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See attachment for assignment details
sources are attached for usage, but additional (current/up to date) sources will be needed.
We began this course with a question: “How can we identify which businesses are great?”
In attempting to answer this, we have explored a number of concepts and tools that investors and financial managers have at their disposal. As we looked at these, we found that two terms, Value and Growth, were frequently used to refer to two broad ways of characterizing companies and investment approaches, but we noted that neither is mutually exclusive of the other in identifying a great company.
This assignment invites you to consider how these terms apply to Salesforce.com, and how one or the other may be a better descriptor of certain products or services of the business, depending on how one views the playing field in which the company competes. As you engage in this assignment, you will draw on financial facts presented in the report to formulate and defend your position. Merely presenting a number, ratio or trend will not be sufficient to earn a high grade.
Instructions
To complete this assignment, you will need to:
Re-read the analyst report “May the Force be With You: Wide-Moat Salesforce.com is the Newest Software Empire”
Read the 2016 Salesforce.com Annual Report (Pages 3-11)
Review additional Salesforce.com valuation and financial data available on the Morningstar.com website by following this link.
Also, you will find it helpful to review the Moat Analysis and Value Creation Checklist, and the Value Investing and Growth Investing Checklist as the categories for the questions below are summarized in those checklists.
This assignment is organized around the FIVE areas of analysis in the “May the Force be With You: Wide-Moat Salesforce.com is the Newest Software Empire” report. Refer to each section of the report as identified below and answer the questions that follow.
1. Review the section on “CRM Opportunity”
a. In what stage of the Competitive Life Cycle is the company?
b. What are the most significant barriers to entry that competitors face? Explain.
2. Review the section on “Sales Cloud Analysis”
a. What are the 5 key moat considerations that Salesforce.com must address in this market?
b. Which of these are most important? Explain.
3. Review the section on “Service Cloud Analysis”
a. Briefly summarize how Porter’s Five Forces apply to this market.
b. What are the most important competitive advantages that Salesforce.com has in this market? Explain.
4. Review the section on “Marketing Cloud Analysis”
a. Briefly summarize the Lay of the Land in this market.
b. What are the most important customer advantages (product attributes, horizontal differentiation, etc.) to doing business with Salesforce.com? Explain.
5. Review the section on “Commerce Cloud Analysis”
a. What technology or process disruptions/disintegrations exist that could create challenges in this market?
b. Which of these present the most realistic threats/opportunities? Explain.
Submission Requirements
Your work for this assignment is to be submitted in the format of an academic paper, including: cover page, executive summary, body, conclusion and references.
The length of the body of your paper is to be between of 5 and 8 pages (double-spaced using 12-point font).
Note that each topic of analysis has an (a) and (b) component to it.
o For the first part (a), you are expected to provide a BRIEF SUMMARY in response to the question. This will require you to correctly identify the position in the analyst report and to craft a synopsis demonstrating that you understand the facts of the author’s positon
o For the second part (b), you must present and defend YOUR POSITION. Your opinion may be in line with positions held in the report or they may differ. What is most important is that your responses show you are thinking about what you are reading and that you are applying appropriate financial tools and concepts to explain why you hold the opinions you do.
o
You are encouraged to use charts, graphs, ratios, and figures in each section to defend your position.
o As a general guide, each section of your paper should be approximately 1/3 for part (a) and 2/3 for part (b).
For each of the five topics above, you must include at least one additional resource to support your position. These resources can include:
o The textbooks from the course
o http://www.morningstar.com/stocks/XNYS/CRM/quote.html
o Salesforce.com Annual Report
o Recent news articles
PLEASE ENSURE THAT THE DETAILS OF THE ASSIGNMENT ARE READ THOROUGHLY. ALSO, WORK HAS TO BE PLAGIARISM FREE AND GRADE A WORK.
1
JWI-531
FINANCIAL MANAGEMENT II
CHECKLISTS
CONTENTS
MOAT ANALYSIS AND VALUE CREATION: Weeks 1-3 ………………………………………………………….. 2
VALUE INVESTING AND GROWTH INVESTING: WEEKS 4-10 ……………………………………………… 4
ENTERPRISE RISK MANAGEMENT: WEEK 6 ………………………………………………………………………… 6
FINANCIAL STATEMENT ANALYSIS: WEEK 9 ……………………………………………………………………… 8
* Material in these checklists is taken from Credit Suisse: “Measuring the Moat” and from
original sources for use by JWI-531 students only.
2
MOAT ANALYSIS AND VALUE
CREATION: WEEKS 1-3
Why Moats Matter: Guiding Principles of
Morningstar’s Equity Research
How Can We Identify Which Businesses
Are Great?
When Is the Best Time to Invest in
Great Businesses?
What Makes a Moat?
Sustainable Competitive Advantages
Valuation
Margin of Safety
Moat Sources – Five Key Considerations for
Moat Trends
Intangibles
Cost Advantage
Switching Costs
Network Effect
Efficient Scale
Moat Valuation
Cost of Capital and Returns on Capital
Morningstar’s Valuation Approach
Ratio Analysis – ROIC, Price/Earnings,
Price/Sales, Price/Cash Flow, and
Price/Book value
Forecasting Future Free Cash Flows
The Morningstar Rating ™ for Stocks
Fair Value Uncertainty and Cost of
Equity
Putting Moat and Valuation to Work:
Portfolio Strategies
Wide Moat Focus Index
The Tortoise and Hare Portfolios
Analysis Overview
In what stage of the competitive life
cycle is the company?
Is the company currently earning a
return above its cost of capital?
Are returns on invested capital
increasing, decreasing, or stable? Why?
What is the trend in the company’s
investment spending, including mergers
and acquisitions?
Lay of the Land
What percentage of the industry does
each player represent?
What is each player’s level of
profitability?
What have the historical trends in
market share been?
How stable is the industry?
How stable is market share?
What do pricing trends look like?
What class does the industry fall into:
fragmented, emerging, mature,
declining, international, network, or
hypercompetitive?
Porter’s Five Forces
How much leverage do suppliers have?
Can companies pass price increases
from their suppliers on to their
customers?
Are there substitute products available?
Is there Product differentiation?
Are there switching costs? Is there a
competitive advantage through cost
leadership, or focus
How much leverage do buyers have?
How informed are the buyers?
Boston Consulting Group Approach
Historical emphasis: experience curve,
product life cycle, product portfolio
balance
Impact of the Internet and other
innovations
Performance measurements – cash flow
return on investment (CFROI)
Barriers to Entry
What are the rates of entry and exit in
the industry?
How will the incumbents react to the
threat of new entrants?
What is the reputation of incumbents?
How specific are the assets?
What is the minimum efficient
production scale?
Does the industry have excess
capacity?
Is there a way to differentiate the
product?
3
What is the anticipated payoff for a new
entrant?
Do incumbents have pre-commitment
contracts?
Do incumbents have costly licenses or
patents?
Are there benefits from the learning
curve?
Rivalry
Is there pricing coordination?
What is the industry concentration?
What is the size distribution of firms?
How similar are the firms in incentives,
corporate philosophy, and ownership
structure?
Is there demand variability?
Are there high fixed costs?
Is the industry growing?
Disruption and Disintegration
Is the industry vulnerable to disruptive
innovation?
Do new innovations foster product
improvements?
Is the innovation progressing faster than
the market’s needs?
Have established players passed the
performance threshold?
Is the industry organized vertically, or
has there been a shift to horizontal
markets?
Firm Specific Analysis
Does the analysis of the value chain
reveal what the firms does differently
from its rivals?
Does the firm have production
advantages? Is there instability in the
business structure? Is there complexity
requiring know-how or coordination
capabilities? How quickly are the
process costs changing?
Does the firm have any patents,
copyrights, trademarks, etc.?
Are there economies of scale? What
does the firm’s distribution scale look
like? Are assets and revenue clustered
geographically? Are there purchasing
advantages with size? Are there
economies of scope? Are there diverse
research profiles?
Are there consumer advantages? Is
there habit or horizontal differentiation?
Do people prefer the product to
competing products? Are there lots of
product attributes that customers
weigh? Can customers only assess the
product through trial? Is there customer
lock-in? Are there high switching costs?
Is the network radial or interactive?
What is the source and longevity of
added value?
Are there external sources of added
value (subsidies, tariffs, quotas, and
competitive or environmental
regulations)?
Firm Interaction—Competition and
Coordination
Does the industry include
complementors?
Is the value of the pie growing because
of companies that are not competitors?
Or, are new companies taking share
from a pie with fixed value?
Brands
Do customers want to “hire” the brand
for the job to be done?
Does the brand increase willingness to
pay?
Do customers have an emotional
connection to the brand?
Do customers trust the product because
of the name?
Does the brand imply social status?
Can you reduce supplier operating cost
with your name?
4
VALUE INVESTING AND
GROWTH INVESTING:
WEEKS 4-10
Value Investing
Value Investing and Two Essential
Principles – It’s Like Buying Christmas
Cards in January
P/E averages, avoid temptations
Does Value Investing Really Work?
