June 12, 2009

Internet: Destroyer of Profit Margin

I have discussed how Internet disrupted or continuing to destroy software business models. So lets look at one of those Internet application companies and how they are "thriving" in the age of the Internet.

Salesforce.com is the poster child of the new Internet company that offers Software-as-as-Service applications, or Customer Relationship Management as a service. The application is really good, we use it at our company and we are happy with it. But does this model can translate to sustainable competitive advantage or at least a viable business?

I reason, NO.

After using Salesforce for few years and being happy with the value we got, competitive alternatives are being offered less costly. Competition, although may not be mature yet, but getting there quickly, are offering similar solutions. Competition have huge advantage over Salesforce, being able to use cheaper and more advance technologies. In this industry it does not pay to have a first mover advantage. Salesforce will not chug its infrastructure but a new entrant to the industry will pick the most efficient platform to launch its service. Competition is everywhere for someone like Salesforce with less costly operating structures, prices for these offerings will continue to go down overtime and eventually they will become free.

Google applications market place is one platform for companies and start-ups to develop on a free platform and data centre. Sure it is yet to mature to offer business ready solution but it will get there. Others will offer similar solutions. Actually salesforce offers something similar but its drawback is it has to be developed on their platform, limiting flexibility.

In order for Salesforce to keep its growth it spends heavily on sales and marketing. Actually, 50% of Revenue is spent on marketing and sales annually to continue with its growth. But how long can you continue with such spending before investor want to see some returns?

If we look at their margins they are very depressed. Actually, there are no margins after some 10 years of operations. Sales and Marketing expenditure
will continue to eat at their profitability to ensure they compete and sustain market share. They have generated cumulative earnings of $42 Million from cumulative revenue of $3 Billion, since they went public. And I do not think that will change in the future.

Salesforce sports a very high multiple, in fact 102 x earnings. Investors are bidding these shares up for the prospect of growth in earnings. I am afraid the growth will come but Salesforce and many outfits like it will not benefit. The market for Software as a service(Saas) will grow like crazy but, profitability will be scarce. Why? Free is the name of the game on the Internet.

This is a good candidate for a short:
  • one product company with the promise of growth.
  • extreme valuations.
  • no earnings after some 10 years operations.
  • tough market dynamic and getting tougher.
  • the accounting is open for games as they book of revenue from deferred customer contracts, which can be messy, I have not analyzed it carefully but it is something I would look at very carefully.
  • Something does not add up about there subscriber base:
    • based on their financials revenue per user should be around $18,733, based on published users of 60,000.
    • however the highest revenue per user is $250 per month or $3000 per year. The two figures are vastly different.
    • The discrepancy between the two figures tell me that they may have few large customer that skew the average higher, while the majority of their users are small (1 user) customers.
Would I short? No. People can continue to believe in future growth longer than I can remain solvent.

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