Is Salesforce.com Worth 100 Times Earnings?

he cloud software stock fetches a stratospheric price. It could be due for a tumble, writes Jack Hough.

ou might not have heard of Salesforce.com (CRM: 146.08, 2.62, 1.83%). It's only 12 years old and it does

business mainly with other companies, not consumers. But its stock market value is larger than that of J.C. Penney, Hasbro and Netflix -- combined.

In fact, relative to the profits Salesforce.com generates, it might be the priciest major company in America. Its shares sell for 103 times projected earnings for its current fiscal year, or several times that much, depending on how one does the math. (More on that in a moment.) The average stock sells now for closer to 15 times earnings.

There are two reasons for this premium. The first is that Salesforce.com is enjoying rapid sales growth at a time when growth is scarce, and investors are willing to pay up for it. The second is that it's a "cloud computing" business, and those have lately been Wall Street darlings, with valuations reminiscent of the dotcom stock mania of the late 1990s.

Shareholders should be cautious. Salesforce.com has multiplied roughly 10 times in value since its 2004 stock market debut. But there's reason to believe the stock is poised for a tumble.

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The San Francisco company is best known for customer relationship management (CRM) software. That's what companies use to log customer phone calls and keep track of sales pitches. The business has long been dominated by major software makers like Oracle (ORCL: 30.07, -0.15, -0.50%) and SAP(SAP: 68.80, 2.12, 3.18%). But Salesforce.com beat the giants to the cloud.

Cloud computing refers to replacing locally installed programs with web-based ones. If years ago you used Turbo Tax discs come tax time but now you file by logging on to TurboTax.com, you've already made the shift to the cloud. Locally installed software is expensive to distribute and clunky to upgrade, and results vary with each user's computer specifications. Cloud computing solves these problems and more.

The universe of cloud computing stocks is made up of several different types of companies. Some like Salesforce.com sell "software as a service" or SaaS -- cloud programs that generate recurring user fees. Some like Amazon.com(AMZN: 187.64, 3.87, 2.11%) specialize in "platform as a service" or PaaS. That is, they provide companies with everything they need to turn own their locally installed programs into cloud-based ones. Still others sell specialized software that makes cloud programs run faster or that allows PaaS companies to squeeze more productivity out of their servers.

Salesforce.com has quickly won market share among mid-size companies that want CRM software but don't want to pay one of the big software firms for an installed program. Sales over the past four years have increased at 35% a year, compounded. The company has also introduced Force.com, its own PaaS product. And last year it launched Chatter, a social media productivity program billed by some as Twitter and Facebook for corporations.

That's enough to make the company's growth potential seem huge and its shares worth plenty. The average Wall Street analyst predicts that the stock will hit $153 in a year, a 14% increase from today's price.

But for that price to prove justified years from today, two remarkable things would have to happen, according to Mark Moerdler, an analyst with Bernstein Research. The first is that the company's sales growth rate would have to jump to around 50% a year over the next four years. The second is that its profit margins would have to more than double. But just the opposite is likely, for three reasons, says Mr. Moerdler, one of only three analysts who say the stock is overpriced among the 42 who cover it.

First, Salesforce.com will soon face more competition in its core CRM business. Last month Oracle bought Right Now, the No. 2 CRM software-as-a-service company behind Salesforce.com. That makes clear that it's targeting the cloud. Nathan Schneiderman, who covers Salesforce for Roth Capital Partners with a "buy" recommendation, wrote in a client note that Oracle is following rather than leading, and that customers will "see Oracle's grudging acceptance of the cloud as validation and give Salesforce.com even more consideration."

Mr. Moerdler disagrees. "When Oracle targets a market it has historically been successful," he says. "To simply say they will fail in the space is making a large presumption." The other software giants have launched or are preparing to launch cloud-based CRM programs, too.

Second, platform-as-a-service is becoming a commodity, says Mr. Moerdler. As it brings in a larger share of sales, it will compress profit margins.

Third, Chatter will fail to generate significant revenue. "They give it to existing customers for free," says Mr. Moerdler. "A year ago it was 'Facebook for corporations.' Now the company says to think of it as an enabling technology rather than a revenue stream.

All told, Mr. Moerdler reckons Salesforce's sales growth will slow to 14% a year over the next four years. That could cause investors to fall out of love with the growth story and focus on some of the company's financial quirks.

For example, it issues gobs of stock options to employees as pay. Options eventually become shares if the stock price rises, and newly created shares dilute the value of existing shares. Whether the stock sells for just over 100 times earnings or much more depends on whether investors include the cost of options grants in their math. Options carry a real cost for investors, and Salesforce.com has shown no sign of halting its issuance.

Then there's the matter of costs. Most software firms treat commissions paid to sales people as an operating expense and deduct them from profits right away. Salesforce.com treats its commissions as capital investments, says Mr. Moerdler, allowing them to be deducted little by little from profits. It does the same with the cost of ongoing tweaks to its software. These are legal tactics, but if the company used the conservative accounting methods typical of its peers, its reported earnings would be sharply lower, says Mr. Moerdler.

A spokeswoman for Salesforce.com said the company doesn't comment on analyst research.

Salesforce.com remains prosperous and strong, and likely to produce enviable growth in coming years. And investor glee being a powerful force, shares could move higher in the short term. But if the main determinant of a stock's future return is its current valuation, as investing pioneer Benjamin Graham taught more than a half-century ago, then Salesforce.com shares are at risk for long-term underperformance, and maybe a sharp slide. It's time to take profits.