Salesforce Is Solidifying Its Leadership With Enterprise Cloud Customers But Market Growth Expectations Are High

With Better Profitability, We Should See More Capital Returned To Shareholders 

Since efficiency gains have likely been reached and market saturation is currently preventing additional growth beyond industry expansion, I believe CRM will likely return the excess cash it now generates to shareholders.

The fundamentals improved shortly after multiple activist investors took positions in Salesforce and pressured management to restructure the business and focus on profitability. 

While management attempted to portray the activists as partners and minimize their influence, it seems that the company was indeed forced to respond to some of their demands. 

Salesforce executed a 10% restructuring plan and reduced the office real-estate in an attempt to cut costs. This resulted in a $7.2B operating income in the last 12 months, up by $4.3B from the $2.9B in the 12 months ending Q3’22. 

The company also disbanded its M&A committee, which was tasked with focusing on growth. Notable acquisitions included: Tableau 2020, the $26B 2021 Slack acquisition for some 26x revenues, Mulesoft in 2018 and Heroku in 2010.

After Salesforce increased efficiency in 2023, the activists have largely exited their positions, likely making a gain from their intervention, but also marking the end of the upside asymmetry revealed by their actions. 

Finally, the company is now returning capital to shareholders and bought back stock worth $1.9B. As a result, the number of shares outstanding (diluted) is down 2% YoY. 

As the company’s growth opportunities start stagnating, and a lot of the efficiency gains have been achieved, a disciplined management team should increase returns to shareholders. I believe we will likely see more buybacks in the future, which, if executed well, should help support the share price.

A Concentrated Revenue Portfolio May Contribute To a Volatile Future

While CRM has more than 60K smaller business customers, the company brings most of its revenue from large enterprise firms. Namely, customers that use 4 or more cloud services tend to bring-in the most revenue. 

This is why we see CRM as a leader in enterprise level software, and a change in its number of large customers can have significant effects on the business.

Salesforce: Revenue Breakdown By Number Of Clouds Used Per Customer

In its latest filing, CRM describes that “...one customer accounted for approximately six percent of accounts receivable”, with no customer accounting for more than 5% of revenues. It seems like the company is on the edge of having a consolidated customer base, which can lead to large fluctuations if they don’t manage to diversify. 

Most of the revenues - around 85% come from the U.S., while the largest sector is professional services.

Statista: Breakdown of Salesforce’s Customers By Industry for 2022

Using a list of customers, I’m highlighting the following companies as examples for Salesforce’s key customers: Amazon web services, American Express, Walmart, Aston Martin, Bayer, Caesars, Deloitte, EA, GE, Japan Airlines, L’Oréal, Kimberly-Clark, KUKA, etc.     

Salesforce is clearly an established company, and its value proposition is highest among large customers that are able to cut headcount costs while integrating their sales operations. However, the dependence on a concentrated base of high-paying customers may be a risk if the company doesn’t secure new growth opportunities, and this is a risk I don’t think the market is accounting for.

Revenue Tailwinds As Software Spend Picks-Up In 2024

Salesforce’s management expects increased sales cycles for growing the business. In their latest press release, they noted:

“Throughout fiscal 2024, we continue to experience elongated sales cycles, additional deal approval layers, and deal compression. Slower growth in new and renewal business, particularly if sustained, impacts our remaining performance obligation, revenues and our ability to meet financial guidance and long-term targets.”

Since the credit tightening in the last two years, companies cut down on software spend, resulting in a decrease in SaaS growth. This deceleration can be viewed from the table below:

Salesforce: Revenue Growth Breakdown By Segment

While the market is now forecasting a relaxation of credit and possibly more growth spending, it is important to analyze what % of the past corporate budgeting will translate into a new, conscientious way of doing business, and what % of projects will increase their growth spend. 

The lessons learned in 2022 and 2023 may change purchasing culture and businesses may be more careful in buying software that translates only in top line growth without increasing profitability.

The forecast from Statista below indicates a reuptake in enterprise software spend from $689B in 2024 to an estimated $722B in 2024 - resulting in a 4.8% growth.

Statista: IT Spend By Segment Forecast To 2024

Gartner also shares similar forecasts, with an estimated (total) software spend of $1T in 2024, up by 13.8% from the estimated $916B spend in 2023. Despite the cautious guidance given from management, we can see that Salesforce has a growth opportunity between 5% to 14% stemming from the industry expansion.

There Is Room To Increase Salesforce’s Market Share

Salesforce has estimated around a $200B global total addressable market (TAM), and seems to have captured some 10% to 15% of the market share. Given the analysis above, I assume an industry expansion of 9% per year, resulting in a Salesforce TAM of $307B in 5 years. 

