With Salesforce (CRM) shares up a whopping 68% this year, including a 3% pop Thursday after another terrific earnings report, it may seem the right time to take profits. But we don’t believe the cloud software company’s incredible run is over — not even close. Improved profitability, demonstrated again in its fiscal 2024 second-quarter results reported Wednesday night, are behind Thursday’s gains. In fact, Salesforce’s adjusted operating margins blew past Wall Street estimates for the third quarter in a row, fresh evidence that the Marc Benioff-led firm can continue to boost profits while also growing at scale. We see that approach driving shares much higher from here. In fact, Jim Cramer says the stock should work its way back to its old highs above $300 per share reached almost two years ago – nearly 40% above where it’s trading Thursday. “This quarter puts Salesforce in a league of its own and isn’t being appreciated nearly enough at these prices,” Jim says. “Even as the stock has rallied, it deserves to go much higher because [Benioff is] still not satisfied with the current numbers.” CRM YTD mountain Salesforce’s year-to-date stock performance. The current margin numbers are quite impressive considering where Salesforce stood a year ago. In the fall, a swarm of activist investors — starting with Starboard Value’s Jeff Smith — began to push for improvements at the company. When Starboard disclosed stake in the firm in October, Smith chided Salesforce’s “subpar mix of growth and profitability” compared with its business software brethren. That is likely why Salesforce stock traded at a valuation “well below” its peers, Smith argued at the time. He centered that belief on a software investing concept called the “Rule of 40.” The basic idea is that ideally a company’s revenue growth rate and operating margin, when added together, should total at least 40%. In its October presentation on Salesforce, Starboard said the Club holding checked in at 37.4%, while a group of seven peers — including ServiceNow (NOW), Adobe (ADBE) and Workday (WDAY) — had an average of 49.4%. That’s a 12-percentage-point difference. Salesforce’s reinvention efforts have closed its Rule of 40 gap to about 9 percentage points, the Club found Thursday, based on our analysis of financial results. Over the past two quarters, Salesforce’s revenue growth rate plus its adjusted operating margin has risen to 41%, compared with 50.1%, on average, for its peers. For context, here’s the full list of Salesforce peers included Starboard’s presentation: Club holding Microsoft ‘s (MSFT) productivity and business processes segment, Adobe, Club holding Oracle (ORCL), Intuit (INTU), ServiceNow, Workday and SAP (SAP). For each company (or business unit), except Intuit, our analysis focused on the year-over-year revenue growth rates and adjusted operating margin in their two most recent quarterly reports. That allowed us to evaluate the more profitable version of Salesforce against the recent performance of rivals. For Intuit, we used data from the company’s past two fiscal years because the parent company of TurboTax has extreme seasonality in its quarterly results, due to massive jumps in revenue and profit in the three-month period that includes the U.S. tax filing deadline. Using full-year figures enabled us to smooth out that seasonality, and take a more-complete look at Intuit’s mix of profitability and growth. Salesforce has made significant strides on profitability as a result of its own cost discipline, which included sizable job cuts . Over the past two quarters, the company’s adjusted operating margin has been an average of 29.6%, versus the 20.4% included in Starboard’s analysis. However, Salesforce’s top-line growth has come under pressure. A souring macroeconomic situation led customers to tighten their IT-spending belts, leading to sales growth of 11.35% over the past two quarters. That’s down from the 17% sales growth from October. “You get any economic lift, [and] you are going to get much higher sales and huge leverage given the expense controls,” Jim says. Additionally, Salesforce’s nascent generative artificial intelligence tools should help reaccelerate sales growth, he noted. When Salesforce’s revenue growth picks up again — combined with the potential for further improvements on profitability — that should nudge its Rule of 40 score closer to the 50% level where its peers have been. If that happens, the significant valuation discount between Salesforce and its software rivals deserves to narrow, translating into further upside for CRM shares back toward its old high. Despite CRM’s rally so far this year, it’s still down about 28% from that November 2021 peak. Tale of the valuation tape Our analysis Thursday shows that Salesforce is still trading at a discount to the group of seven, based on the two valuation methodologies used by Starboard in October: Enterprise value to sales, and price to free cash flow (FCF). After normalizing for their different Rule of 40 scores, we found that Salesforce trades at a roughly 20% discount on an enterprise value-to-sales basis compared with the average multiple of its even peers. On a price-to-FCF basis, the stock trades at an approximately 4% discount to the rival group average. To illustrate how a closing Rule of 40 adjusted valuation gap could translate to upside in the stock price, imagine for a moment if Salesforce traded at an EV-to-sales multiple in line with its seven peers, adjusted appropriately for its below-average Rule of 40 result. Our analysis shows the stock should trade closer to $290 per share. Extending the same logic to its peer’s price-to-FCF multiple, and the result is a $240 per share. A blended average price target of these two valuation methodologies would be around $265 per share. Importantly, that $265 target is strictly the result of applying current average peer valuation to Salesforce’s current growth/profit mix. As growth and profitability improve — and we fully expect that to be the case — then even more upside should be realized as we would be applying a multiple more in line with the peer group average to a higher Rule of 40 score. Put another way, a higher EV/S multiple on a larger sales number or a higher P/FCF multiple on a higher FCF number. To get a sense of how much higher the price could go if our thesis plays out and management does indeed close the Rule of 40 gap, consider that if were we to take the current peer average valuation multiples and apply them to CRM currently, you get a blended price target of around $322.75. That would be a new all-time high. (Jim Cramer’s Charitable Trust is long CRM. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. 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With Salesforce (CRM) shares up a whopping 68% this year, including a 3% pop Thursday after another terrific earnings report, it may seem the right time to take profits.
But we don’t believe the cloud software company’s incredible run is over — not even close.
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