Last month I posted an article titled “Landgrab Economics – Making Sense of the Facebook-WhatsApp Deal” to try to explain, among other things, the wild valuations and bewildering events that occur in consumer-focused cloud businesses that are in mass-market hyper-growth mode. My specific objective with regard to the Facebook-WhatsApp deal was to help readers judge whether the deal made sense, particularly at the outsized valuation involved.
In this article I hope to demonstrate to anyone who considers themselves an “investor” – whether a customer, business partner, interested observer, analyst, or active investor – what Landgrab Economics looks like in today’s B2B/enterprise markets. The specific case today focuses on SaaS-based CRM/ERP/HCM applications, which have been experiencing sustained hyper-growth (AKA the Tornado) in North America and other major markets. Unlike earlier or later adoption stages such as the Early Market, Chasm, Bowling Alley, or Main Street*, the Tornado is the one stage where landgrab economics actually make sense.
Tornadoes generally occur once large herds of pragmatic customers have anointed one vendor as the Gorilla in the category. At times the business performance or financial reporting by vendors, in particular the gorilla, leave customers, analysts and investors alternately ecstatic and incensed (or at least disappointed): ecstatic about the dramatic and sustained growth and dominance of a vendor they feel they can bet on; but incensed by some of that same vendor’s behavior or actions that call into question their professionalism or even their integrity. One of today’s best examples because of its considerable, well-earned success is Salesforce.com, the gorilla in cloud CRM enterprise applications. Investors are increasingly perturbed about several issues: the continued lack of profitability, apparently out-of-control expenditures, habit of overpaying for acquisitions, and sometimes opaque reporting. Workday, today the second most closely followed player in this SaaS due its recent eye-popping growth, has also attracted criticism for its lack of focus on profitability and fat executive compensation packages. Interestingly, NetSuite, the current leader in SaaS-based ERP for small and mid-market customers, has followed a more discreet track and attracted little if any controversy despite still not being profitable, per the prevailing SaaS hyper-growth business model.
A look at the respective valuations of these three companies is instructive: Salesforce today has a market valuation of $36bn and sales of approximately $5bn (P/S ratio of just 7x), whereas Workday has a valuation of $19bn on sales of around $400m (P/S ratio of 45x), while NetSuite’s valuation is $8bn on sales of around $400m (P/S of 20x). Despite having been the pre-eminent standard-bearer for the entire SaaS/cloud super-category, Salesforce has a considerably lower P/S multiple than the two smaller companies. This is partly because of its perceived over-payment for a number of acquisitions over the years and other financial management factors cited above, and partly due to the law of large numbers. Workday’s much higher P/S multiple is due to its growth and perceived Gorilla potential in both cloud HCM and ERP. Both Workday and NetSuite, among other SaaS players, have benefited from Salesforce’s effective thought leadership in championing “the End of Software” ever since its founding in the late nineties.
Toward the end of this post I’ve noted some simple steps that CEOs and CFOs can take to help investors relate to their priorities during this frenetic and often ferociously disruptive growth phase for customers, partners, investors, and the companies themselves. One obstacle is that many CEOs regard reporting to Wall Street as akin to undergoing quarterly proctology exams; as a result they can be defensive or dismissive when asked probing questions. But refusing to provide investors with unambiguous answers is not acceptable. It can’t hurt CEOs that much to remind analysts of the thinking behind their current strategy nor provide them with a committed path to profitability. In the case of Salesforce and Workday today this is not yet happening as it needs to. Instead the relationship is becoming fraught with adversarial attitudes and rhetoric. In Salesforce’s specific case, investor angst is undoubtedly suppressing the company’s stock price.
Tornado dynamics in SaaS/Cloud business applications
To go a bit deeper, the Tornado is the stage when pragmatic customers, having held back for some time from adopting a technology such as SaaS-delivered applications while monitoring the success of early adopters (techies and visionaries), suddenly move as a herd to keep up with their peers and competitors. This causes a stampede to adopt new solutions as fast and as broadly as possible. In the case of B2C internet businesses such as Facebook and WhatsApp, they focus initially on achieving hyper-growth in areas such as viral user adoption and increasing transaction volumes or engagement levels. Revenues or profits only become truly important later on, as growth slows down – and this fits their business model.
