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Tech Stocks

Software Update, 2.0

By Elliott H. Gue, on Aug. 31, 2015

Our strategy to profit from the structural shift in the software industry focused on three opportunities:

  • Established, pure-play SaaS companies that should be able to deliver outsized revenue growth as their solutions win market share from traditional software packages;
  • Names that produce specialized, on-premises software that have started to transition to the SaaS model; and
  • Traditional software companies that serve the financial services industry and stand to benefit from much-needed system upgrades and onerous requirements for regulatory compliance.

By and large, our strategy has panned out, with our picks delivering an average total return of 15.9 percent, besting the 5.8 percent total return generated by the Russell 3000 Computer Services & Software Index over comparable holding periods.

Founded in 1999 by former Oracle Corp (NSDQ: ORCL) executive Marc Benioff and three developers, salesforce.com has emerged as the 800-pound gorilla in the cloud-computing space, accounting for about 11 percent of the SaaS market.

The San Francisco-based company was the first pure-play SaaS application provider to achieve $1 billion in quarterly revenue and ranks as the world’s sixth-largest enterprise software firm. Management has set its sights on becoming the first SaaS company to deliver $10 billion in annual revenue—a target that looks eminently achievable with the firm expected to eclipse $7 billion by the end of this year.

Salesforce.com specializes in cloud solutions that enable businesses to engage with their customers through four core offerings that users can access on any device:

  • Sales Cloud (48.7 percent of annual subscription revenue): A sales-force automation platform that provides users with accurate customer and prospect information while enabling them to track leads and progress and collaborate with colleagues from anywhere.
  • Service Cloud (26.3 percent):A platform for companies to engage with customers and address their service and support needs.
  • Marketing Cloud (10.1 percent):A platform that uses data from any source to help develop and deliver personalized messages to any customer on any channel–email, mobile, social media or within their own product.
  • Salesforce1 Platform (14.9 percent):A cloud platform for developing custom applications. Customers use this service to connect all its apps and customer data and make them accessible anywhere on any device. Veeva Systems (NYSE: VEEV) is the first company that developed its SaaS applications on Saleforce1 to complete an initial public offering. The firm offers customers in the life sciences industry a suite of cloud-based solutions tailored specifically to their needs.

At this juncture in its life cycle, salesforce.com continues to invest heavily in research and development and mergers and acquisitions in an effort to innovate and broaden its capabilities.

These investments compress profit margins, but are essential to staying on top in this highly competitive industry and winning contracts from Global 500 companies–usually the province of industry heavyweights such as Oracle, IBM (NYSE: IBM) and SAP (Frankfurt: SAP, NYSE: SAP).

Dislodging these incumbents, many of which are developing their own cloud-based packages, has proved to be a challenge; uptake of SaaS products has been particularly strong among small to midsize businesses, many of which had been priced out by the infrastructure expense associated with traditional enterprise resource management solutions.

We like the company’s efforts to become even more customer-centric and build solutions targeted to six specific verticals: media and communications, the public sector, financial services, health care, automotive and retail. Speaking the language of these industries should help to drive sales and yield more big contracts.

These strategies paid off handsomely during salesforce.com’s fiscal second quarter ended July 31, 2015.

Salesforce.com delivered a blowout quarter, headlined by $1.63 billion in sales (up 24 percent) and $1.52 billion in subscription revenue (up 23 percent). Equally impressive, the company grew its operating margins by 170 basis points relative to year-ago levels and generated $304 million in cash flow.

Management attributed these impressive results to a 44 percent increase in the number of salesforce.com-certified consultants relative to the previous year and an increase in the value of its “large” deals across all its various clouds—both signs that the company continues to make inroads with major customers.

These impressive results prompted management to increase its full-year revenue guidance to between $6.6 and $6.625 billion from the previous range of $6.52 billion to $6.55 billion. And this updated sales target still looks conservative in light of recent trends.

A number of major upside catalysts for the stock also appear on the horizon.

During salesforce.com’s most recent earnings call, management indicated that the firm would debut its first industry-focused products in September and emphasized that these solutions were designed in close consultation with leaders in those verticals.

CEO Marc Benioff also indicated that salesforce.com would introduce a new cloud service—some have speculated an e-commerce solution could be forthcoming—at its Dreamforce conference.

Moreover, a partnership with Microsoft to integrate salesforce.com’s solutions with Office, Outlook and Azure has prompted speculation that this agreement could be the precursor to a merger. Reports also circulated earlier this year that listed Oracle as a potential suitor for salesforce.com.

Unfavorable currency exchange rates will remain a near-term headwind, but salesforce.com remains the preeminent SaaS company and has the vision and execution to take advantage of its considerable growth opportunities.

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