Performance of High versus Low P/E
stocks
Performance of High versus Low
Market-to-Book Stocks
The Power of Multiple Variables
Growth Investing
How to Identify Growth Stocks
Importance of Track Record: Sales and
Earnings
Is There Potential to Grow Sales and
Earnings for Several Years?
How Are Relations with Employees?
How Does the Company Respond to
Challenges?
Is Management Quality Excellent?
How Important Are Profit Margins?
What Is the Company’s Achilles’ heel?
Intrinsic Value
When to Buy Any Stock: Consider
Margin of Safety
The Buffett Investing = Value + Growth
Value Plus Growth
Risk and Volatility: How to Think Profitably
about Them
Risk and Return: Holding Period impact
Volatility Offers Opportunities. Volatility
is a great time to buy low or sell high
More on Downside Risk
Why Hold Cash: Liquidity Brings
Opportunities
Liquidity and the Opportunities it brings
Berkshire’s Investments in Convertibles
Diversification: How Many Baskets Should
You Hold?
Diversification in your portfolio
How Many Stocks Should You Hold?
Philip Fisher Warns against Too Much
Diversification
Diversification and “Diworsification”
When to Sell
Turnover of Berkshire’s Equity Portfolio:
Why Buffett Holds Almost Forever
Two Main Reasons to Sell
How Efficient Is the Stock Market?
Can I Make Money in the Stock Market?
Most Academics Favor Market
Efficiency Recent Evidence on Market
Inefficiency Conclusions
Arbitrage and Hedge Funds
Arbitrage in Merger Deals
An Example of a Successful Arbitrage
Deal by Buffett
Long-Term Capital Management: The
Story of a Hedge Fund and Berkshire
Hathaway
Should You Invest in Hedge Funds or
Private Equity Funds?
Widen the Moat
What is the profitability of Monopolies?
Dominance Does Not Mean High Profits
How to Look for Monopolies
Do Not Sell a Monopoly in a Hurry
Who Wins in Highly Competitive Industries?
Insurance example: Insurance is a
Commodity Business Like Retailing
Two Main Characteristics of a Leader:
Low Cost and Customer Satisfaction
How Do Companies Keep Costs Low?
Property, Plant, and Equipment: Good or
Bad?
Capital Intensity
Capital Intensity and Management
Quality
Key to Success: ROE and Other Ratios
ROE: Return on Equity. The underlying
Performance of a Business
ROA: Return on Assets. Some
companies create more value with the
assets they have.
Accounting Goodwill: Is It Any Good?
Accounting Goodwill and Its Economic
Value
Goodwill and Earnings
5
Goodwill and Profitability of Acquired
Businesses
Behavioral Finance
Behavioral finance tells us that investors
always don’t behave rationally.
When combined with overconfidence,
anchoring and herding can contribute to
market bubbles.
Examine Your Buying and Selling
Patterns: Can You Change Yourself?
How Psychology May Help You? How to
Think about Psychological Biases?
Herding: The assumption by many is
that others have better information than
ourselves and we should follow another
investor’s lead instead on our own
rationale. This can be a costly mistake
for many as this type of thinking only
adds to the panic inside of a market
bubble.
Bigger Fool Theory: States that
investors periodically loose site of the
long run nature of the stock as
investment and forget that in order to
sell a stock at a profit, one must find a
buyer who will pay a higher price.
Anchoring bias: describes how we
associate past performance to future
predictions. While recent and past
events can give us an idea of what to
expect, this is in no way indicative of
what the future will bring. The addition of
our own over confidence in our ability to
predict makes this an issue.
How to Learn from Mistakes
Mistakes versus Bad Luck: mistakes are
a result of effort
Learning from Mistakes: As managers,
mistakes makes us better managers
Mistakes of Commission and Mistakes
of Omission
Dividends: Do They Make Sense in This Day
and Age?
Why does Berkshire Not Pay
Dividends?
Example of Microsoft and a Special
Dividend
Should You Invest in Companies That
Repurchase Their Own Shares?
Share Repurchasing Is Good News
Share Repurchases by Companies in
Which Berkshire Has Invested
Why Doesn’t Berkshire Repurchase Its
Own Shares?
Corporate Governance: Employees,
Directors, and CEOs
Employee Compensation at Berkshire
Compensation for Directors and
Executive Officers
What Is Wrong with Compensation
through Stock Options?
How to Identify Good CEOs or Other
Senior Managers
Large Shareholders: They Are Your Friends
Founder Control Matters
6
ENTERPRISE RISK
MANAGEMENT: WEEK 6
Financial Risks
Price – is the margin on products
sufficient to meet operating expenses
and generate a profit? Are prices being
pushed up or down by competition or
customers?
Liquidity – Is there positive cash flows
and ability to meet investing, operational
and cash flows? Check Statement of
Cash Flows
Credit Worthiness – compare credit
rating amongst firms
Valuation Risk – does the company’s
stock value have high or low volatility
Business model – is the company
hedging for financial risks such as
foreign currency?
Taxation Risk – taxes can factor into a
business model, products or locations.
Interest Rate Risk: cash flows decline
when interest rates rise.
Downgrade Risk: is there a risk that
agencies will downgrade the ratings.
This might be an indication that the
issuer company might default in the
future.
Inflation Risk: costs or revenues can be
impacted by changes in inflation
Default/Credit Risk: Does the company
have any issues in making interest and
principal payments. Default risk is
inversely related to credit quality.
Currency Exchange (Denomination)
Risks: For example: If we purchase a
corporate bond denominated in Euros,
and if Euro value falls relative to US
dollar, then we will lose money even if
the company does not default on its
bonds.
External Risks
Regulatory: are regulations or tax laws
changing the business model?
Legal: are there large pending lawsuits?
Investor Relations: are there many or
few large investors? Are investors
demanding change in the management?
Competitors: Is the industry highly
competitive where the products and
services are a commodity, or an
oligopoly, or significant product/services
differentiation?
Financial Markets: Are there sources for
borrowing of funds, issuance of bonds
Catastrophic Loss: is there the potential
for large losses? For example, patents
expiring? Large insurance claims?
Sovereign/Political Risk: is the company
exposed to country risks in its
international operations?
Strategic Risks
Market Bubbles: Prices climb rapidly to
heights that would have been
considered extremely unlikely before the
run –up. The volume of trading is much
higher than past volume. Many new
investors enter the market (speculators).
Prices suddenly fall, leaving behind the
new investors with heavy losses.
Leadership: is there poor leadership, or
loss of leaders due to death or illness?
Strategic and Tactical Alignment: are
the tactical initiatives going in the same
direction as the strategy?
Planning: what is the quality of the
financial forecasts?
Communication: is management able to
properly communicate the strategy and
risks?
Business Model: is the company
maximizing the core value drivers?
Reputation risk: is the firm exposed to
activities that can damage its reputation
with consumers or business partners?
Operational risks
Product Pricing: are margins too low? Is
the market so competitive that prices
cannot be increased?
Customer: is the company dependent of
a few large clients? How does the 80/20
rule apply to the client base?
Human Resources: are there issues in
hiring resources domestically,
internationally? Are staff costs
competitive?
Product Development: is the firm
investing in R&D? How does it compare
to the competition?
Supply Chain: does the firm have
advantages in the buying, building,
delivering and stocking inventory?
7
Business Interruption: does the firm
have business continuity plans to
ensure mission critical activities
continue?
Compliance: is the firm meeting
regulatory requirements?
Audit: is the firm meeting internal and
external auditing requirements?
Information Risks
Performance Measurement: are the
right revenue and costs activities being
monitored and managed?
Budget and Planning: is forecasting
realistic and relative to internal and
external factors?
Accounting Information: is accounting
data available in a timely and
consolidated manner?
Financial Reporting: is the reporting
being done in accordance to GAAP and
IFRS and meeting all disclosure
requirements?
Technology Risks
Financial systems: are the financial
applications capable of processing the
right data and producing the proper
management and financial reports?
Access: are there risks of external
hacking and the stealing of sensitive or
financial data?
Availability: do the financial systems
have disaster recovery and business
continuity plans?
Infrastructure: is the age of the
technology mean large and costly
expenditures in the near future?
8
FINANCIAL STATEMENT
ANALYSIS: WEEK 9
Assess the Quality of the financial
statements
Form 10-K Annual Report
Proxy Statements
Prospectus or Registration Statement
Industry Analyst Ratings
Shareholder Letters
Annual Report to Shareholders
Regulatory Reports
Value the Firm
Review Market versus Book Valuation
Historical technical trends on the value
of the stock
Calculate valuation based on
Dividends, Earnings, Cash flows,
Calculate and compare Intrinsic Value
vs DCF
Identify Company Strategy
What is the nature of products or
services?
How is the integration within value
chain?
What is their geographical
diversification?
What is their industry diversification?
Is the firm targeting its products or
services to its domestic market or
integrating horizontally across many
countries?
Essential elements in financial statement
analysis
Assess changes in the environments:
are there new regulations, competitors,
changes in the economy, new markets
they have entered?
