It finally happened. After spending 16 months stuck between $140 and $160, shares of enterprise software giant Salesforce (NYSE:CRM) are finally breaking out, thanks to the convergence of a few positive catalysts. Namely, the company reported solid third-quarter numbers in early December that showed revenue growth acceleration and improving profit trends.
The analyst community has issued broadly positive updates on the stock over the past month. And, investors have been buying ahead of what should big a rebound year in 2020 in terms of global information technology spending and investment.
In response to these positive catalysts, CRM stock has rallied more than 20% over the past three months to new all time highs. The big question now is can this breakout in CRM stock keep going?
It can. But I have my doubts. Here’s why.
Broader IT Environment Improving
Salesforce stock can keep rallying in 2020 because the broader global information technology (IT) environment should dramatically improve this year and provide a meaningful lift to Salesforce’s growth trends.
Specifically, the sustained easing of U.S.-China trade tensions and global monetary policies set up the economy for a big rebound in 2020. As the economy rebounds, corporations around the globe will re-accelerate their spending on IT and enterprise software products. That’s why Gartner projects IT spending to rise 3.7% in 2020, while enterprise software spending is projected to rise 10.9% in 2020, up from 8.8% growth in 2019.
In that faster growth environment, Salesforce’s growth trends should improve. That’s because this company dominates most cloud-based verticals in the enterprise software category, and as such, when companies spend more on enterprise software, they spend more on Salesforce products.
As such, Salesforce’s revenue growth rates will remain robust in 2020. Historically speaking, CRM stock goes as the company’s revenue growth rates go. So, as revenue growth rates move higher this year, logic and history say that CRM stock should go higher, too.
Valuation Is a Problem
The only problem with the aforementioned 2020 bull thesis on CRM stock is valuation. Put simply, Salesforce stock is richly valued, even after considering its robust growth prospects, and this rich valuation could short-circuit the recent rally.
Salesforce has an ambitious goal to hit $34.5 billion in revenue by 2024. That seems entirely doable for a few reasons. First, Salesforce management has a history of laying out ambitious revenue targets and either hitting or exceeding them. Second, only 20% of enterprise workloads have migrated to the cloud so far. That number will move closer to 100% over the next several years. As it does, that implies tons of growth potential for Salesforce, the leading enterprise cloud software provider in the world. Third, Salesforce’s new ventures, like Customer 360, are gaining significant traction, and have a long runway ahead for further growth.
All in all, $34.5 billion in revenue by 2024 seems entirely doable.
But, here’s the problem — the enterprise software category is intensely competitive, and in order to get to $34.5 billion in revenue by 2024, Salesforce is going to have to spend an arm and a leg on research, development and marketing. Thus, big revenue growth will be accompanied by big expense growth, and margins won’t head that much higher over the next several years.
My long-term model on Salesforce — which assumes $34.5 billion in revenue by 2024 and steady but not huge margin expansion — pegs 2025 earnings per share at $7.50. Based on an application software sector-average 35-times forward earnings multiple and a 10% annual discount rate, that equates to a 2020 price target for CRM stock of about $180.
That’s roughly where shares trade hands today.
Bottom Line on CRM Stock
Salesforce is a great company doing very innovative things and optimally capitalizing on a huge growth opportunity in the cloud-based enterprise software category. Because of this, CRM stock deserves to trade at a premium valuation. But, today’s valuation seems unnecessarily stretched, and I wouldn’t be surprised to see valuation friction ultimately short-circuit the recent rally.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
