Salesforce.com Is Challenging for Software Supremacy

Since pioneering the software-as-a-service movement in the late 1990s,

Salesforce.com CRM has evolved into one of the world's true software powerhouses. The firm boasts several cloud products that address large enterprise markets, creating substantial switching costs for its customers. As such, it has established itself as the runaway leader in the pure-play SaaS market.

Salesforce has created a product portfolio that spans all of the key verticals in customer relationship management, delivered in a multitenant, public cloud environment that allows for rapid deployments, instant updates, and lower total cost of ownership for customers. We believe enterprises will increasingly turn to cloud computing to eliminate costly IT infrastructure and maintenance costs, creating a long runway for growth in each of Salesforce's product verticals.

Though the firm is best known for its salesforce automation services, it has diversified its revenue stream into three $1 billion-plus clouds (sales, service, and applications) along with a fourth (marketing) that should eclipse that mark in short order. Salesforce has solidified its status as a software platform, with more than 75% of the firm's customers deploying at least three of these clouds. Despite Salesforce's movement into adjacent markets over the past several years (highlighted by acquisitions like ExactTarget and Buddy Media), customer and dollar attrition rates have fallen into the single digits, indicating the robustness of the firm's applications. Further, we believe switching costs have room for upside as the firm pushes more aggressively into new markets such as analytics and the Internet of Things, though these products are in their relative infancies.

Despite a boatload of success to date and the strong likelihood of quickly reaching $10 billion in annual sales, Salesforce will continue to feel the heat from the likes of Microsoft MSFT , Oracle ORCL , and SAP SAP as each races to establish its cloud business. Still, we think Salesforce's SaaS prowess and broadening application portfolio will spur the firm's rise in the global software market.

Switching Costs, Network Effect Dig Wide Moat
Salesforce.com's software lineup has grown from a singular salesforce automation product to a suite of offerings spanning customer relationship management, digital marketing, campaign management, customer service, analytics, and application development, making Salesforce the largest pure-play software-as-a-service company in the world by many multiples. We think the combination of the mission-critical applications Salesforce offers, the ubiquity of its products in the enterprise, and increasingly valuable data generated by these applications yield substantial customer switching costs and a network effect that support one of the widest economic moats in software.

Salesforce has quickly become the dominant vendor in the customer relationship management vertical between its sales and service cloud offerings. These products include features around lead management, performance tracking, and engagement insights for the salesforce as well as general customer engagement management in the service cloud. The company's salesforce automation products boast upward of 40% market share, more than tripling that of competitors Microsoft, IBM IBM , Oracle and SAP, and Salesforce controls roughly 20% of the broader customer relationship management market overall, which incorporates most of the firm's flagship products around sales, marketing, and customer engagement. Given the tenure and strong reputation that Salesforce holds over its larger software contemporaries as a cloud software vendor, we think the firm will continue to take share in these verticals.

From the customer's perspective, the advantages of using Salesforce's applications are increasingly apparent. By gaining insights into which practices are most effective, enterprise sales teams can close potential customers more efficiently. Further, by layering in customer feedback via Salesforce's customer service offerings, sales teams can be more proactive when there are issues, diminishing customer attrition. These applications are closely tied to revenue-generating activities in the enterprise, and when coupled with the necessary integration process, training required to get users up to speed, and customization that occurs around proprietary customer application development leveraging Salesforce's applications and data, we think each product holds substantial switching costs once deployed.

Salesforce has successfully expanded into adjacent markets, including marketing and more recently analytics, though it has some ground to cover before it can claim a leading position in the latter. The company is an established contender in digital marketing and campaign management, though it faces some heavy hitters from the likes of Adobe ADBE , IBM, Oracle, and SAP, and we believe Adobe will hang on to the top spot in this market. Still, we think Salesforce is carving out an advantageous position in this market, and marketing revenue is growing much faster than it is for the number-two player, IBM.

As users across the enterprise flock to the Salesforce platform for a bevy of use cases, we think the firm has a unique opportunity to position its analytics offerings. The Salesforce applications house valuable data on employee efficiency and customer satisfaction, creating clear use cases for Salesforce Wave. Revenue contributions from this product are negligible relative to the sales, service, and marketing clouds, but we think the firm will continue to make inroads into this space.

Salesforce has built a powerful application development platform with Force.com, Heroku, Lightning, and other products, as well as an application store, AppExchange. Enterprise developers can use internal data generated by employees and customers across Salesforce applications and tools from Salesforce to build powerful applications to improve business processes, while independent software vendors can build and sell their own applications on AppExchange, which boasts nearly 3,000 applications. For example, large-scale applications from the likes of DocuSign, S&P, Sage, and Veeva Systems have been built and run on the Salesforce platform.

Competition Isn't Going Away
We still see a fair amount of risk to Salesforce.com's long-term success, though the company continues to progress into a well-rounded application software vendor. The firm's marketing cloud offering is vying for the number-two spot in this vertical, as we believe Adobe will maintain its lead in this space, leaving Salesforce, IBM, Oracle and SAP in a battle for market share. Further, we could be overestimating the size of Salesforce's addressable market across all of its operating verticals, which could jeopardize management's long-term goals of reaching $20 billion of revenue and our key valuation assumptions. Larger vendors such as Microsoft, Oracle, and SAP are not going anywhere in terms of pursuing revenue in software as a service, platform as a service, and infrastructure as a service, which will keep the heat on Salesforce to continue to deliver high-quality applications with virtually flawless reliability. Security concerns remain top of mind for enterprises when considering cloud vendors, so any disruption or security breach could be catastrophic to Salesforce's operating reputation, costing the company customers and revenue. Acquisitions have been a key strategic initiative to round out existing applications and move into new verticals, and the company faces overpayment risk if it continues to pursue this strategy as it enters adjacent markets.

Salesforce.com has about $2.7 billion in cash and marketable securities and about $1.1 billion in debt. We expect the company to continue to use the balance sheet to fund opportunistic acquisitions as it attempts to expand into new markets. Operating and free cash flow generation remains solid, representing roughly 25% and 20% of sales, respectively. The bulk of Salesforce's long-term debt comes due in 2018, and while the firm may seek to refinance, we think the firm's debt load is manageable as currently structured.

We believe the firm's capital allocation has been quite prudent, with heavy investment in sales and marketing to support revenue growth that we believe enhances returns on capital. Furthermore, management has often chosen to forgo near-term accounting profitability in favor of higher spending that, we believe, generates excess shareholder returns. For example, the firm maintained GAAP profitability for several years leading into fiscal 2012 before the company invested heavily in service, marketing, and application cloud, which has paid off in the form of larger revenue and an exponentially larger addressable market despite dipping back into the red. Still, we anticipate that the company will turn the corner in terms of GAAP net profitability in fiscal 2017.

Over the past several years, the firm has spent more than $3 billion on acquisitions, using a combination of cash and stock. Some of these acquisitions are supporting the company's aggressive push of its marketing cloud products. While some of these initiatives may be delaying profits, we believe the integrated product strategy is likely to make Salesforce the most significant provider of cloud products for the foreseeable future.