenty of potential

Salesforce is the leader in its field. Its Sales Cloud comprises nearly 40% of the market, well ahead of competitors such as Oracle, Microsoft, SAP and IBM. Salesforce invests heavily in research and development (R&D) to maintain its lead.

And there is ample scope for future growth. Salesforce's total addressable market is estimated at $100bn and growing. With $10.5bn of revenue in 2017, it has the potential to keep growing at the 20%-plus rate of recent years. Growth is partly organic and partly by bolt-on acquisition. Salesforce took over Mulesoft, a leading platform for building application networks, for $6.5bn in May 2018.

Mulesoft's 1,200 customers include Coca-Cola and Unilever its 2017 revenue was up 58%. A customer can use Mulesoft to connect Salesforce's CRM data, SAP's billing data and whatever e-commerce application is used. This helps Salesforce become the backbone of a customer's multiple IT systems.

Salesforce has been able to fend off competitors thanks to its reputation, top quality and the high cost of switching to another provider. Switching costs include employee training, implementation and integration. And since SaaS is a perpetual subscription, there is no contract end-date to force a possible switch. No wonder customer attrition rates are down in single digits. Salesforce also boasts AppExchange, a top application marketplace.

Cementing its dominance

Consultancy Gartner estimates 89% of Fortune100 companies have AppExchange applications supplementing their Salesforce products.

Such heft is self-reinforcing: new customers are drawn to Salesforce because of its application and partner ecosystem, while the big customer base in turn draws in developers to write new applications. This again increases switching costs.

Salesforce has software partners including Google, Facebook and IBM. It recently announced a partnership with Apple to provide exclusive new features on iOS, the iPhone operating system. Lamborghini is its latest big-name CRM customer. The balance sheet shows cash and marketable securities of $3.4bn and debt of $3.2bn. The debt is easily manageable given the company's strong free cashflow of 21% of sales. There are risks as with any high-growth software company. It could take a wrong turn and allow competitors to erode its dominant position. And any SaaS vendor faces a potential risk should a security breach erode customer trust and the brand's reputation. But given the firm's impressive showing so far, it looks set to lead its industry for years to come.

Sales should more than double by 2022

Salesforce is not the easiest company to value because it has been investing heavily in R&D and new initiatives to fund revenue growth.

As a result, its earnings per share (EPS) have bounced around, going from slightly negative in 2014-2016 to modestly positive in 2017-2018. It has used its strong cashflow and balance sheet to make a series of bolt-on acquisitions. MarketWatch estimates EPS of $2.51 for 2019 and $2.73 for 2020 which, at a current price of $131, gives a high forward price-earnings ratio (PE) of 47.8. This reflects the company's policy of investing in growth to secure its market position.

It may be more helpful to set aside the volatile earnings-per-share figures and think of it this way: sales growth is expected to continue at around 25% per year. Salesforce has a published revenue target of $23bn for 2022, up 119% up on 2018. As revenue grows and the company cements its dominance, we can expect its margins and EPS to grow substantially. That is the thinking behind investment analysis platform Morningstar's current fair-value estimate of $180 per share.

The overall market sell-off last month depressed the prices of technology stocks. Salesforce's shares would now have to rise by 38% to reach Morningstar's fair value. The current price provides a good entry point to one of the world's highest-quality software companies with a strong market position and enviable growth. There is no dividend, but that is normal for a high-growth software company.

I own shares in Salesforce and have done for several years.