A Force to Be Reckoned With

In its highly anticipated initial public offering Wednesday, Salesforce.com (CRM) saw its shares soar 56% to $17.20. It was the best first-day showing by a technology IPO this year, surpassing Friday's 43% rise of educational-software maker Blackboard (BBBB). Only the upcoming offering of stock in search engine Google is generating more excitement among tech investors.

"There's a small float and a lot of pent-up demand," says Francis Gaskins, editor of IPOdesktop.com, a Los Angeles research firm, who says 90% of the company will still be held by insiders. "A lot of people want to own a little bit of Salesforce. And that's because you don't often find companies that are market leaders with these kinds of gross margins. This company has 82% gross margins, and that puts it into a category by itself."

Salesforce sells customer-relationship-management, or CRM, software (hence its ticker symbol) that helps sales representatives track customer accounts. While useful, the technology isn't new. Siebel Systems (SEBL), the leading vendor of traditional CRM software, has been selling it for years. What makes Salesforce's CRM software so attractive — and its stock so compelling — is the fact that it's entirely Web-based, meaning Salesforce doesn't install its products on customers' computers. Rather, its software runs at Salesforce's own data centers, and businesses pay a monthly subscription fee to access it on demand. For budget-conscious companies, not laying out huge amounts of money for a complicated system that can take months of integration has been a blessing. Siebel also offers an on-demand service, in addition to its more prevalent traditional CRM software.

The five-year-old company claims nearly 9,800 customers in 65 countries that have purchased more than 147,000 software subscriptions. For its 2004 fiscal year ended Jan. 31, Salesforce earned $3.5 million, or four cents a share, on revenue of $96 million. It was the company's first profitable year. For its first quarter ended April 30, it earned $437,000 as revenues soared 84% to $34.8 million. In a June 17 report, Fulcrum Global Partners' Jamie Friedman, the only analyst covering the stock, projected the company would earn 12 cents a share for fiscal 2005 and 29 cents for fiscal 2006. (Friedman doesn't own shares of Salesforce; Fulcrum doesn't have an investment-banking relationship with the company.)

Demand for the IPO has been steadily increasing since the company filed for the offering in December. Back in April, Salesforce expected shares to sell for between $7.50 and $8.50 apiece. By early this week, the target price climbed to between $9 and $10. Then late Tuesday, the company priced the offering of 10 million shares above the range at $11 each. Not even an earnings restatement and ill-timed comments by the chief executive, which resulted in the Securities and Exchange Commission delaying the IPO, dissuaded interest in the stock.

In April, Salesforce restated sales commissions and marketing expenses it had reported the previous two years. For fiscal 2002, it lowered sales expenses to $24.6 million from $25.2 million, while in fiscal 2003, expenses rose to $33.5 million from $33.1 million. This narrowed the 2002 net loss to $28.6 million from $29.2 million, and widened the 2003 loss to $9.7 million from $9.3 million.

Then on May 9, Chief Executive Marc Benioff gave an interview to the New York Times during the mandated "quiet period," a stretch preceding public stock sales when communication by company executives is limited. Benioff was accused of hyping the company, and the SEC imposed a 30-day cooling-off period, during which time the shares couldn't be marketed to potential investors. In documents filed with the SEC, the company said it may have violated securities law. If the SEC rules against the company, it may be forced to rescind the IPO and buy back all the shares, though most market watchers consider such a drastic ruling unlikely.

In another twist, before the Dec. 18 filing of the preliminary prospectus, CEO Benioff sold two million shares to an institutional shareholder at what was then an estimated IPO price of $8 apiece. The move raised eyebrows among some on Wall Street.

"Normally you don't see the CEO selling just before the company files," says Gaskins of IPOdesktop.com. Such a move could be interpreted as a lack of confidence in a stock, he says. "It messed around with the income statements, and then [CEO Benioff] sold $16 million worth of shares. Still, after the offering, he holds 27.8% of the company."

Despite its spectacular stock-market debut, Gaskins sees potential obstacles to Salesforce's long-term success.

"It's spending 72% of gross margins on marketing and sales," he says. "It's like a rat in a cage. It needs to keep running fast just to stay even, because if revenue growth falters, then people won't hold the stock. And when you spend as much as it does on marketing and sales, it can't falter one bit."

Salesforce also isn't expensing stock options, a big part of its employee compensation. If options had been expensed in the first quarter, Gaskins says they would've totaled $2 million, changing that period's profit to a $1.5 million loss. This could prove to be a problem next year, when accounting rules change and mandate most U.S. companies treat options as expenses. (Gaskins doesn't own shares of Salesforce.com; IPOdesktop.com doesn't have a business relationship with the company.)

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"I do believe that every technology stock, or every offering that is more than just a marginal position, will be another foundation layer for a more robust IPO market," says David Menlow, president of IPOfinancial.com, a research firm in Millburn, N.J. "This is a stock that opened four points higher, hovered in a certain range most of the day, then people said, 'It's not going down, we need to buy it.' When you hear that Siebel Systems cut its prices because it was worried about Salesforce's business model, this is something investors will look at a little deeper." (Menlow doesn't own shares of Salesforce.com; IPOfinancial.com doesn't have a business relationship with the company.)