How Can Salesforce.com Make Profits?

I recently syndicated a Technology Stocks column to Seeking Alpha. It was titled Salesforce.com’s Platform Strategy Holds Immense Promise. The argument was as follows:

Salesforce has benefited tremendously from its platform strategy. There is still enormous headroom for it to grow in this arena, and I don’t think the opportunity is lost on Marc Benioff. Judging by its recent investment in Apttus, a company that has built on the Force.com platform, and has become quite successful, Salesforce is aware of the vast potential of the platform strategy. Investing aggressively in incubating these start-ups would yield handsomely for the company.

The Seeking Alpha article generated a ton of comments, mostly asking why am I bullish about a company that never generates profits.

Salesforce.com has been wildly successful – look at the 10-year chart and the accompanying revenue growth making it the largest CRM player in the market, up from virtually nothing 10 years ago. It did $3 billion in revenue last year and will do $4 billion this year. When the company achieves scale we should see the 30-40% operating margins we see at ORCL /SAP. Software companies must spend a ton on marketing to generate 25-30% organic growth and can’t generate operating profits while doing so. BUT looking forward to 2015-2016 we should have $6-7 billion in revenue and $2 billion in operating profits. Thus, the $33-34 billion valuation (fully diluted), while expensive, isn’t necessarily crazy. And we’ve got a lot of momentum.

Salesforce.com doesn’t have sufficient scale at $3-4 billion of revenue? Nonsense I say! The business isn’t earning any money because either 1) it is a bad business or (2) it is poorly run.

We are in a SaaS bubble fueled by the lie that it isn’t possible to generate profits while growing. This simply isn’t true. These companies’ business models simply aren’t high margin models. I suspect we will see significant valuation compression over the medium term. I’m short a basket and see even greater downside in some of the smaller players.

The Salesforce.com stock is trading at a market capitalization of over $30 billion. It touched a life high of $54.25 soon after the most recent quarter’s results were announced.

It appears that I am not the only one bullish about the stock’s performance.

However, the question of profitability is looming large in the minds of investors, so I thought it would be a good one to address. Even more importantly, some investors are beginning to question the entire SaaS business model, so we need to take a close look at that. Our industry is fully invested in this model now, so its viability is of paramount importance.

The criticisms against the SaaS business model include high sales and marketing costs, high churn, low exit barrier, etc. The points in favor are many, but the one that financial investors like the most is predictability.

My observation is that Salesforce.com DOES HAVE in its arsenal a strategy that should help the company become vastly more profitable, lower sales and marketing costs as a percentage of revenue, and also, dramatically improve churn.

That strategy centers around its platform eco-system.

The Seeking Alpha article also references my recent Harvard Business Review article on corporate incubation called When Big Companies Support Start-ups, Both Make More Money:

I routinely meet companies that are growing smartly by leveraging platforms provided by big companies. In 2007, I met Kirk Krappe, CEO of a small startup called Apttus. Kirk and his two cofounders Neehar Giri and Nathan Krishnan had earlier done a venture-funded startup called Nextance. Nextance was an enterprise software company providing contract management software. It raised $60 million in venture capital, and eventually failed. The team then decided to take their domain knowledge and start Apttus as a cloud-based contract management software company.

This time round, they decided to take no venture capital. They chose to build the company on Salesforce.com’s Force.com platform, which kept development costs low. The team was able to bootstrap the company, and within a couple of years, shot to $5 million in revenue. Recently, they have received a large influx of funding of $37 million from a group of investors including Salesforce.com.

The beauty of this model is that Salesforce.com has made available a cloud platform-as-a-service upon which entrepreneurs can rapidly and cost-effectively build businesses. The eco-system works really well, and Salesforce.com takes a percentage of the revenues for products built on their platform.

Today, thousands of developers are building on Salesforce.com’s multiple cloud platforms. They all pay royalties to the corporation. Thus, if Salesforce.com were to enter the field of business incubation, helping these companies grow their businesses, the economic benefit would be staggering.

And Salesforce.com itself would also benefit from the increased royalties that would increase their revenues and profits.

The best thing about the corporate incubation model is that it is a win-win for both the corporation and the small business, and it doesn’t have to worry about the startups being fundable by VCs.

I think the platform strategy, if executed properly, holds the key to addressing Salesforce.com’s profitability problem on all dimensions. The small companies building on their platform will do the sales and marketing. They will also create reasons for the customers to stay within the eco-system, and not go to cheaper alternatives like Zoho. Once these smaller companies hit their stride, the net impact should be pure bottomline.

The criticism on Salesforce.com is that they provide a lot of technical assistance to the developer network, but not much business help. This is a legitimate criticism, but one that can be addressed.