Here’s The Reason Behind Salesforce’s Declining Gross Margin

Global cloud computing behemoth Salesforce.com (NYSE:CRM) has been plagued by declining gross margins in the last few years. The gross margin of its cloud software business has contracted every year since 2011, falling from 87% in 2011 to 84% in 2014. Notably, its adjusted EBITDA margin (adjusted for stock-based compensation and amortization of intangible assets) has improved from 15.5% to 16% over the same period. We believe that the decline in Salesforce’s gross margin is due to its heavy investments in new data centers, which is leading to increasingly higher depreciation allocated to its cost of goods sold. This view is underpinned by the fact that Salesforce’s depreciation as a percentage of revenue has steadily increased from 3% in calendar 2008 to 8% in calendar 2014.

Our price estimate of $65 for Salesforce is about 10% lower than its current market price.

See our complete analysis for Salesforce.com here

What Does Salesforce’s Cost of Goods Sold Include?

Naturally, the decline in Salesforce’s gross margin is due to an increase in its cost of goods sold (COGS). Salesforce provides a service, not a product, and the service is in the form of subscription for Salesforce’s software-as-as-service (SaaS) offerings. Therefore, its COGS is the cost of providing these services. Such costs primarily include hosting and monitoring costs, customer support and account management costs, and licenses/royalties for embedded products.

Hosting and monitoring costs include the cost of hosting the computing capacity that is provided to customers through the cloud. Such hosting cost may be in the form of rent paid towards data centers or depreciation on owned data centers. In case of Salesforce, it is the latter as the company uses its vast resources to build data centers rather than rent them.

Customer support and account management costs include the cost of providing customer support, onboarding, troubleshooting, and fulfilling customer-specific requests. Licenses or royalties for embedded products include the license fee payable to third-party software vendors whose products Salesforce uses to develop its own cloud applications.

Which of These Components is Causing the Decline in Gross Margin?

Salesforce does not provide a breakout of its cost of goods sold, so it is not possible to precisely pinpoint the underlying reason for the decline in margins. However, we believe that a spike in depreciation, arising out of rising investment in data centers is responsible for the decline in the company’s gross margin. For expanding its customer base, Salesforce needs to have sufficient computing capacity to offer to its software to customers through the cloud. As explained above, computing capacity is hosted in data centers. Therefore, in order to increase the computing capacity in tandem with its rapidly expanding customer base, Salesforce has had to make substantial investments in data centers in recent years, which is in turn driving up depreciation.

Indeed, Salesforce’s depreciation as a percentage of revenue shot up from just 3% in 2008 to 9% in 2013, before contracting modestly to 8% in 2014. Further, the reduction in Salesforce’s estimated plant age is testimony to its aggressive investments in recent years. Salesforce’s estimated plant age, which is calculated as accumulated depreciation, divided by annual depreciation for that year, fell from 1.6 in 2009 to 1.0 in 2013, before recovering slightly to 1.4 in 2014. That the number is this low suggests not only the rapid pace of recent investment, but the relatively brief interval over which computing capacity is depreciated.

Thus, Salesforce’s need for more and more computing capacity is clear from its recent heavy investments in data centers. The company has been opening up new data centers all over the world, including the UK, France, Germany ^[1] and Japan. ^[2] Earlier this month, Salesforce announced that it plans to invest $1 billion in Germany alone over the next five years. ^[3] These investments have steadily ramped up Salesforce’s depreciation, and are expected to continue to do so as long as the company is in an aggressive expansion mode. Consequently, we expect Salesforce’s gross margin of its cloud products to continue to decline in the medium term and fall to 80% by 2019.

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1. Salesforce Press Release, March 3, 2014 [↩]
2. Salesforce Press Release, December 3, 2014 [↩]
3. Salesforce’s Benioff Says SAP Rebuffed His ‘Olive Branch’, Bloomberg, July 2, 2015 [↩]