Salesforce: Estimated Total Addressable Market

I estimate that Salesforce has an opportunity to close new customers. This will accelerate its market leadership position and push its market share to 20%. This would result in $61.5B in sales in 2029, and requires a growth of around 12% per year.

The problem I see with Salesforce’s growth strategy is that when we go through the company’s pre-AI business commentary (1, 2, 3, 4), we see that it relied on increasing the cloud offering to existing customers, further penetration in the enterprise level market, and growth via acquisitions. 

In other words, other than selling more of the same, it was hard to see a thought-out growth strategy coming from management before AI broke and saved their story. Now that it has though, I believe that it will take advantage of this opportunity and retain leadership. 

Competition Is Targeting The High Margins In The CRM Space

Salesforce competes in a large market reaching supply saturation. The market comprises a number of general and niche peers. Despite the stiff competition and challenges of getting embedded customers to switch, I think Salesforce can still acquire users.

If specialized CRMs move more aggressively on price and manage to take market share from Salesforce, this would make it harder for the company to realize its target 27%+ operating margins.

Salesforce still ranks best in class for enterprise clients, and is moving to solidify leadership in this category. On the flip side, the level of market saturation may make growth difficult as key customers already have a CRM vendor and their large structure makes it difficult to switch. 

However, Salesforce’s data integration endpoints may lower switching costs and allow large customers that are otherwise invested with competitors’ products to gradually adopt Salesforce’s cloud products.

Key peers in the enterprise customer market include: SAP SE, Microsoft, Oracle, Workday, ServiceNow, and HubSpot. 

Best CRM Software for Enterprise Businesses in 2023 | G2

The industry is also moving from making the best general CRM software, to making software that is best for a specific use case or type of company. 

This may further limit the company’s ability to grow, however Salesforce is tackling multiple avenues such as small businesses, commerce, etc. The same can be said for peers, since they are also expanding their growth efforts to more types of customers and additional services.

My expectation is that while Salesforce will remain the leading enterprise level software, it will have to consolidate its pricing because producing even more services will not be enough to sustain their margins and fend off niche competitors.

Adopting AI May Destroy Value, But Salesforce Has No Choice

CRMs are indeed a great target for developing AI products since most of its offering can benefit from AI innovation and automation. There are a number of services that can be streamlined with AI, and a large portion of the workload per employee can be shifted to a well trained AI that can communicate with customers, execute tasks and deliver insights on its own.

Salesforce is developing Einstein GPT, a generative AI tool, bringing automation to CRM processes. It generates personalized emails, creates targeted content, and integrates with Slack.

While it’s likely that Salesforce benefits from AI advances in the short-term, we need to evaluate what happens when the industry has mostly caught up on the technology in five years. 

The positive aspect of a high-scaling product like CRM is that you can build it once, and instantly scale to thousands of customers. Herein lies the flip side, you need to build it once, and many competitors, as well as in-house engineers, will be able to do just that.

Ultimately, AI may become so productive and widely available that companies have a difficult time justifying high AI-based pricing.

• Business: I assume that Salesforce will win the enterprise CRM race, but waste capital in trying to acquire small to medium size customers. Competitors will lower margins but won’t be able to support large customers to the degree that Salesforce can.
• Revenue: Given my estimated 2029 TAM of $307B and a market share of 20%, I forecast that the company reaches $61.5B in revenue in five years, up from $33bn today, a 13% CAGR.
• Margins: I assume that 27%+ operating margins are achievable, but the hard part will be sustaining them. For this reason, I will cut the initial projection to 25% in order to account for some of the possible profitability drain from peers and AI advancement. This results in an EBIT of $15.4B. My analysis indicates that delivering a one-time efficiency margin expansion from 1.4% EBIT in Q3’22 to 21.4% in the last 12 months is easier than growing the margin by an additional 4% in the next 5 years.
• Net income: I expect Salesforce to be able to convert 70% of the operating margins to net income and make $10.7B in 2029.
• Outstanding shares: I expect persistent buybacks in the future, and estimate that the share count drops from 968M to 872M in 5 years, or some 2.1% annually.
• Valuation Multiple: I estimate that the PE multiple will stabilize in the next five years around 21x as the market prices-in the limited enterprise growth potential from a saturated market.

• Salesforce may keep exceeding expectations on a fundamental basis, as onboarding even a few enterprise level customers can have a large effect on the company’s income.
• Salesforce’s strategy to capture small businesses may be successful, and the company may be able to provide attractive services that maintain its high pricing power.
• As Salesforce is a prime candidate for leveraging AI, it may manage to enact barriers to entry and produce AI services that are valuable when integrated with other Salesforce products - something which smaller competitors won’t be able to compete with.
• The value proposition from creating and continuously maintaining AI products may be large enough for customers that they still benefit, even given higher pricing.