Last year, around this time, I wrote about Marc’s Lemonade Stand. This was my attempt to demystify the cash flow of Salesforce. From their annual reports we know they have not made a profit for four years so how do they stay afloat? If the money from selling subscriptions is insufficient to cover costs where does the extra money come from? Now, with Salesforce’s financial year at a close we can, again, revisit, Marc’s Lemonade stand.
Cash is King
There are three financial reports released with an annual report:
- Statement of Operations (Revenues and Costs)
- Balance Sheet (Assets and Liabilities)
- Cash Flow Statement (Incoming and Outgoing Cash)
Marc is quite the fan of Non-GAAP results. This is Marc being creative with the Statement of Operations where he literally turns a financial loss into a profit. In short, if you have the motivation, you can make the statement of operations sing whatever tune you want it to.
With the balance sheet, we list our assets and liabilities. I once heard of a creative account who argued research and development is an asset for the Balance Sheet and not an expense on the Statement of Operations because it is an ‘investment in the future’. He had turned a business cost into a valuable asset simply through creative accounting.
The Cash Flow Statement is harder to mess with. It simply shows what money came into the business and what money left the business over the financial year. Concepts like ‘revenue recognition’ are thrown away. Either the cash came in, or it did not. The best you can do is something like add a positive value in one part of the Cash Flow Statement and then put a matching negative one in another part of the Cash Flow Statement. For an example of this ‘give with one hand and take with the other’, see the most recent quarterly statement of Salesforce and spot the two “Excess tax benefits from employee stock plans” entries.
The Story So Far
Marc runs a successful lemonade stand outside of his home in Hawaii. He buys the ingredients from the local corner store (Subscription and Support Costs) and puts up posters in the surrounding streets to promote his stand (Marketing and Sales). His sister also helps out, making the lemonade and sitting on the stand (General and Administrative Costs). She is a strong believer in the future success of the stand and frequently buys shares in the business from Marc (Expenses Related to Stock-Based Awards).
Uncle Sam visits around Christmas and takes a few lemonades and sometimes, if he has a few extra coins in his pocket, will add them to Marc’s kitty (Provision for Income Taxes). Similarly, his Dad comes home from work, thirsty and sometimes borrows money from Marc to buy a lemonade (Accounts Receivable). Marc also borrows money from Mom occasionally when money is short (Financing Activities).
Marc runs a loyalty program where, for new customers, if you pay $9 today you get ten lemonades over the rest of the year (Deferred Revenue).
Finally, Marc has been so successful at running his lemonade stand, he has bought out a few of the local rival stands, keeping the staff but taking the profits (Business Combinations).
Excess money earned from the stand goes into the bank and earns interest (Investment Income) or goes into comics (Purchases of Marketable Securities)
There are a few other entries in my ledger but you get the general idea.
As an exercise in masochism, I took the numbers back to 2003, using the Annual Reports on the Salesforce web site. The only exception to this were the 2015 results which I took from the latest quarterly announcement.
I then grouped the cash flows as if they related to a lemonade stand. So, for example, “Taste Testing” is “Research and Development” and “Fixing Up the Lemonade Stand” is “Land Activity and Building Improvements” plus “Capital Expenditures” plus “Principal Payments on Capital Lease Obligations”.
Finally I scaled all entries, relative to the revenue for that year, setting the revenue to equal $1. In effect, this tells us, in a given year what percentage was spent or how much money was received for that line item. So, in the above sheet, for 2015, 51% of Revenue (Lemonade Sales) was spent on Marketing and Sales (Posters).
Values in green are greater than or equal to 10c and values in red are less than or equal to -10c
Marc’s Main Sources of Revenue
Marc has three main sources of revenue:
- Lemonade Sales (Subscription, Support, Professional and Other Revenue) $1.00
- Selling Sister a Share of the Business (Expenses related to stock-based awards + Proceeds from the exercise of stock options + Repurchase of unvested shares) $0.16
- Loyalty Program (Deferred Revenue) $0.15
Lemonade sales are, by far, the largest source of cash with the other two running roughly equal second. The use of options and shares as compensation (Selling Sister…) keeps cash flowing into the business but dilutes the value of the business per share. This source of cash is only viable while the receivers perceive value in the underlying stock. As the stock becomes diluted, this value diminishes.
