Salesforce: Company Has Become A Show Me Story (NYSE:CRM)

Investment Thesis

The last time I wrote about Salesforce (NYSE:CRM)(NEOE:CRM:CA), back in March 2024, I talked about the company’s Q4 performance and discussed the potential of the company’s AI-related tools, Data Cloud and Einstein Copilot, to be the catalysts for the company’s next leg of growth. I had a Buy rating on the stock. Since my article was published, the stock has unfortunately tanked 26%, significantly underperforming the S&P 500, which gained 3% during the same period. The 26% decline includes the 20% decline seen in the stock post its Q1 report.

In this article, I dissect the company’s Q1 performance and argue why the growth potential of CRM’s AI tools has been severely dented by enterprises’ reluctance to adopt AI for their businesses.

A Snapshot of Salesforce’s First Quarter Performance

Despite management calling it an “incredible,” quarter, the reality is that CRM had a poor start to the fiscal year. Q1 revenues came in at $9.13 billion, and although that represents a 10.7% y/y growth, it missed analyst estimates by $13.44 million. Current remaining performance obligations (CRPO), which are a measure of the revenues expected in the next twelve months, that are not yet recognized, grew 9.5% y/y, the first time that they failed to register a double-digit growth. Non-GAAP EPS, however, came in at $2.44, registering a growth of 44% y/y and beating analyst estimates by $0.06. Non-GAAP operating margins came in at 32.1% and the company generated free cash flows of $6.1 billion.

It is the company’s guidance that makes the report anything but “incredible.” For the second quarter, the company expects revenues to come between $9.20 and $9.25 billion, well below the analyst estimates of $9.35 billion. Non-GAAP EPS is expected to come between $2.34 and $2.36, once again missing analyst estimates.

What is confounding to me is that despite the softer Q2 guidance, the company maintained its full-year guidance, expecting sales to come between $37.7 and $38 billion and non-GAAP EPS for FY25 to come in the range between $9.86 and $9.94. It is hard to believe the company achieving these targets, especially given that it is struggling to close large deals.

A Lot of Talk About Data Cloud but Nothing to Show For Yet

The last time I wrote about CRM, I talked about how the company’s Data Cloud has all the makings of a strong catalyst for the company’s AI ambitions. While I still believe this to be the case, as things stand, the potential of Data Cloud has not translated to top-line growth. For instance, while the management said during the earnings call that they are seeing “strong demand for Data Cloud and multi-cloud adoption,” the company’s CRPO failed to hit double-digit growth for the first time and the Q2 guidance was much lighter than expected.

Furthermore, in the fourth quarter of last fiscal year, 25% of the company’s deals that were valued at more than $1 million included Data Cloud. Coincidentally, the figure has stayed the same during this quarter as well. The only difference is the buying environment has considerably weakened, as evidenced by the slowdown seen in the subscription & support revenues. This indicates that the number of deals in excess of $1 million has gone down, subsequently implying that the adoption of Data Cloud has not gathered steam.

Yet another similarity between last quarter’s earnings call and this quarter’s earnings call was CEO Marc Benioff’s distaste for some of the existing AI tools, such as ChatGPT. In order to stress the importance of data and by extension, Data Cloud, he touched upon the copyright issues faced by companies like OpenAI who have used third-party data to train their models. He then went on to talk about how, for enterprise customers, the data for their AI models needs to be their own client data, their transaction history, and their metadata. He claimed that this is where CRM will be of help, and this need of enterprise customers, he suggested, “is going to be a huge driver for our growth going forward and provide the foundation for this future and what the future of the enterprise is going to look like.”

The aforementioned comments from Mr Benioff make sense and are something that I do foresee being a growth driver for CRM. However, as of now, the presence of such data through Data Cloud and the fact that it can be used by any user of Customer360 has not translated into actual growth. This is a cause for concern and is one that CRM investors would need to watch out for in the coming quarters.