Evaluate company capabilities and
limitations: what the company’s primary
capabilities?
Assess of expectations of stakeholders
Analyze company, competitors, industry,
domestic economy and international
economies
Analyze the missions, goals and policies
for the master strategy
Determine critical environmental
changes
Analyze Profitability and Risk
Review or prepare common-size
financial statements
Review percentage change in financial
statements year over year
Review Financial Statement Ratios and
identify variance anomalies and
compare to industry and major
competitors
What are the Profitability Ratios:
EBITDA, Product, EPS, ROCE, and
they in growth or decline?
What are the Risk Ratios: Current Ratio,
Debt to Equity Ratio etc.
Project Future Financial Statements
Identify Economic Characteristics and
Competitive Dynamics in the Industry
Prepare a value chain analysis
Prepare an Economic Attributes
Framework
Conduct an Industry analysis
Conduct a Competitor analysis
Conduct a Supplier analysis
Conduct a Customer analysis
Determine if there are Substitute
products that can impact sales
Determine if there are technology
changes or disruptors that can impact
sales or costs – including those of the
competitors
Determine if societal factors have an
impact on sales
Review the firm’s strengths/weaknesses
relative to present/future industry
conditions
Create a goal/capability analysis: Are
current goals, policies appropriate? Do
goals, policies match resources? Does
timing of goals/policies reflect ability of
firm to change?
Alternative Analytical Frameworks
Product life cycle – introduction, growth,
maturity, decline stages with changing
opportunities, threats
Learning curve – costs decline with
cumulative volume experience (first
mover advantage)
9
Competitive analysis – industry,
suppliers, customers, complementary
products, etc.
Value chain analysis – seek to add
product characteristics valued by
customers
Niche opportunities – specialize in
particular needs or interests of customer
groups
Cost leadership – low-cost advantages
Product differentiation – develop
products that achieve customer
preference
Product breadth – carryover of
organizational capabilities
Correlations with profitability – statistical
studies of factors associated with
profitability
Market share – high market share
associated with competitive superiority
Product quality – customer allegiance
and price differentials for higher quality
Technological leader – keep at
knowledge frontiers
Resource-based view – capabilities are
inimitable
Relatedness matrix – unfamiliar markets
and products involve greatest risk
Focus matrix – narrow versus broad
product families
Growth/share matrix – aim for high
market share in high growth markets
Attractiveness matrix – aim to be strong
in attractive industries
2
0
1
6
A
N
N
U
A
L
R
E
P
O
R
T
The evolution came in waves.
The mainframe.
The client server.
And the cloud.
Now, the next wave is building.
A fourth industrial revolution is here.
But the biggest change underway today is not happening in technology itself.
It’s happening to the customer.
Your customer.
Technology, mobility, and the Web have made the customer smarter, faster,
and more in control than ever before.
And they’re looking for a trusted advisor.
They want a platform they can build and shape with you into the future.
They want deep, meaningful insights.
And before they meet you, they want to meet your community.
For the past 17 years, our focus as a company has been on one simple thing:
the customer.
And we’re moving into the future with the same focus, bringing you
data science, analytics, and the Internet of Things to name just a few.
Now a
FORTUNE 500
Company
hero
24%
REVENUE GROWTH
JOHN EDELMAN
CEO
DESIGN WITHIN REACH
Salesforce helps
us offer the kind of
service that — like good
design — never goes
out of style.
“
source: Forbes
One of the
MOST INNOVATIVE
COMPANIES
in the world.
BARBARA AGOGLIA
GLOBAL HEAD OF E2E MARKETING FOR
CORPORATE PAYMENTS
AMERICAN EXPRESS
“
source: Fortune Magazine, 2015
World’s Most
Admired Software
Company
#1
We use Salesforce
to nurture our
relationships with
both prospects and
customers.
FY16
$6.67
BILLION
in revenue
THE CUSTOMER.FOR 17 YEARS, our focus as a company has been on one simple thing:
Salesforce delivered another exceptional year of growth and customer
success. We reached $6 billion in annual revenue faster than any other
enterprise software company, and we expect to surpass $8 billion in
fiscal year 2017, on our way to our next milestone of $10 billion.
Fiscal year 2016 marked the year that Salesforce became a Fortune 500
company, and was once again ranked by Forbes as one of the “World’s
Most Innovative Companies” and recognized by Fortune Magazine as
one of the “Most Admired Software Companies” and one of the “Top
Ten Companies to Work For.” Our success is driven by our undivided
focus on making our customers successful and helping them connect
to their customers in a whole new way.
We are in the Age of the Customer, where powerful technology forces
driven by the cloud, social, mobile, data science, and the Internet
of Things have opened a door for every company to transform their
business models and customer experiences.
With our industry-leading Customer Success Platform, Salesforce is
uniquely positioned to bring our customers into the future. We meet
with thousands of CEOs across every industry and region, and they are
turning to Salesforce as trusted advisors to help them digitally transform
their businesses and become more customer-centric companies. As
a result, we hit an all-time high in large transactions this year and are
winning some of the largest and most strategic transactions in the
enterprise software industry. As we look to the year ahead, we will
continue to deliver the industry’s most exciting, innovative products and
invest in opportunities to expand our market leadership.
Salesforce is not just transforming businesses, we are also transforming
our communities. Since inception, the Salesforce Foundation,
Salesforce.org, and Salesforce have together given nearly $120 million
in grants, more than 1.3 million hours to the community, and our
service offerings to nearly 28,000 nonprofit and higher education
organizations.
I would like to extend our gratitude to our more than 150,000
customers and partners for their inspiration, and our more than
20,000 employees around the world for living our core values — trust,
innovation, growth, and equality — and delivering customer success
every day. And, our gratitude to you, our stockholders, for your
continued support of Salesforce.
Aloha,
8121Insert_FrontC5.indd 18121Insert_FrontC5.indd 1 4/15/16 11:17 AM4/15/16 11:17 AM
THANK YOU
for driving us.
THANK YOU
for inspiring us.
AND AS ALWAYS,
THANK YOU
for making us
who we are today.
source: Fortune Magazine, 2015
#1 World’s Most
Admired Software
Company
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
È Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended January 31, 2016
OR
‘ Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Commission File Number: 001-32224
salesforce.com, inc.
(Exact name of registrant as specified in its charter)
Delaware 94-3320693
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
The Landmark @ One Market, Suite 300
San Francisco, California 94105
(Address of principal executive offices)
Telephone Number (415) 901-7000
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
Common Stock, par value $0.001 per share New York Stock Exchange, Inc.
Securities registered pursuant to section 12(g) of the Act:
Not applicable
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act. Yes È No ‘
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of Act. Yes ‘ No È
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days: Yes È No ‘
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes È No ‘
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not
contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated
by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ‘
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller
reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act. (Check one):
Large accelerated filer È Accelerated filer ‘
Non-accelerated filer ‘ (Do not check if a smaller reporting company) Smaller reporting company ‘
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ‘ No È
Based on the closing price of the Registrant’s Common Stock on the last business day of the Registrant’s most recently completed
second fiscal quarter, which was July 31, 2015, the aggregate market value of its shares (based on a closing price of $73.30 per share) held by
non-affiliates was approximately $32.9 billion . Shares of the Registrant’s Common Stock held by each executive officer and director and by
each entity or person that owned 5 percent or more of the Registrant’s outstanding Common Stock were excluded in that such persons may be
deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
As of January 31, 2016, there were approximately 670.9 million shares of the Registrant’s Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s definitive proxy statement for its 2016 Annual Meeting of Stockholders (the “Proxy Statement”), to be filed
within 120 days of the Registrant’s fiscal year ended January 31, 2016, are incorporated by reference in Parts II and III of this Report on
Form 10-K. Except with respect to information specifically incorporated by reference in this Form 10-K, the Proxy Statement is not deemed
to be filed as part of this Form 10-K.
salesforce.com, inc.
INDEX
Page No.
