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Why Wall Street Called It Wrong On Salesforce.com (CRM) This Quarter March 2, 2010

Posted by bernardlunn in Uncategorized.
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Most Wall Street analysts were looking for deferred revenue. Why? Because in the old model that is what matters. So they missed the stunning upside in the actual quarter to quarter growth (Q-Q). The Q-Q growth estimate was $324m. Salesforce.com surprised us by announcing actual revenues in the quarter of $354m. That is:

  • 7.11% Q-Q growth, which for a company over $1 billion in revenue is pretty good.
  • $12m more than the market was expecting
  • $23.5m more than the previous quarter.

To put that $23.5m of new revenue in perspective by looking at the 14 companies in the SaaS Index:

  • the 14 companies including Salesforce.com produced $38.2m of new revenue in the quarter.
  • Excluding Salesforce.com, the remaining 13 produced $14.7m of new revenue in the quarter. That is right, all the others combined produced $8.8m less growth than Salesforce.com alone

Stripping out the ones that had negative growth and focusing only on the top 5 by Q-Q growth we see this picture:

  • Salesforce.com comes in # 5 on a Q-Q % basis at (7.11%). # 1 was 9.25%
  • The top 5 produced $37.1m of Q-Q growth. Excluding Salesforce.com, the other top 4 produced $13.6m (ie $9.9m less than than Salesforce.com alone).

Which is a long-winded way of saying Salesforce.com is a dominant market leader. One lesson that Internet stocks teach us again and again is that these stocks are never cheap. The real market – the market of customers – flocks to success. Buyers feel safer with a market leader. So they continue to grow even when they are way bigger than  their competitors.

The Wall Street analysts are focusing on deferred revenue because they are (quite correctly) looking at the future and not the past. Their point would be that a good quarter just reported is history. The stock price should reflect what will happen in the future quarters.

What these analysts missed with all their number crunching is what is happening in the real market, the market of customers and vendors. Any entrepreneur in  the SaaS business can see this in a heartbeat.

First, here is how deferred revenue works. You sell a 12 month contract, but bill monthly. So the 11 months revenue is deferred. It is great. It is like money in the bank, you can count on it. So you know that next quarter you can totally count on the contracts you sold in previous quarters.

Certainty is lovely.

But it misses what is happening in the real world. Customers are balking at 12 month contracts. Most SaaS companies – certainly all the upstarts – are selling month to month without any long term commitment. Vendors are happy to offer month-month contracts as it reduces Customer Acquisition Cost (CAC).

If you want to obsess on one number, obsess on CAC. That is where the combination of free trials, freemium and month to month contracts are the key. This is based on a simple reality that all SaaS entrepreneurs and VCs know:

Once a user gets into the habit of using the software, the churn rate is low.

In other words they are locked in by habit and not by contract. Look at Google. Do you search on Google because you signed a 12 month contract? Do advertisers buy Adwords because they signed a 12 month commitment? Does that lack of commitment worry Google or their investors?

The reason this matters is that the real growth is in small business, even really tiny businesses. The big enterprises are being fought over by all the big guys and most have made their decisions. But millions of small businesses are up for grabs. They don’t sign 12 month contracts. And if they do it is only after taking up so much time from your sales team for a small contract that the cost of sale (CAC) will kill your numbers.

Meta lessons:

1. Real market knowledge is Alpha and that does not mean insider knowledge. It means entrepreneurs and operating execs who understand what drives the real market – the market of customers. Wall Street used to employ more of these types of people. Now they tend to employ super-smart MBA number-crunching types who have never run a business – have never had to “make payroll”.

2. Small business is where the action  is and most Wall Street analysts still work for behemoths. The companies that employ these analysts may still sign 12 month contracts. But if they get laid off and start a new venture, I bet that they would only sign month to month contracts!

Disclosure: I do not own any of these SaaS stocks. If I was buying I would find CRM valuation a bit high and would look for opportunities to buy on the dips (and then I would watch Q-Q growth like a hawk). And I would look for any SaaS stocks that have that combination of both growth and value (yes, there are some candidates).

Buy the SaaS Insights report here if you want to know more:

  1. The driver for long-term of Salesforce.com (hint, it is not deferred revenue)
  2. The Top 5 SaaS stocks by value parameters
  3. The Top 5 SaaS stocks by Q-Q growth %
  4. The one SaaS stock that is in both value top 5 and growth top 5.

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