The loyalty program (Deferred Revenue) is an interesting source of revenue.This refers to Salesforce taking the full value of an annual subscription at the start of the contract. They receive the cash but still have to deliver the service. In the quarterly calls, a big deal is made of the deferred revenue with the inference it is an indicator of future income. For a subscription model there is some truth to this, in that the clients will be paying the same next year, but it is also an indication of services yet to be delivered. In the case of the lemonade stand, Marc now has lots of money but eventually the customers will come asking for their lemonades which Marc will be compelled to provide for no additional cash.
In terms of historical significance, relative to subscription and support revenue, I was surprised to see that these additional sources of cash are not new. Both have provided significant cash inflows for most of the company’s life. In the case of deferred revenue, its relative importance is dropping, now only accounting for 15c for every dollar of revenue earned, compared to historic highs of 32c.
Marc’s Main Costs
Marc has quite a few significant costs in the business:
- Cost of Ingredients (Subscription, Support, Professional and Other Costs) $0.24
- Taste Testing (Research and Development) $0.15
- Posters (Marketing and Sales) $0.51
- Lending Dad Money (Accounts Receivable) $0.10
- Borrowing Money From Mom (Financing Activities) $0.10
In total, this is $1.10 which explains the need for additional sources of revenue and the financial loss we see in the annual reports. By cherry-picking the sources of cash and sources of cost, this also explains how the financial loss is turned into a Non-GAAP profit.
Marketing and Sales absorbs half of the revenues received by Salesforce. This compares to, say, Microsoft whose Marketing and Sales runs at around 18c to the dollar (18% of revenue).
In terms of historical norms, ingredient costs have remained constant. Research and development appears to be increasing in cost, relative to revenue, which strikes me as unusual. Generally costs remain fixed or reduce as volume increases. Marketing and Sales are less than they were back in 2003-2004 but now seem to have flattened, relative to revenue. The other two (Accounts Receivable and Financing Activities) have no discernable pattern in terms of growing or shrinking.
What Happens If Sales Flatten?
Salesforce has enjoyed strong, on-going sales growth of over 20% year on year since 2003. However, Hawaii is an island and, similarly, markets are not infinite in size so sales will eventually flatten. When all the possible market share has been grabbed, Salesforce will rely on its existing subscription base to support it. How will this affect our cash sources and sinks?
With the client base regularly buying their lemonade, sales will remain constant and this source of revenue will remain the same. It is assumed defections will be countered by new sales.
However, with flattening sales, the future prospects of Salesforce will not be as rosy and the optimistic share price (based on consideration of stock’s P/E ratio) will flatten or drop. Marc’s sister may be less interested in buying shares in the business and this source will diminish, relative to sales.
With the only new sales being those to cover clients defecting to other lemonade stands, the loyalty program will disappear or diminish significantly as the new sales dry up.
Ingredient costs will remain the same and, as the lemonade quality needs to be maintained, I argue taste testing (R&D) will remain the same to maintain the existing client base.
Posters (marketing and sales) may increase to bolster demand but let us be generous and assume it will remain the same to ensure when the existing clients think of lemonade, they think of Marc’s lemonade. In terms of Salesforce, I am assuming marketing spend remains the same and the Salesforce sales team continue to get commission on active subscriptions.
Lending Dad Money (Accounts Receivable) will remain the same or increase as credit terms are relaxed to maintain the client base.
Borrowing from Mom (Financing Activities) will need to remain flat if the business is to be sustainable. We cannot rely on Mom to constantly bail us out.
Therefore, overall, if sales flatten, cash inflows will reduce and costs will remain the same or increase. With the current cash profit level of 2% (2c for every lemonade sold) we do not have a lot of wiggle room. The only place I can see concessions being made is in a reduction in posters (Marketing and Sales) and this will have to go down from around 50c for every lemonade sold down to around 20c, in line with the competition, to cover the 30c loss in cash inflows from the share sales and the loyalty program. If the costs of the business increase, this will mean a further reduction in posters.
Salesforce is sustainable while sales continue to grow. Sales growth brings optimism to the share price (ensuring revenue from stock sales) and allows them to take money from new customers to cover the costs of existing customers. However, if sales growth falters, this will affect these sources of cash and Salesforce will need to get even more creative with their financing to support the costs in their business.
The GAAP financials advertise this warning but the unique growth profile has allowed Salesforce to defy the warning so far. I sincerely hope that Salesforce see the end of the sales growth coming and adjust their business accordingly.