PART I
Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Item 1A. Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Item 1B. Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 4. Mine Safety Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Item 4A. Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations . . 38
Item 7A. Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Item 8. Consolidated Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . . 117
Item 9A. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
Item 9B. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
PART III
Item 10. Directors, Executive Officers and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Item 13. Certain Relationships and Related Transactions and Director Independence . . . . . . . . . . . . . . 119
Item 14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
PART IV
Item 15. Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Index to Exhibits
2
FORWARD-LOOKING INFORMATION
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of
1934, as amended (the “Exchange Act”). Words such as “expects,” “anticipates,” “aims,” “projects,”
“intends,” “plans,” “believes,” “estimates,” “seeks,” “assumes,” “may,” “should,” “could,” “foresees,”
“forecasts,” “predicts,” variations of such words and similar expressions are intended to identify such forward-
looking statements, which may consist of, among other things, trend analyses and statements regarding future
events, future financial performance, anticipated growth and industry prospects. These forward-looking
statements are based on current expectations, estimates and forecasts, as well as the beliefs and assumptions of
our management, and are subject to risks and uncertainties that are difficult to predict, including the effect of
general economic and market conditions; the impact of foreign currency exchange rate and interest rate
fluctuations on our results; our business strategy and our plan to build our business, including our strategy to be
the leading provider of enterprise cloud computing applications and platforms; our service performance and
security; the expenses associated with new data centers and third party infrastructure providers; additional data
center capacity; real estate and office facilities space; our operating results; new services and product features;
our strategy of acquiring or making investments in complementary businesses, joint ventures, services,
technologies and intellectual property rights; our ability to successfully integrate acquired businesses and
technologies; our ability to continue to grow and maintain deferred revenue and unbilled deferred revenue; our
ability to protect our intellectual property rights; our ability to develop our brands; our ability to realize the
benefits from strategic partnerships and investments; our reliance on third- party hardware, software and
platform providers; the effect of evolving government regulations; the valuation of our deferred tax assets; the
potential availability of additional tax assets in the future; the impact of expensing stock options and other equity
awards; the sufficiency of our capital resources; factors related to our outstanding convertible notes, revolving
credit facility and loan associated with 50 Fremont; compliance with our debt covenants and capital lease
obligations; and current and potential litigation involving us. These and other risks and uncertainties may cause
our actual results to differ materially and adversely from those expressed in any forward-looking statements.
Readers are directed to risks and uncertainties identified below under “Risk Factors” and elsewhere in this
report for additional detail regarding factors that may cause actual results to be different than those expressed in
our forward-looking statements. Except as required by law, we undertake no obligation to revise or update
publicly any forward-looking statements for any reason.
PART I
ITEM 1. BUSINESS
Overview
Salesforce is a leading provider of enterprise cloud computing solutions, with a focus on customer
relationship management, or CRM. We introduced our first CRM solution in February 2000, and we have since
expanded our service offerings with new editions, solutions, features and platform capabilities.
Our mission is to help our customers transform themselves into customer-centric companies by empowering
them to connect with their customers in entirely new ways. Our Customer Success Platform, including sales force
automation, customer service and support, marketing automation, community management, analytics, application
development, Internet of Things integration and our professional cloud services, provide the next-generation
platform of enterprise applications, or apps, and services to enable customer success.
Our service offerings are intuitive and easy-to-use, can be deployed rapidly, customized easily and integrated
with other platforms and enterprise apps. We deliver our solutions as a service via all the major Internet browsers
and on leading mobile devices. We sell to businesses of all sizes and in almost every industry worldwide on a
subscription basis, primarily through our direct sales efforts and also indirectly through partners. Through our
platform and other developer tools, we also encourage third parties to develop additional functionality and new apps
that run on our platform, which are sold separately from, or in conjunction with, our services.
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We were incorporated in Delaware in February 1999. Our principal executive offices are located in
San Francisco, California, and our principal website address is www.salesforce.com. Our office address is
The Landmark @ One Market, Suite 300, San Francisco, California 94105.
The Age of the Customer
We believe that the convergence of cloud, social, mobile, data science and Internet of Things technologies is
fundamentally transforming how companies sell, service, market and innovate to connect with their customers.
Cloud computing has changed the way enterprise business apps are developed and deployed. Organizations
no longer need to buy and maintain their own infrastructure of servers, storage and development tools in order to
create and run business apps. Instead, companies can gain access to a variety of business apps via an Internet
browser or mobile device on an as-needed basis, without the cost and complexity of managing the hardware or
software in-house.
Social networking has transformed the way people engage and collaborate and is accelerating the adoption
of technologies that connect people, products and brands. In addition, the proliferation of mobile phones
worldwide continues, and enterprise mobile apps are making it possible for people to conduct business from their
phones anytime and anywhere.
Progress in data science and machine learning is moving companies beyond just automating business
processes to more data-driven, predictive computing solutions. As more people and devices become connected
via the Internet of Things, mobile devices and apps, companies are unlocking insights and turning data into
meaningful actions to help them to proactively engage one-to-one with customers in real time.
By bringing together the power of cloud, social, mobile, data science and Internet of Things technologies in
our Customer Success Platform, we believe Salesforce is at the forefront of enabling companies to digitally
transform into customer-centric companies.
Our Cloud Service Offerings
We provide enterprise cloud computing solutions that include apps and platform services, as well as
professional services to facilitate the adoption of our solutions. Our service offerings empower companies to
grow sales faster; deliver customer service on multiple devices and channels; enable marketers to create one-to-
one customer journeys; build branded communities for customers, partners and employees; deliver analytics for
every business user; turn data generated by the Internet of Things, or IoT, into meaningful actions; and develop
modern mobile and desktop apps quickly and easily.
Our service offerings are as follows:
Sales Cloud. The Sales Cloud enables companies to store data, monitor leads and progress, forecast
opportunities, gain insights through relationship intelligence and collaborate around any sale on desktop
and mobile devices. Our customers use the Sales Cloud to grow their sales pipelines, improve sales
productivity, simplify complex business processes and close more deals. The Sales Cloud also offers
solutions for partner relationship management (including channel management and partner communities)
and complete, accurate customer and contact information.
Service Cloud. The Service Cloud enables companies to deliver smarter, faster and more personalized
customer service and support. Our customers use the Service Cloud to connect their service agents with
customers at any time and anywhere, on popular devices and across multiple channels—phone, email,
chat, self-service web portals, social networks, online communities and directly within their own products
and mobile apps.
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Marketing Cloud. The Marketing Cloud enables companies to plan, personalize and optimize one-to-one
customer interactions. Our customers use the Marketing Cloud to map customer journeys to digital
marketing interactions across email, mobile, social, web and connected products. With the Marketing
Cloud, customer data can also be integrated with the Sales Cloud and Service Cloud in the form of leads,
contacts and customer service cases to give companies a complete view of their customers.
Community Cloud. The Community Cloud enables companies to engage directly with groups of people
by giving them access to relevant information, apps and experts, creating trusted, branded destinations for
customers, partners and employees to collaborate.
Analytics Cloud. The Analytics Cloud is an app for business intelligence powered by our Wave platform.
It enables companies to quickly deploy sales, service, marketing and custom analytics apps using any data
source. Our customers use the Analytics Cloud to enable any employee to quickly and easily explore
business data, uncover new insights, make smarter decisions and take action from anywhere on popular
mobile devices.
IoT Cloud. The IoT Cloud, which we announced in September 2015, connects billions of events from
devices, sensors, apps and more from the Internet of Things to Salesforce—enabling companies to take
action in a connected world. Our customers use the IoT Cloud to process massive quantities of data, build
smarter, more personalized actions and engage proactively with customers in real time. We are currently
piloting this new offering with several enterprises.
App Cloud. The App Cloud is an app development platform that includes Force, Heroku, Enterprise and
Lightning—along with shared identity, data and network services to empower companies to deliver
connected apps for any business need. In addition, the App Cloud’s platform services include Trailhead,
an interactive learning environment for all Salesforce developers, and the AppExchange, Salesforce’s
enterprise app marketplace. The App Cloud empowers companies with everything they need to build apps
quickly, in any language, for any device, and manage them in a single enterprise cloud environment.
Professional Cloud Services
We offer professional cloud services including consulting, deployment, training, user-centric design and
integration to our customers to facilitate faster adoption of our cloud solutions and enable customer success. We
also offer architects and innovation program teams that act as advisors to plan and execute digital transformations
for our customers, mission critical support, cloud specialists and admin and configuration services that allow our
customers to make the best use of our technology.
We offer several education service offerings to our customers and partners, ranging from introductory
online courses to advanced architecture certifications. With the Trailhead learning platform, our customers and
partners have free online access to courses that address topics such as using and administering our services and
developing on our platform. For more advanced education, we offer instructor-led and online courses to certify
our customers and partners on architecting, administering, deploying and developing our services. In addition,
there is a selection of online educational classes available at no charge to customers that subscribe to our
customer service plans.
Business Benefits of Using Our Solution
The key advantages of our solution include:
Secure, private, scalable and reliable. Our service has been designed to provide our customers with
privacy and high levels of performance, reliability and security. We have built, and continue to invest in, a
comprehensive security infrastructure, including firewalls, intrusion detection systems, and encryption for
transmissions over the Internet, which we monitor and test on a regular basis. We built and maintain a multi-
tenant application architecture that has been designed to enable our service to scale securely, reliably and
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cost effectively. Our multi-tenant application architecture maintains the integrity and separation of customer
data while still permitting all customers to use the same application functionality simultaneously.
Rapid deployment and lower total cost of ownership. Our services can be deployed rapidly since our
customers do not have to spend time procuring, installing or maintaining the servers, storage, networking
equipment, security products or other hardware and software. We enable customers to achieve up-front
savings relative to the traditional enterprise software model. Customers benefit from the predictability of
their future costs since they generally pay for the service on a per subscriber basis for the term of the
subscription contract.