AI Adoption Among Enterprises Has Not Taken Off Yet

The main premise behind CRM pitching Data Cloud is, of course, to show that CRM is going to be at the forefront of the AI revolution, especially in the enterprise world. Unfortunately, there are numerous issues that still need to be resolved before this pitch becomes believable, in my opinion.

First, AI adoption among enterprise customers is yet to fully take off, as businesses figure out how to make the best of AI and how to reconfigure their existing processes so that they maximize the potential of AI. For instance, based on a recent survey by Microsoft and LinkedIn, three in four white-collar workers currently use AI for their work. On the contrary, another survey by Ramp, according to the Wall Street Journal, found that only about a third of companies pay for at least one AI tool. While this represents a significant jump from a year, when that figure was only 21%, there is a massive discrepancy between the proportion of individuals using AI and the proportion of businesses willing to adopt AI. Put simply, AI adoption among enterprises has simply not taken off yet.

Moreover, the existing AI tools are not completely fool-proof yet. As such, they are not ready yet to replace the mundane tasks, which would subsequently free up time for employees to focus on more important tasks, thereby boosting productivity. On the contrary, given the tendency of these tools to make errors, employees are likely to spend more time ensuring that AI has done the task correctly, which actually has a negative impact on productivity.

If the very goal of boosting productivity cannot be met by AI, then the question is why businesses would shell out money to incorporate AI into their businesses. And it’s not like the AI tools are cheap. In the case of CRM, Einstein for Service, which adds predictive and gen AI to the Service cloud costs £60 per user per month in the UK (approx. $77/user/month). That is more than double the cost of Microsoft’s Copilot, which costs $30/user/month. These costs, along with limited use cases of AI tools could explain why CRM is struggling to attract big deals.

Having said all of this, I do stand by my thesis from my last article on CRM, which is that the company is indeed well-positioned to capitalize on the AI boom among enterprises when it does happen. The problem is that investors might have to wait longer than initially expected before they see this growth. And given that the company has already said that the challenging buyer environment is set to stay for the rest of FY25, the wait is likely to be a long one.

Salesforce Continues to Obsess Over M&A

CRM, over the years, has been a poster child for using M&A as a growth mechanism. The next big thing has always been on the radar for CRM in the past, as evidenced by the company’s acquisition of the likes of Tableau and Slack. Last year, however, it did appear that the company had turned over a new leaf, especially after a bunch of activist hedge funds took stakes in the company and called for the company to focus on improving profitability and rely less on M&A. For a while, the activists’ campaigns paid off, as the company initiated cost cuts, boosted share buybacks, and more importantly, dismantled its M&A committee. Having done their bit, the activists either exited their position or drastically reduced the stake.

This year, CRM seems to have caught the M&A bug again, as evidenced by its initial pursuit of data management software provider, Informatica. The deal, had it been completed, would have cost in excess of $10 billion. Investors were not impressed when the news of the acquisition first broke, and thankfully the company backed off from the deal after the two companies failed to agree terms. However, the company did manage to make one deal, when it announced that it was acquiring Spiff, a company specializing in automating commission management for sales teams, for $419 million.

During the earnings call, CEO Marc Benioff announced that the company is “not going to shy away from M&A for any one particular reason if it’s within our framework.”

The obsession with M&A makes sense, especially with the company seeing a slowdown in its sales growth. Informatica’s cloud subscription ARR, for instance, was projected to grow 35%. So, it is no surprise that CRM wanted to acquire it and likely integrate it with Mulesoft. However, given that CRM had started to chart a new course, one that was built on pursuing organic growth, albeit under activist pressure, it was something that investors had hoped would be the strategy going forward since it would have meant more capital for buybacks and dividends. However, with the M&A obsession seemingly back, it calls into question whether the company trusts itself to grow organically, and that, in my opinion, is a potential red flag.

