Salesforce: license to foam

Drop a mentos mint into a bottle of coke, and a geyser of foam erupts. A similar result comes from combining fast growing software companies: extreme froth. One example is the recent furore over Salesforce, a $50bn company that sells subscription software. Its shares shot up 10 per cent when unconfirmed acquisition rumours swirled. But such rumours can only be taken seriously in a market prone to excess.

Forget, for a moment, everything you know about Salesforce. Consider a faceless entity, NewCo, with $5.4bn in revenue that grew by a third last year, and is expected to grow by a fifth this year. NewCo's sales and marketing costs are on the high side at just over half of revenues, and it has not turned a profit since the 2011 financial year.

On the plus side, selling subscriptions provides plenty of operating cash flow as well as visibility of near-term growth. But NewCo's attrition rate (the value of contracts that are not renewed) is roughly 10 per cent a year, meaning that it needs to keep up the marketing to maintain growth. The company is also relying on success in new areas, such as analytics, to drive its next phase of growth.

Perhaps more concerning is that NewCo hands out generous stock options to retain talent at its California headquarters. Its share count rose 7 per cent last year, which would have been dilutive to earnings, had there been any.

How much should this business be worth? Today's market prices put Salesforce's equity at $48bn - more than 45 times forward earnings before interest, tax, depreciation and amortisation. Analysts at Nomura think a takeover, if one materialises, could happen at around $64bn. That is more than the GDP of Guatemala. For mature tech companies with large piles of cash (we will not name names), Salesforce's growth may look enticing. But it is hardly a value proposition.

Froth is exciting, but it leaves a mess.

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