Ease of integration and configuration. IT professionals are able to integrate and configure our solutions
with existing applications quickly and seamlessly. We provide a set of application programming
interfaces (“APIs”) that enable customers and independent software developers to both integrate our
solution with existing third-party, custom and legacy apps and write their own application services that
integrate with our solutions. For example, many of our customers use our App Cloud API to move
customer-related data from custom-developed and packaged applications into our service on a periodic
basis to provide greater visibility into their activities.
High levels of user adoption. We have designed our solutions to be intuitive and easy to use. Our
solutions contain many tools and features recognizable to users of popular consumer web services, so
users have a more familiar user experience than typical enterprise applications. As a result, our users can
often use and gain benefit from our solutions with minimal training. We have also designed our solutions
to be used on popular mobile devices, making it possible for people to conduct business from their
phones.
Rapid development of apps and increased innovation. Our customers and third-party developers can
create apps rapidly because of the ease of use and the benefits of a multi-tenant platform. We provide the
capability for business users to easily customize our applications to suit their specific needs, and also
support a variety of programming languages so developers can code complex apps spanning multiple
business processes and deliver them via multiple mobile devices. By providing infrastructure and
development environments on demand, we provide developers the opportunity to create new and
innovative apps without having to invest in hardware. Developers with ideas for a new app can create, test
and support their solutions on the App Cloud and make the app accessible for a subscription fee to
customers.
Continuous innovation. We release hundreds of new features to all of our customers three times a year.
Our metadata-driven, multitenant cloud runs on a single code base, which enables every customer to run
their business on the latest release without disruption. Because we deploy all upgrades on our servers,
new features and functionality automatically become part of our service on the upgrade release date and
therefore benefit all of our customers immediately.
Positive environmental impact. Our multi-tenant cloud platform makes it possible to use a remarkably
small number of servers as efficiently as possible. When organizations move business applications to
Salesforce, they can significantly reduce their energy use and carbon footprints compared to traditional
on-premises solutions.
Our Strategy
Our objective is to deliver solutions that transform how companies sell, service, market and innovate to
connect with their customers in a whole new way. Not only do we provide enterprise cloud apps, we also provide an
enterprise cloud computing platform upon which our customers and partners build and customize their own apps.
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Key elements of our strategy include:
Strengthening our market-leading solutions. We offer multiple editions of our solutions at different
price points to meet the needs of customers of different sizes and we have designed our solutions to easily
accommodate new features and functionality. We intend to continue to extend all editions of our solutions
with new features, functions and increased security through our own development, acquisitions and
partnerships. We also provide solutions for certain vertical industries.
Expanding strategic relationships with customers. We see significant opportunity to deepen our
relationships with our existing customers. As our customers realize the benefits of our services, we aim to
upgrade the customer to premium editions and sell more subscriptions by targeting additional functional
areas and business units, ultimately becoming our customers’ trusted advisors, inspiring enterprise-wide
transformation and accelerating strategic engagements, including through direct engagement with the
highest levels of our customers’ executive management.
Extending distribution into new and high-growth product categories. As part of our growth strategy,
we are delivering innovative solutions in new categories, including analytics, communities and the
Internet of Things. We drive innovation both organically and through acquisitions, such as our February
2016 acquisition of a company that has a next generation quote-to-cash solution delivered 100 percent
natively on our platform.
Expanding our world-class sales organization. We believe that our offerings provide significant value
for businesses of any size. We will continue to pursue businesses of all sizes in top industries and major
regions, primarily through our direct sales force. We have steadily increased and plan to continue to
increase the number of direct sales professionals we employ, and we intend to develop additional
distribution channels for our service.
Reducing customer attrition. Our goal is to have all of our customers renew their subscriptions prior to
the end of their contractual terms. We run customer success and other related programs in an effort to
secure renewals of existing customers.
Building our business in top software markets globally, which includes building partnerships that
help add customers. We believe that there is a substantial market opportunity for our solutions globally.
We plan to continue to aggressively market and sell to customers worldwide via local sales and support
professionals with deep expertise in target industries and through partnerships with other enterprise
software vendors, ISVs and system integrators. Additionally, we plan to increase the capacity that we are
able to offer globally through data centers and third party infrastructure providers.
Encouraging the development of third-party applications on our cloud computing platforms. The
App Cloud enables existing customers, ISVs and third-party developers to create and deliver cloud-based
apps. It is a platform on which apps can be created, tested, published and run. In addition, these apps can
be marketed and sold on the AppExchange, our online marketplace for business apps, or sold directly by
software vendors. We believe our ecosystem of developers and software vendors will address the business
requirements of both current and future customers.
Technology, Development and Operations
We deliver our Salesforce solutions as highly scalable, cloud computing application and platform services
on a multi-tenant technology architecture.
Multi-tenancy is an architectural approach that allows us to operate a single application instance for multiple
organizations, treating all customers as separate tenants who run in virtual isolation from each other. Customers
can use and customize an application as though they each have a separate instance, yet their data and
customizations remain secure and insulated from the activities of all other tenants. Our multi-tenant services run
on a single stack of hardware and software, which is comprised of commercially available hardware and a
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combination of proprietary and commercially available software. As a result, we are able to spread the cost of
delivering our services across our user base. In addition, because we do not have to manage thousands of distinct
applications with their own business logic and database schemas, we believe that we can scale our business faster
than traditional software vendors. Moreover, we can focus our resources on building new functionality to deliver
to our customer base as a whole rather than on maintaining an infrastructure to support each of their distinct
applications.
Multi-tenancy also allows for faster bug and security fixes, automatic software updates and the ability to
deploy major releases and frequent, incremental improvements to our services, benefiting the entire user
community.
Our services are optimized to run on specific databases and operating systems using the tools and platforms
best suited to serve our customers rather than on-premise software that must be written to the different hardware,
operating systems and database platforms existing within a customer’s unique systems environment. Our
developers build and support solutions and features on a single code base on our chosen technology platform.
Our efforts are focused on improving and enhancing the features, functionality, performance, availability
and security of our existing service offerings as well as developing new features, functionality and services. From
time to time, we supplement our internal research and development activities with outside development resources
and acquired technology. As part of our business strategy, we periodically acquire companies or technologies,
and we incorporate the acquired technologies into our solutions. Performance, functional depth, security and the
usability of our solutions influence our technology decisions and product direction.
Our customers access our services from any geography over the Internet via all of the major Internet
browsers and on most major mobile device operating systems.
We provide the majority of our services to our customers from infrastructure operated by us but secured
within third-party data center hosting facilities located in the United States and other countries. These third-party
data center providers provide space, physical security, continuous power and cooling. The remainder of our
services operate from cloud computing platform providers who offer Infrastructure as a Service, including
servers, storage, databases and networking.
Sources of Revenue
We derive our revenues primarily from subscription fees for our service. We also derive revenues from
premier support, which provides customers with additional support beyond the standard support that is included
in the basic subscription fee.
We recognize subscription and support revenue ratably over the contract term, beginning on the
commencement date of each contract. The majority of our professional services contracts are on a time and
materials basis, for which we generally recognize revenue as the services are rendered.
Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue,
depending on whether the revenue recognition criteria have been met. Deferred revenue primarily consists of
billings or payments received in advance of revenue recognition from subscription services described above and
is recognized as the revenue recognition criteria are met. Unbilled deferred revenue represents future billings
under our subscription agreements that have not been invoiced and, accordingly, are not recorded in deferred
revenue. We generally invoice customers in annual installments. Deferred revenue and unbilled deferred revenue
are influenced by several factors, including new business seasonality within the year, the specific timing, size and
duration of large customer subscription agreements, the timing and compounding effects of customer renewals,
varying billing cycles of subscription agreements, invoice timing, foreign currency fluctuations and new business
linearity within the quarter.
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Customers
We sell to businesses of all sizes and in almost every industry worldwide. The number of paying
subscriptions at each of our customers ranges from one to hundreds of thousands. None of our customers
accounted for more than five percent of our revenues in fiscal 2016, 2015 or 2014.
Digital Transactions
Our digital transaction volume, representing transactions processed through our solutions and platform,
excluding Marketing Cloud and one of our platform service offerings, Heroku, was 976 billion for fiscal 2016, an
increase of 67 percent as compared to fiscal 2015. A transaction is a retrieval or update within the Salesforce
database, which can be a page load, an information query or an API call, among other things.
Our transaction metrics are used to illustrate the growing usage of our service by our customers and to
highlight the scalability of our service. We do not believe such transaction metrics are key performance
indicators of our financial condition. Specifically, there is no direct correlation between the transaction activity
and our financial results, such as our revenue or expense growth and changes in our operating cash flow balances
and deferred revenue balances. Additionally, such transaction activity cannot be relied upon as an indicator of
future financial performance.
Sales, Marketing and Customer Support
We organize our sales and marketing programs by geographic regions, including the Americas, Europe and
Asia Pacific, which includes Japan. The majority of our revenue from the Americas is attributable to customers
in the United States. Approximately 26 percent of our revenue comes from customers outside of the Americas.
