Fool me once, shame on you; Fool me twice, shame on me.
About a year and a half ago, I wrote an article explaining why Salesforce (New York Stock Exchange: CRM) is a powerful cloud ecosystem with red flags everywhere. At the time, the company was trading around $225 per share and hype around its expected growth was high.
Contrary to popular opinion, however, CRM has fallen 30% since then, at a time when the broader market saw a positive return of 9%.
During this period, total revenue continued its parabolic growth, although it was largely driven by ever-increasing M&A transactions.
Expectations for future growth have also remained stable, dropping from around 20% in December 2020 to 21% to date.
The reason I’m so focused on earnings is that forward sales growth has been a key driver of software and cloud valuations for years. Therefore, one could easily be led to expect that Salesforce is now heading for levels well above the $225 price point I mentioned earlier.
In the lines that follow, I will explain why this is not the case and why it is not the right reasoning to be optimistic about the future evolution of the CRM stock price.
It wasn’t a top business performance
As Salesforce hit highs in the second halves of 2020 and 2021, many investors likely attributed this outperformance to their unique ability to pick winners. Moreover, the optimistic picture of the future has also led to the expectation that CRM may continue to generate similar returns in the future.
But the reality was that this exceptional performance was not so much caused by higher profits, but rather by a massive increase in multiples.
As we have seen above, the expected growth rate of revenues has been relatively stable in recent years, while profitability has not improved significantly. The high net income figures for fiscal years 2021 and 2022 were almost entirely due to gains on strategic investments and one-time tax benefits.
Beware of exogenous factors
Therefore, if the exceptional returns of the CRM were not dictated by the fundamentals of the company, the fact remains that they were subject to exogenous factors.
In the chart below, we see the performance of iShares Edge MSCI USA Momentum Factor ETF (MTUM) versus iShares Edge MSCI USA Value Factor ETF (VLUE). What we are seeing over the past 3 years is that there have been two distinct periods where the gap between the two has peaked and that is the second half of 2020 and the second half of 2021.
This performance gap also coincides with the peak levels of CRM’s Price-to-Sales multiple that we saw above. Similar dynamics were seen for other high-growth stocks popular with retail investors, such as Block (SQ), Shopify (SHOP) and PayPal (PYPL).
A possible explanation for all of this could simply be higher economic growth and an acceleration of digitalization that we have recently witnessed. Such a narrative is also popular for why these high growth stocks suddenly traded at such high multiples to boring value stocks.
Unfortunately, however, the real driver has been fiscal and monetary intervention. The two periods of high P/S multiples we saw above also coincided with periods when the Federal Reserve significantly expanded its balance sheet.
And also with the two periods where bond yields fell significantly.
In a nutshell, Salesforce’s exceptionally strong performance through the second half of 2021 was not caused by the company’s exceptional business fundamentals, but rather by policy decisions made by the US Federal Reserve. Therefore, in hindsight, misattributing CRM’s strong share price performance to exceptional stock-picking skills was likely a mistake.
Are we done?
All of which brings us to the current period, where it looks like many retail and institutional investors are about to make a second mistake – assuming that, since Salesforce continues to execute well on its growth strategy, the company is significantly under -valued at current levels (following the massive drop in the stock price in recent months).
What has really happened in recent months is a kind of normalization that I warned about in November last year in a thought piece titled: “Cloud space in numbers: what matters most”.
To illustrate the process, below we’ve plotted the gross margins on the x-axis of the top cloud and software companies against their price-to-sales multiples on the y-axis. The first chart is from September last year, around peak valuation levels for many of these companies.
What we notice is that CRM was among the high priced companies relative to their forward sales and the P/S multiple was supported by the company’s high gross margin, although it is still doubtful that the company will soon achieve the necessary operating margins.
All of this, however, is irrelevant to our discussion so far, unless we are also looking at the same chart in May of this year (see below).
A priori, nothing stands out because the relationship between the two variables is still relatively strong on a cross-sectional basis. If we look closer, however, we will see that the slope of the trendline is now significantly lower (note that the maximum on the y-axis is now only 12, compared to 25 in the September chart) .
This means that companies valued at large premiums were most at risk from the recent normalization of monetary policy. This is why, companies such as VMware (VMW), Oracle (ORCL) and SAP (SAP) have experienced much smaller declines in share price compared to the top performers – Salesforce, Adobe (ADBE) and Intuit. (INTU).
Although Adobe and Intuit are exceptionally strong companies, I warned of a possible decline due to their high exposure to momentum factors:
- Intuit: at the epicenter of market meltdown
- Adobe: compelling fundamentals, but outdated feedback
Unlike ADBE and INTU, however, CRM still has a long way to go before it can convince its shareholders that it could achieve such high margins and maintain them over the long term, without compromising the growth rate. high expected.
Salesforce is one of the leaders in the cloud space with an exceptional offering ecosystem.
That’s why many retail investors have been puzzled by the company’s recent poor share price performance and many are now calling for a potential reversal, believing CRM has become significantly undervalued. In reality, however, it will take yet another round of quantitative easing or another loose monetary or fiscal policy to replicate the abnormal returns for corporate shareholders over the 2020-21 period. Additionally, the company may need to maintain its aggressive approach to mergers and acquisitions in order to meet its growth expectations, as questions about GAAP profitability remain.
On the plus side, however, following the recent decline, CRM has become much less risky than it was when I first covered the business nearly a year and a half ago. This is why I am now changing my rating from Bearish to Neutral.