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11/27/2012
10:39 AM
Doug Henschen
Doug Henschen
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Salesforce.com Revenues Surge, But Should You Ignore Losses?

Why cloud application vendors are held to a different standard when it comes to profitability.

Salesforce.com reported yet another quarter of double-digit revenue growth last week, but financial analysts didn't seem to blink about the losses it reported. In fact, most prominent cloud application vendors do report losses, at least as measured by generally accepted accounting principles (GAAP). So why do they appear to play by different rules than their on-premises counterparts?

The short answer is that investors tend to tolerate losses from fast-growing companies in emerging technology markets.

Last week's Salesforce.com earnings report for the third quarter ended Oct. 31 was like so many others in recent years, with revenue beating expectations. Revenue was up 35% over the year-earlier period to $788 million, surpassing the company's estimate of $773 million to $777 million. The company also projected revenue of $3.04 billion for the full year, up 34% from last year. It was a show of strength and a contrast to more than few on-premises software vendor financial reports in which shortfalls were blamed on exchange-rate woes, fiscal troubles in Europe or softness in the global economy.

[ Salesforce.com CEO Marc Benioff is one of the originators. Read 10 Cloud Computing Pioneers. ]

The profit picture at Salesforce was far different. On a GAAP basis the company lost $220 million on the quarter, or $1.55 per share. That included a one-time charge of $149 million tied to tax accounting changes, but that still left more than $70 million in losses. Last year in the same quarter the company also lost money on a GAAP basis, but only $3.8 million. Why the big difference? For one thing, Salesforce.com's operating expenses rose 40% year over year to $656.3 million, with big increases in head count as well as research and development, sales and marketing, and general administrative expenses.

So why weren't alarms going off during last week's call with financial analysts? A review of the call transcript reveals there were zero questions about the loss.

"GAAP versus non-GAAP is not entirely meaningful in terms of understanding profitability," explains Wells Fargo analyst Jason Maynard. "Ultimately, cash generation is what drives valuation, and it's probably the best measure of the value of a firm."

As measured by cash flow, Salesforce.com generated $106 million on the quarter, so the company is profitable, says Maynard. What's more, he says, the operational cost increases (for sales and marketing and R&D) were roughly in line with the increases in revenue. Wells Fargo confirmed its "outperform" rating on Salesforce.com after last week's financial results were announced.

As for other cloud apps vendors that post losses? "Companies that grow faster and that are at an earlier stage of maturation are generally given much more latitude in terms of investor patience," Maynard says.

Good to know, but when should we stop cutting these companies slack? Or, to ask it another way, when are they "mature"? That, too, gets back to growth. Citing Google as an example, Maynard says that when the growth rates slow down, the stock valuations compress. "Five years ago Google traded at 30 to 40 times earnings, but today it trades in the mid teens," he says.

As with men, you can't equate age with maturity. Salesforce.com and NetSuite.com were both founded within months of Google, but they're positively juvenile by comparison as measured by growth potential. And then there's Workday Inc., a company that just mounted a hugely successful IPO, despite predicting it would "experience a net usage of cash from operations" in the second half of the fiscal year ending Jan. 31.

Workday has a market cap of $8.32 billion, yet it's expected to report a loss of 49 cents a share on Wednesday for its fiscal 2013 third quarter on revenue of $64 million. The vast gulf between Workday's market cap and its revenue and non-existent profit is all about growth potential.

"Workday has a $40 billion total available market ahead between human resources apps, financial apps and related business intelligence apps, but cloud vendors in this market today have mid-single-digits in revenue," Maynard says.

Investment growth potential is not a technology selection criteria, but it's important for customers and would-be customers of fast-growing vendors to keep the investor's perspective in mind. Rivals have been known to sow seeds of fear, uncertainty and doubt when squaring off in competitive bidding situations. And when people want to pick holes in these companies, Maynard says, they focus on the income statement, but a well-rounded assessment will also consider the balance sheet and, most importantly, cash flow.

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