In stark contrast, B2B-focused SaaS companies generally start life with a revenue-generating business model, albeit one that takes longer to deliver actual profits than the traditional on-premise license plus maintenance business model allowed for. This is due to the considerable percentage of revenues in subscription-based term contracts that are not yet recognizable but instead deferred to future years. Since Salesforce – and Workday too, though it slightly earlier in the adoption process and generates less than 10% of Salesforce’s revenues – is enjoying hyper-growth in numbers of users, customers and revenues, and has reached $5bn in annual recognized revenue, many investors want to see profits today, or at the very least a clear path to profitability. This is partly because most financial analysts don’t fully understand the landgrab economics model that often characterizes growth businesses in the tornado, and partly because of the strategy that Marc Benioff is implementing at Salesforce, with his explicit “revenues now, profits later” approach to running the business.
Today, tornado winds are still blowing strong and providing plenty of unmet demand in markets such as the North America or EMEA as well as in Asia and Latin America, many of which are at differing stages of adoption some of which don’t warrant a landgrab strategy. For Salesforce, unmet demand relates to existing customers who have yet to sign up for (all of) Salesforce’s four core service offerings across the whole organization, as well as potential customers who have yet to make their first purchase decisions. What’s not helping matters today is that neither Salesforce nor Workday is conveying serious intent to generate profits in the foreseeable future, instead sticking to their “growth-at-all-costs strategy”. Worse, their earnings reports tend to contain opaque metrics that delay investors’ decisions to get in, stay in, or get out of the stock.
Not surprisingly, analysts are puzzling about whether the growth-at-all-costs strategy is justified. Recent questions following Salesforce’s Q4-’13 earnings call included: Why do they sound elusive when asked to break down their business results in ways that we can relate to? For example, why is Salesforce unable to break down total revenues by product? Or to provide growth rates of each of their four core service offerings..? Or to identify revenue growth separately, due to new customers, upgrades, and additional subscriptions..? And why did the company omit the fact that 20% of its 2013 revenue growth came from a single acquisition?
What it’s like to live in the Tornado
When the tornado occurs vendors respond by scaling up their operations as fast possible to take advantage of the new rush of demand. SaaS companies today have to be preoccupied constantly with defending against security breaches, avoiding or fixing data center outages, repairing bugs in new products, achieving adoption of new offerings, managing upgrade cycles, addressing high attrition rates, and other problems, all while trying to grow faster than their closest competitors in an increasingly competitive race to win. To most participants, it feels like a zero-sum game even though it usually doesn’t need to be one because during this stage there’s usually plenty of unmet demand to go around.
Consider for a moment what it’s like to deal with 30%+ growth every year for, say, five or ten years. The arithmetic shows us that at 30% p.a. you’ll be 10 times the size (and complexity) in year 10 compared to year 1. And growth is often considerably higher during some of these years. Adding new people and systems, keeping products fresh, introducing new products, meeting rising customer expectations, training and retaining your best people, competing for new talent, acquiring and integrating companies, producing the best possible financial results, reporting them with clarity – all of these critical activities take enormous reserves of management and employee energy to manage rapid change. This chaotic environment is the reality that the management teams and employees have been living at Salesforce, Workday, NetSuite, and many other companies for years. It’s impossible to cover all the bases all the time, so it’s no surprise when one or more wheels come off. Strange though it may seem, alongside the thrill of success, dealing with such intense activity can cost dearly in terms of burnout and high attrition.
Perhaps not surprisingly, CEOs and management teams living in this vortex can become de-sensitized to the needs of outside stakeholders and a little intoxicated with their new-found power. To make matters worse, executives at Salesforce and Workday are paying themselves what are seen by some analysts as fat compensation packages while also making large stock-option grants to employees. In all probability management believes that they and others have worked long, hard and successfully enough to be well rewarded – and they often feel compelled to try to retain their best talent this way too. Nevertheless, some investors are asking if some of this compensation shouldn’t be deferred until these companies actually produce some financial returns. Soon investors start voicing more serious doubts: Is this company’s growth for real? How long can they keep it up? When can we expect GAAP-based profits rather than this non-GAAP mumbo-jumbo? Are they telling us the whole story about their strategy or operating expenses? What is it that they aren’t telling us?
Since companies in the tornado become addicted to high growth, when growth slows they tend to increase the frequency and number of acquisitions to supplement their organic growth. As they feel increasing pressure of expectations to “feed the beast” they may be tempted to get creative with metrics to keep investors believing their growth story. This type of opacity is what Salesforce is being challenged on from many quarters, in the absence of a profitability story.
