Good morning. Yesterday was another day of chunky moves up in Treasury yields — and yet stocks managed, once again, to eke out gains. The massive shift in inflation and rate expectations in recent weeks have left a surprisingly small mark on stocks. Earnings have been OK, of course, but the market is supposed to be forward-looking. Please tell us what is going on: firstname.lastname@example.org & email@example.com.
Salesforce and the activists
I can’t remember another case where three major activist investors piled into a single company at more or less the same time. But it makes perfect sense that Elliott Management, Starboard Capital and ValueAct have all converged on Salesforce. It’s a wonderfully juicy target.
The software group is an activist’s dream: a very large company with an outstanding core business that is goofing around on the periphery and has a weak valuation as a result. It’s been this way for a long time, but there is no entry point for activists when a company’s stock price only goes up, as Salesforce’s did between 2004 and late 2021. Over the following year or so, the stock fell almost 60 per cent, and the door was suddenly wide open.
To see the where the juice is, compare a few of Salesforce’s basic metrics with those of other large US software companies:
The activists main complaint is that Salesforce’s margins and valuations are too low. Start with former. The company’s operating margin, at 23 per cent, is miles short of the over-40 levels of the legacy monsters Microsoft and Oracle (see line 6 of the table). But that is to be expected: what is galling is that it lags behind its smaller peers Adobe and Intuit, and even the much smaller and faster-growing ServiceNow. There is something going wrong with spending at Salesforce.
It should be noted that all the operating earnings numbers in the table are presented on an adjusted basis, as is standard in the software industry. This means taking the GAAP operating profit number and adding back two non-cash costs, equity compensation expense and intangible amortisation, as well as cash merger and restructuring costs. You can debate the justice of the non-cash add-backs. Restructuring and acquisition cost adjustments are always to be treated with extreme suspicion. Salesforce backed out $828mn of restructuring costs from its adjusted operating profits last year. Do I suspect some dubious stuff has been thrown in there? I sure do, and I bet the activists do, too. But the company is capable of producing so much profit that investors can put these fiddles in a weary footnote and move on.
Given that there seem to be heaps of potential for margin expansion, Salesforce’s valuation is relatively cheap. Here I use enterprise value (equity value plus net debt) to operating income, a metric that removes the impact of capital structure and tax rates (see line 7 in the table). At a multiple of 24, it trades close to Microsoft and Intuit. But Salesforce has a huge amount of room to expand its margins; Microsoft and Intuit do not.
But there is an additional wrinkle. Margins aside, Salesforce’s business consistently generates immense amounts of free cash flow: $6.3bn of it last year. If you value the company on free cash flow yield (line 9), which may be the purest of all valuation metrics, it trades cheaper than slow-growing Oracle, and almost as cheap as Microsoft, even though it grows much faster than either (see lines 3 and 4). Look at cash, and Salesforce starts to look like a bargain.
This is why news that the Salesforce board has disbanded its mergers and acquisitions committee is such a victory for the activists. Essentially all the free cash flow Salesforce generates has been going to acquisitions, a lot of them — most notably the $28bn purchase of Slack in 2020 — don’t seem very smart.
Over the [past five years, the company has generated more than $22.2bn in free cash; $22.1bn of cash has gone to M&A. If this stops, Salesforce becomes a different kind of financial animal. It has begun buying back shares, and at the current valuation, that makes sense.
It looks like activists are on to a good one, then. Where could things go wrong? One is that Salesforce’s acquisition binge, and in general its rush to expand quickly, has created internal disorder that will become a barrier to future growth. This happens to a lot of software companies, most recently FIS. And the problems always seem to pop up out of nowhere.
The second risk is more subtle. In the years of low interest rates, the valuations of two sorts of companies were driven up. Growth companies were bid up because (in theory) low discount rates made cash flows far in the future more valuable. Companies with very safe recurring revenue were also highly valued under near-zero rates, because the usual source of safe returns in a portfolio — bonds — yielded nearly nothing.
Salesforce is both a fast grower and, as a “software as a service” company, a recurring revenue company. If we are heading into a world of higher rates in which growth and recurring revenues are less sought after, Salesforce could be devalued twice. The activist investors may be right that the company is on the cusp of much higher profits, but a lower valuation of those profits could eat up the returns. I’m not sure this will happen, even if rates do stay high, but it is worth thinking about.