Valuation

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Source: Company’s Q1FY25 Press Release, LSEG Workspace (formerly Refinitiv), Seeking Alpha and Author’s Calculations

CRM, according to LSEG Workspace (formerly Refinitiv), currently trades at a forward P/E of 23x, which is significantly cheaper than its peers such as ServiceNow (44.8x), Microsoft (32x), and Snowflake (183x). Even relative to its historical levels, the stock is cheap today. The 2-year historical median forward P/E is 27x, and its 5-year historical median forward P/E is 48x. In my last article on CRM, I assumed a forward P/E of 31.5x. However, given the challenges that the company is currently facing and given that there are question marks surrounding its plans to monetize AI, I am of the opinion that 31.5x is a high multiple. At the same time, 23x is too low in my opinion, given that the company’s prospects are not that dire. As such, I have assumed its 2-year historical median multiple of 27x for my calculations.

The company now expects FY25 non-GAAP diluted EPS to be between $9.86 and $9.94, above the consensus estimates of $9.80. I simply don’t believe that the company can achieve its EPS guidance, given the environment it currently operates in, where it is struggling to close large deals. I also believe that the company would have to continue to invest in its AI initiatives if at present, it is unable to meaningfully monetize its AI products. As such, I have assumed the consensus estimate of $9.80 for my calculations, which is marginally higher than my previous estimate of $9.72.

According to Seeking Alpha, the company currently trades at a forward PEG ratio of 1.15, significantly below the industry median of 1.92. I have assumed a forward PEG of 1.92 for my calculations, which would translate to an FY26 earnings growth of 14%. A forward PEG ratio of 1.15 would have resulted in an earnings growth of 24%, which I believe is too high. A 14% earnings growth is more realistic in my opinion, and is also in line with the company’s mean long-term EPS growth of 16%. An earnings growth of 14% would result in FY26 non-GAAP EPS of $11.20.

A forward P/E of 27x and FY26 EPS of $11.20 would result in a price target of $302, which reflects an upside of about 29% from current levels. I, therefore, maintain my buy rating on the stock, solely from a valuation perspective.

Despite maintaining my buy rating, I have drastically cut my price target, which was previously set at $355. This reflects the challenging environment that the company currently operates in and also reflects the company’s inability to translate all the “incredible” work it has been doing on the AI front to top-line growth. In addition, I have also projected a lower earnings growth than last time (14% vs 16%). Finally, the stock has lost its momentum following the earnings release, as evidenced by D grade on Seeking Alpha’s Momentum Metrics for its 3-month price performance. As such, I do expect that the upside potential will take time to achieve until there is more clarity with respect to its AI ambitions.

Risk Factors

The single-digit growth in the company’s CRPOs, which occurred for the first time, is a cause for concern. As I mentioned earlier, the use case of AI is still something that enterprises are figuring out, which has had a negative impact on the rate of adoption. Furthermore, the more companies wait to figure out how to integrate CRM’s AI-related cloud services, the more the company falls behind its peers such as Microsoft who have actually figured out how to generate revenues from AI.

Furthermore, the company now sees a larger-than-expected stock-based compensation, due to “lower voluntary employee attrition in Q1 than in recent years.” While this is not a case to be alarmed at the moment, it’s a figure that investors should keep an eye on, in the event that it becomes a regular occurrence.

Concluding Thoughts

CRM’s quarter was anything but “incredible.” The top-line growth is showing clear signs of a slowdown and given that AI adoption among enterprises has been slow, it is not clear when the company will get its growth mojo back. The obsession with M&A has also made a comeback, which begs the question as to whether the management believes in their ability to achieve organic growth.

The only solace, and the main reason why I am maintaining my buy rating is that valuation has become compelling, especially after the steep selloff seen in the stock following its earnings report. I continue to believe in the AI story, and I do believe that Einstein and Data Cloud have the potential to be strong growth catalysts for the future. The only issue is that the future could be a lot further away than initially expected and mentioning AI 40 times during the earnings call is not going to change that.