Strategic Investments
Since 2009, we have been investing in early-to-late stage technology and professional cloud service
companies across the globe to support our key business initiatives, which include, among other things, extending
the capabilities of our platform and CRM offerings, increasing the ecosystem of enterprise cloud companies and
partners, accelerating the adoption of cloud technologies and creating the next-generation of mobile applications
and connected products. Our minority investments in over 150 companies as of January 31, 2016 also help us
stay connected with the pace of innovation that is currently occurring within the technology industry. In some
cases, we have acquired companies in which we have previously invested.
Because of the inherent risk in investing in early-to-late stage technology companies, our individual
investments are subject to a risk of partial or total loss of investment capital.
Direct Sales
We sell our services primarily through our direct sales force, which is comprised of telephone sales
personnel based in regional hubs, and field sales personnel based in territories close to their customers. Both our
telephone sales and field sales personnel are supported by sales representatives, who are primarily responsible for
generating qualified sales leads.
Referral and Indirect Sales
We have a network of partners who refer sales leads to us and who then assist in selling to these prospects.
This network includes global consulting firms, systems integrators and regional partners. In return, we
typically pay these partners a fee based on the first-year subscription revenue generated by the customers whom
they refer. Also included in this network are ISVs, whom we typically pay a percentage of the subscription
revenue generated by their referrals.
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We continue to invest in developing additional distribution channels for our subscription service.
Marketing
Our marketing strategy is to promote our brand and generate demand for our offerings. We use a variety of
marketing programs across traditional and social channels to target our prospective and current customers,
partners, and developers.
Our primary marketing activities include:
• Press and industry analyst relations to garner third-party validation and generate positive coverage for
our company, offerings and value proposition;
• User conferences and events, such as Dreamforce, as well as participation in trade shows and industry
events, to create customer and prospect awareness;
• Content marketing and engagement on social channels like Facebook, Twitter, LinkedIn and YouTube;
• Search engine marketing and advertising to drive traffic to our Web properties;
• Web site development to engage and educate prospects and generate interest through product
information and demonstrations, free trials, case studies, white papers, and marketing collateral;
• Multi-channel marketing campaigns;
• Customer testimonials; and
• Sales tools and field marketing events to enable our sales organization to more effectively convert
leads into customers.
Customer Service and Support
Our global customer support group responds to both business and technical inquiries about the use of our
products via the web, telephone, email, social networks and other channels. We provide standard customer
support during regular business hours at no charge to customers who purchase any of our paying subscription
editions. We also offer premier customer support that is either included in a premium offering or sold for an
additional fee, which can include services such as priority access to technical resources, developer support, and
system administration. In addition, we offer a mission critical support add-on that is designed to provide
customers with responses for incidents from a dedicated team knowledgeable about the customer’s specific
enterprise architecture, and which offers instruction to optimize their usage of our products.
Seasonality
Our fourth quarter has historically been our strongest quarter for new business and renewals, and our first
quarter is our largest collections and operating cash flow quarter. For a more detailed discussion, see the
“Seasonal Nature of Deferred Revenue and Accounts Receivable” discussion in Management’s Discussion and
Analysis.
Competition
The market for our service offerings is highly competitive, rapidly evolving and fragmented, and subject to
changing technology and frequent introductions of new products and services. Many prospective customers have
invested substantial personnel and financial resources to implement and integrate their current enterprise software
into their businesses and therefore may be reluctant or unwilling to migrate away from their current solution to an
enterprise cloud computing application service. Additionally, third-party developers may be reluctant to build
application services on our platform since they have invested in other competing technology platforms.
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We compete primarily with generalized platforms and vendors of packaged business software, as well as
companies offering enterprise apps, including CRM, collaboration and business intelligence software. We also
compete with internally developed apps. We may encounter competition from established enterprise software
vendors, as well as start-up and midsized companies focused on disruption, who may develop toolsets and
products that allow customers to build new apps that run on the customers’ current infrastructure or as hosted
services. Our current principal competitors include:
• On-premises offerings from enterprise software application vendors;
• Cloud computing application service providers;
• Software companies that provide their product or service free of charge, and only charge a premium for
advanced features and functionality;
• Social media companies;
• Traditional platform development environment companies;
• Cloud computing development platform companies;
• Internally developed applications (by our potential customers’ information technology (“IT”)
departments); and
• Internet of Things platforms from large companies that have existing relationships with hardware and
software companies.
We believe that as traditional enterprise software application and platform vendors shift more of their focus
to cloud computing, they may become a greater competitive threat.
Intellectual Property
We rely on a combination of trademark, copyright, trade secret and patent laws in the United States and
other jurisdictions as well as confidentiality procedures and contractual provisions to protect our proprietary
technology and our brands and maintain programs to protect and grow our rights. We also enter into
confidentiality and proprietary rights agreements with our employees, consultants and other third parties and
control access to software, services, documentation and other proprietary information. We believe the duration of
our patents is adequate relative to the expected lives of our service offerings. We also purchase or license
technology that we incorporate into our products or services. At times, we make select intellectual property
broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards,
advancing interoperability, fostering open source software or attracting and enabling our external development
community. While it may be necessary in the future to seek or renew licenses relating to various aspects of our
products and business methods, we believe, based upon past experience and industry practice, such licenses
generally could be obtained on commercially reasonable terms. We believe our continuing research and product
development are not materially dependent on any single license or other agreement with a third party relating to
the development of our products.
Employees
As of January 31, 2016, we had more than 19,000 employees. None of our employees in the United States is
represented by a labor union, however, for certain foreign subsidiaries, workers’ councils represent our
employees.
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Available Information
You can obtain copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K, and other filings with the SEC, and all amendments to these filings, free of charge from
our website at http://www.salesforce.com/company/investor/sec-filings/ as soon as reasonably practicable
following our filing of any of these reports with the SEC. You can also obtain copies free of charge by contacting
our Investor Relations department at our office address listed above. The public may read and copy any materials
filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580,
Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by
calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and
information statements and other information regarding issuers that file electronically with the SEC at
www.sec.gov. The contents of these websites are not incorporated into this filing. Further, the Company’s
references to the URLs for these websites are intended to be inactive textual references only.
ITEM 1A. RISK FACTORS
The risks and uncertainties described below are not the only ones facing us. Other events that we do not
currently anticipate or that we currently deem immaterial also may affect our results of operations, cash flows
and financial condition.
Risks Related to Our Business and Industry
If our security measures or those of our third-party data center hosting facilities, cloud computing
platform providers, or third-party service partners, are breached, and unauthorized access is obtained to a
customer’s data, our data or our IT systems, our services may be perceived as not being secure, customers may
curtail or stop using our services, and we may incur significant legal and financial exposure and liabilities.
Our services involve the storage and transmission of customers’ proprietary information, and security breaches
could expose us to a risk of loss of this information, litigation and possible liability. While we have security
measures in place, they may be breached as a result of third-party action, including intentional misconduct by
computer hackers, employee error, malfeasance or otherwise and result in someone obtaining unauthorized access
to our IT data, our customers’ data or our data, including our intellectual property and other confidential business
information. Additionally, third parties may attempt to fraudulently induce employees or customers into disclosing
sensitive information such as user names, passwords or other information in order to gain access to our customers’
data, our data or our IT systems. Because the techniques used to obtain unauthorized access, or to sabotage systems,
change frequently and generally are not recognized until launched against a target, we may be unable to anticipate
these techniques or to implement adequate preventative measures. In addition, our customers may authorize third-
party technology providers to access their customer data, and some of our customers may not have adequate
security measures in place to protect their data that is stored on our services. Because we do not control our
customers or third-party technology providers, or the processing of such data by third-party technology providers,
we cannot ensure the integrity or security of such transmissions or processing. Malicious third parties may also
conduct attacks designed to temporarily deny customers access to our services. Any security breach could result in a
loss of confidence in the security of our services, damage our reputation, negatively impact our future sales, disrupt
our business and lead to legal liability.
Defects or disruptions in our services could diminish demand for our services and subject us to
substantial liability.
Because our services are complex and incorporate a variety of hardware and proprietary and third-party
software, our services may have errors or defects that could result in unanticipated downtime for our subscribers
and harm to our reputation and our business. Cloud services frequently contain undetected errors when first
introduced or when new versions or enhancements are released. We have from time to time found defects in, and
experienced disruptions to, our services and new defects or disruptions may occur in the future. In addition, our
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customers may use our services in unanticipated ways that may cause a disruption in services for other customers
attempting to access their data. As we acquire companies, we may encounter difficulty in incorporating the
acquired technologies into our services and maintaining the quality standards that are consistent with our brand
and reputation. Since our customers use our services for important aspects of their business, any errors, defects,
disruptions in service or other performance problems could hurt our reputation and may damage our customers’
businesses. As a result, customers could elect to not renew our services or delay or withhold payment to us. We
could also lose future sales or customers may make warranty or other claims against us, which could result in an
increase in our provision for doubtful accounts, an increase in collection cycles for accounts receivable or the
expense and risk of litigation.
Interruptions or delays in services from our third-party data center hosting facilities or cloud computing
platform providers could impair the delivery of our services and harm our business.