Complicating matters further, business management processes and systems in fast-growing tech companies tend to lag where they need to be by at least 2-3 years. Since young tech companies focus most attention on revenue growth, they allocate insufficient resources to their back-office systems. In fact, one of the tech businesses worst-kept dirty secrets is how process-averse many companies are, and how poorly they treat their internal IT systems. They cope for too long with outdated or dysfunctional systems, even those that are most critical to their business, including such basics as billing and A/R, customer data management, and financial reporting. At Salesforce, the fact that they still use traditional client-server ERP systems is seen as a hindrance to producing accurate information on their critical performance issues that analysts have been asking about. Shocking as it may seem, in some publicly traded companies the quarter-end reporting process is an intensive, largely manual nightmare consuming enormous amounts of management time and attention – and still not managing to convey an accurate picture.
Minimizing the Agony to maximize the Ecstasy
My strongest advice to CEOs, CFOs and other officers of high-flying cloud software vendors is: PLAY BALL with analysts – it’s better to get them on your side than alienate them, since they can materially impact how your stock is perceived by retail and wholesale investors:
- At each investor presentation or earnings call, remind your audience why you are giving priority to, for example, growth over profitability, based on the adoption stage that you’re your business is at in its most important markets. If you are in a land grab, say why and stick to your guns. But avoid citing exotic metrics that no reasonable investor can take seriously, or that invite suspicion that you are concealing something.
- Provide analysts and investors with a comprehensible and committed roadmap to profitability within a reasonable timeframe (say, 2-3 years) with clearly stated caveats to avoid having this understood as firm guidance on future earnings. It’s unreasonable to resist doing this, and you gain friends among all stakeholders for doing so.
- Stop treating your back-office processes and IT systems reactively – and not only get them designed for today’s requirements, but designed and implemented to support the next three to five years of your growth.
As for investors and analysts (this includes customers, partners and other interested participants) who are following fast-growing cloud companies, here are three simple pointers:
- Do your homework: Make sure you understand the adoption dynamics and therefore growth strategy relative to the product category(ies) of the company you are tracking. See the notes on metrics for each stage in the adoption life cycle below for reference.
- Keep your natural impatience for actual profits in check if profitability is not the most important metric today because of, say, the land grab priority, provided that valid growth-related metrics that are being applied correctly.
- Demand that the company provides a clear roadmap to profitability even if they need to couch their statements in cautionary terms.
Seeking Alpha analyst James Ryans says pointedly at the end of a recent blog: “Clearly Salesforce is a phenomenal success, and investors should remember that a quality business and quality financial reporting need not go hand in hand. But an enterprise software company should be embarrassed if it is incapable of basic analysis of its own data.” These are the words of just one analyst, but the financial blogosphere is teeming with concerned commentary on this issue, which is basically about (the lack of) visibility and transparency. To its great credit, Salesforce has generated tremendous growth during recent years, and is the undisputed leader – or Gorilla – in SaaS CRM. As such, it is a magnet for investors and customers. But that is the point: With enormous success comes enormous responsibility.
* Note on performance metrics along the technology adoption life cycle: During different stages of the technology adoption life cycle, metrics vary significantly. In earlier stages customer adoption is key, without expectation of significant revenues or, much less, profitability. When crossing the chasm, the two main criteria to look for are rapid adoption in targeted market segments generating a strong exponential revenue growth rate. In the Tornado, investors (like customers) look for one or two dominant players that are setting the pace for every other participant in the category by generating high growth year after year in many verticals and regions. This is a growth and scale game where the year-over-year growth trend is expected to be increasingly measurable and predictable. Once the category matures on Main Street, stakeholders want to see solid and predictable margins and net earnings, as well as persistent and measurable customer loyalty. To net this out, the key performance metrics as B2B companies enter the tornado are rapid growth and dramatically increasing scale and coverage. While highly desirable, profits may not be an imperative provided that there is a committed roadmap to get there. The stages in the Technology Adoption Life Cycle are defined in detail in Crossing the Chasm, Geoffrey Moore’s seminal book on the technology adoption life cycle and related market strategies. The third edition of the book was published last month.
Disclosure: The author provided advisory services to Salesforce.com from 2010-2012.