We currently serve our customers from third-party data center hosting facilities and cloud computing
platform providers located in the United States and other countries. Any damage to, or failure of, our systems
generally could result in interruptions in our services. We have from time to time experienced interruptions in our
services and such interruptions may occur in the future. Interruptions in our services may reduce our revenue,
cause us to issue credits or pay penalties, cause customers to terminate their subscriptions and adversely affect
our attrition rates and our ability to attract new customers, all of which would reduce our revenue. Our business
would also be harmed if our customers and potential customers believe our services are unreliable.
As part of our current disaster recovery and business continuity arrangements, our production environment
and all of our customers’ data are currently replicated in near real-time in a separate facility located elsewhere.
Companies and products added through acquisition may be served through alternate facilities. We do not control
the operation of any of these facilities, and they may be vulnerable to damage or interruption from earthquakes,
floods, fires, power loss, telecommunications failures and similar events. They may also be subject to break-ins,
sabotage, intentional acts of vandalism and similar misconduct, as well as local administrative actions, changes to
legal or permitting requirements and litigation to stop, limit or delay operation. Despite precautions taken at these
facilities, the occurrence of a natural disaster or an act of terrorism, a decision to close the facilities without
adequate notice or other unanticipated problems at these facilities could result in lengthy interruptions in our
services. Even with disaster recovery and business continuity arrangements, our services could be interrupted.
When we add data centers and add capacity, we may move or transfer our data and our customers’ data.
Despite precautions taken during this process, any unsuccessful data transfers may impair the delivery of our
services, which may damage our business.
Privacy concerns and laws, evolving regulation of cloud computing, cross-border data transfer
restrictions and other domestic or foreign regulations may limit the use and adoption of our services and
adversely affect our business.
Regulation related to the provision of services on the Internet is increasing, as federal, state and foreign
governments continue to adopt new laws and regulations addressing data privacy and the collection, processing,
storage and use of personal information. In some cases, foreign data privacy laws and regulations, such as the
European Union’s Data Protection Directive, and the country-specific laws and regulations that implement that
directive, also govern the processing of personal information. Further, laws are increasingly aimed at the use of
personal information for marketing purposes, such as the European Union’s e-Privacy Directive, and the country-
specific regulations that implement that directive. Such laws and regulations are subject to new and differing
interpretations and may be inconsistent among jurisdictions. These and other requirements could reduce demand
for our services or restrict our ability to store and process data or, in some cases, impact our ability to offer our
services in certain locations or our customers’ ability to deploy our solutions globally. For example, in October
2015, the European Court of Justice invalidated the U.S.-EU Safe Harbor framework that had been in place since
2000, which allowed companies to meet certain European legal requirements for the transfer of personal data
from the European Economic Area to the United States. While other adequate legal mechanisms to lawfully
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transfer such data remain, the invalidation of the U.S.-EU Safe Harbor framework may result in different
European data protection regulators applying differing standards for the transfer of personal data, which could
result in increased regulation, cost of compliance and limitations on data transfer for Salesforce and its
customers. The costs of compliance with and other burdens imposed by laws, regulations and standards may limit
the use and adoption of our services, reduce overall demand for our services, lead to significant fines, penalties or
liabilities for noncompliance, or slow the pace at which we close sales transactions, any of which could harm our
business.
In addition to government activity, privacy advocacy and other industry groups have established or may
establish new self-regulatory standards that may place additional burdens on us. Our customers expect us to meet
voluntary certification or other standards established by third parties, such as TRUSTe. If we are unable to
maintain these certifications or meet these standards, it could adversely affect our ability to provide our solutions
to certain customers and could harm our business.
Furthermore, concerns regarding data privacy may cause our customers’ customers to resist providing the
data necessary to allow our customers to use our services effectively. Even the perception that the privacy of
personal information is not satisfactorily protected or does not meet regulatory requirements could inhibit sales
of our products or services, and could limit adoption of our cloud-based solutions.
Industry-specific regulation and other requirements and standards are evolving and unfavorable
industry-specific laws, regulations, interpretive positions or standards could harm our business.
Our customers and potential customers conduct business in a variety of industries, including financial
services, the public sector, healthcare and telecommunications. Regulators in certain industries have adopted and
may in the future adopt regulations or interpretive positions regarding the use of cloud computing and other
outsourced services. The costs of compliance with, and other burdens imposed by, industry-specific laws,
regulations and interpretive positions may limit our customers’ use and adoption of our services and reduce
overall demand for our services. Compliance with these regulations may also require us to devote greater
resources to support certain customers, which may increase costs and lengthen sales cycles. For example, some
financial services regulators have imposed guidelines for use of cloud computing services that mandate specific
controls or require financial services enterprises to obtain regulatory approval prior to outsourcing certain
functions. If we are unable to comply with these guidelines or controls, or if our customers are unable to obtain
regulatory approval to use our services where required, our business may be harmed. In addition, an inability to
satisfy the standards of certain voluntary third-party certification bodies that our customers may expect, such as
an attestation of compliance with the Payment Card Industry (PCI) Data Security Standards, may have an adverse
impact on our business and results. Further, there are various statutes, regulations, and rulings relevant to the
direct email marketing and text-messaging industries, including the Telephone Consumer Protection Act (TCPA)
and related Federal Communication Commission (FCC) orders. The interpretation of many of these statutes,
regulations, and rulings is evolving in the courts and administrative agencies and an inability to comply may have
an adverse impact on our business and results. If in the future we are unable to achieve or maintain industry-
specific certifications or other requirements or standards relevant to our customers, it may harm our business and
adversely affect our results.
In some cases, industry-specific laws, regulations or interpretive positions may also apply directly to us as a
service provider. Any failure or perceived failure by us to comply with such requirements could have an adverse
impact on our business.
We rely on third-party computer hardware, software and cloud computing platforms that could cause
errors in, or failures of, our services and may be difficult to replace.
We rely on computer hardware purchased or leased from, software licensed from, and cloud computing
platforms provided by, third parties in order to offer our services, including database software and hardware from
a variety of vendors. Any errors or defects in third-party hardware, software or cloud computing platforms could
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result in errors in, or a failure of, our services, which could harm our business. These hardware, software and
cloud computing platforms may not continue to be available at reasonable prices, on commercially reasonable
terms or at all. Any loss of the right to use any of these hardware, software or cloud computing platforms could
significantly increase our expenses and otherwise result in delays in the provisioning of our services until
equivalent technology is either developed by us, or, if available, is identified, obtained through purchase or
license and integrated into our services.
The market in which we participate is intensely competitive, and if we do not compete effectively, our
operating results could be harmed.
The market for enterprise applications and platform services is highly competitive, rapidly evolving and
fragmented, and subject to changing technology, shifting customer needs and frequent introductions of new
products and services. We compete primarily with generalized platforms and vendors of packaged business
software, as well as companies offering enterprise apps, including CRM, collaboration and business intelligence
software. We also compete with internally developed apps and face competition from enterprise software
vendors and online service providers who may develop toolsets and products that allow customers to build new
applications that run on the customers’ current infrastructure or as hosted services. Our current competitors
include:
• on premise offerings from enterprise software application vendors;
• cloud computing application service providers;
• software companies that provide their product or service free of charge, and only charge a premium for
advanced features and functionality;
• social media companies;
• traditional platform development environment companies;
• cloud computing development platform companies;
• internally developed applications (by our potential customers’ IT departments); and
• Internet of Things platforms from large companies that have existing relationships with hardware and
software companies.
Many of our current and potential competitors enjoy substantial competitive advantages, such as greater
name recognition, longer operating histories and larger marketing budgets, as well as substantially greater
financial, technical and other resources. In addition, many of our current and potential competitors have
established marketing relationships and access to larger customer bases, and have major distribution agreements
with consultants, system integrators and resellers. As a result, our competitors may be able to respond more
quickly and effectively than we can to new or changing opportunities, technologies, standards or customer
requirements. Furthermore, because of these advantages, even if our services are more effective than the products
and services that our competitors offer, potential customers might select competitive products and services in lieu
of purchasing our services. For all of these reasons, we may not be able to compete successfully against our
current and future competitors.
We are subject to risks associated with our strategic investments. Other-than-temporary impairments in
the value of our investments could negatively impact our financial results.
We invest in early-to-late stage companies for strategic reasons and to support key business initiatives, and
may not realize a return on our strategic investments. Many such companies generate net losses and the market
for their products, services or technologies may be slow to develop, and, therefore, are dependent on the
availability of later rounds of financing from banks or investors on favorable terms to continue their operations.
The financial success of our investment in any company is typically dependent on a liquidity event, such as a
public offering, acquisition or other favorable market event reflecting appreciation to the cost of our initial
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investment. The capital markets for public offerings and acquisitions are dynamic and the likelihood of liquidity
events for the companies we have invested in could significantly worsen. Further, valuations of privately-held
companies are inherently complex due to the lack of readily available market data. If we determine that any of
our investments in such companies have experienced a decline in value, we may be required to record an other
than temporary impairment, which could be material. We have in the past written off the full value of specific
investments. Similar situations could occur in the future and negatively impact our financial results. All of our
investments are subject to a risk of a partial or total loss of investment capital.
As we acquire and invest in companies or technologies, we may not realize the expected business or
financial benefits and the acquisitions could prove difficult to integrate, disrupt our business, dilute
stockholder value and adversely affect our operating results and the market value of our common stock.
As part of our business strategy, we periodically make investments in, or acquisitions of, complementary
businesses, joint ventures, services and technologies and intellectual property rights, and we expect that we will
continue to make such investments and acquisitions in the future. Acquisitions and investments involve
numerous risks, including:
• potential failure to achieve the expected benefits of the combination or acquisition;
• difficulties in, and the cost of, integrating operations, technologies, services and personnel;
• diversion of financial and managerial resources from existing operations;
• the potential entry into new markets in which we have little or no experience or where competitors may
have stronger market positions;
• potential write-offs of acquired assets or investments, and potential financial and credit risks associated
with acquired customers;
• potential loss of key employees of the acquired company;
• inability to generate sufficient revenue to offset acquisition or investment costs;
• inability to maintain relationships with customers and partners of the acquired business;
• difficulty of transitioning the acquired technology onto our existing platforms and maintaining the
security standards for such technology consistent with our other services;
• potential unknown liabilities associated with the acquired businesses;
• unanticipated expenses related to acquired technology and its integration into our existing technology;
• negative impact to our results of operations because of the depreciation and amortization of amounts
related to acquired intangible assets, fixed assets and deferred compensation, and the loss of acquired
deferred revenue and unbilled deferred revenue;
• delays in customer purchases due to uncertainty related to any acquisition;
• the need to implement controls, procedures and policies at the acquired company;
• challenges caused by distance, language and cultural differences;
• in the case of foreign acquisitions, the challenges associated with integrating operations across different
cultures and languages and any currency and regulatory risks associated with specific countries; and
• the tax effects of any such acquisitions.
Any of these risks could harm our business. In addition, if we finance acquisitions by issuing equity or
convertible or other debt securities or loans, our existing stockholders may be diluted, or we could face
constraints related to the terms of and repayment obligation related to the incurrence of indebtedness that could
affect the market price of our common stock.
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Our quarterly results are likely to fluctuate and our stock price and the value of our common stock could
decline substantially.
Our quarterly results are likely to fluctuate. For example, our fiscal fourth quarter has historically been our
strongest quarter for new business and renewals. The year-over-year compounding effect of this seasonality in
billing patterns and overall new business and renewal activity causes the value of invoices that we generate in the
fourth quarter to continually increase in proportion to our billings in the other three quarters of our fiscal year. As
a result, our fiscal first quarter is our largest collections and operating cash flow quarter.
Additionally, some of the important factors that may cause our revenues, operating results and cash flows to
fluctuate from quarter to quarter include:
• our ability to retain and increase sales to existing customers, attract new customers and satisfy our
customers’ requirements;
• the attrition rates for our services;
• the amount and timing of operating costs and capital expenditures related to the operations and
expansion of our business;
• changes in deferred revenue and unbilled deferred revenue balances, which are not reflected in the
balance sheet, due to seasonality, the compounding effects of renewals, invoice duration, size and
timing, new business linearity between quarters and within a quarter and fluctuations due to foreign
currency movements;
• changes in foreign currency exchange rates;
• the number of new employees;
• changes in our pricing policies and terms of contracts, whether initiated by us or as a result of
competition;
• the cost, timing and management effort for the introduction of new features to our services;
• the costs associated with acquiring new businesses and technologies and the follow-on costs of
integration and consolidating the results of acquired businesses;
• the rate of expansion and productivity of our sales force;
• the length of the sales cycle for our services;
• new product and service introductions by our competitors;
• our success in selling our services to large enterprises;
• evolving regulations of cloud computing and cross-border data transfer restrictions and similar
regulations;
• variations in the revenue mix of editions of our services;
• technical difficulties or interruptions in our services;
• expenses related to our real estate, our office leases and our data center capacity and expansion;
• changes in interest rates and our mix of investments, which would impact the return on our investments
in cash and marketable securities;
• conditions, particularly sudden changes, in the financial markets, which have impacted and may
continue to impact the value of and liquidity of our investment portfolio;
• income tax effects;
• our ability to realize benefits from strategic partnerships, acquisition or investments;
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• other than temporary impairments in the value of our strategic investments in early-to-late stage
privately held companies, which could be material in a particular quarter;
• expenses related to significant, unusual or discrete events, which are recorded in the period in which
the events occur;
• general economic conditions, which may adversely affect either our customers’ ability or willingness to
purchase additional subscriptions or upgrade their services, or delay a prospective customer’s
purchasing decision, reduce the value of new subscription contracts, or affect attrition rates;
• timing of additional investments in our enterprise cloud computing application and platform services
and in our consulting services;
• regulatory compliance costs;
• changes in payment terms and the timing of customer payments and payment defaults by customers;
• extraordinary expenses such as litigation or other dispute-related settlement payments;
• the impact of new accounting pronouncements;
• equity issuances, including as consideration in acquisitions or due to the conversion of our outstanding
convertible notes at the election of the note holders;
• the timing of stock awards to employees and the related adverse financial statement impact of having to
expense those stock awards on a straight-line basis over their vesting schedules;
• the timing of commission, bonus, and other compensation payments to employees; and
• the timing of payroll and other withholding tax expenses, which are triggered by the payment of
bonuses and when employees exercise their vested stock awards.
Many of these factors are outside of our control, and the occurrence of one or more of them might cause our
operating results to vary widely. As such, we believe that historical quarter-to-quarter comparisons of our
revenues, operating results, changes in our deferred revenue and unbilled deferred revenue balances and cash
flows may not be meaningful and should not be relied upon as an indication of future performance.
Additionally, if we fail to meet or exceed the expectations of securities analysts and investors, or if one or
more of the securities analysts who cover us adversely change their recommendation regarding our stock, the
market price of our common stock could decline. Moreover, our stock price may be based on expectations,
estimates and forecasts of our future performance that may be unrealistic or that may not be met. Further, our
stock price may fluctuate based on reporting by the financial media, including television, radio and press reports
and blogs.
If we experience significant fluctuations in our rate of anticipated growth and fail to balance our
expenses with our revenue forecasts, our results could be harmed.
Due to the pace of change and innovation in enterprise cloud computing services and the unpredictability of
future general economic and financial market conditions and the impact of foreign currency exchange rate
fluctuations, we may not be able to accurately forecast our rate of growth. We plan our expense levels and
investment on estimates of future revenue and future anticipated rate of growth. We may not be able to adjust our
spending appropriately if the addition of new subscriptions or the renewals of existing subscriptions fall short of
our expectations. A portion of our expenses may also be fixed in nature for some minimum amount of time, such
as with a data center contract or office lease, so it may not be possible to reduce costs in a timely manner or
without the payment of fees to exit certain obligations early. As a result, we expect that our revenues, operating
results and cash flows may fluctuate significantly on a quarterly basis. Our recent revenue growth rates may not
be sustainable and may decline in the future. We believe that historical period-to-period comparisons of our
revenues, operating results and cash flows may not be meaningful and should not be relied upon as an indication
of future performance.
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Our efforts to expand our services beyond the CRM market and to develop our existing services in order
to keep pace with technological developments may not succeed and may reduce our revenue growth rate and
harm our business.
We derive substantially all of our revenue from subscriptions to our CRM enterprise cloud computing
application services, and we expect this will continue for the foreseeable future. The markets for our Analytics,
Communities and Internet of Things Clouds remain relatively new and it is uncertain whether our efforts will
ever result in significant revenue for us. Further, the introduction of significant platform changes and upgrades,
including our conversion to our new Lightning platform, and introduction of new services beyond the CRM
market, may not be successful, and early stage interest and adoption of such new services may not result in long
term success or significant revenue for us. Our efforts to expand our services beyond the CRM market may not
succeed and may reduce our revenue growth rate.
Additionally, if we are unable to develop enhancements to and new features for our existing or new services
that keep pace with rapid technological developments, our business will be harmed. The success of
enhancements, new features and services depends on several factors, including the timely completion,
introduction and market acceptance of the feature, service or enhancement. Failure in this regard may
significantly impair our revenue growth. In addition, because our services are designed to operate on a variety of
network hardware and software platforms using a standard browser, we will need to continuously modify and
enhance our services to keep pace with changes in Internet-related hardware, software, communication, browser
and database technologies. We may not be successful in either developing these modifications and enhancements
or in bringing them to market timely. Furthermore, uncertainties about the timing and nature of new network
platforms or technologies, or modifications to existing platforms or technologies, could increase our research and
development or service delivery expenses. Any failure of our services to operate effectively with future network
platforms and technologies could reduce the demand for our services, result in customer dissatisfaction and harm
our business.
Additionally, if we fail to anticipate or identify significant Internet-related and other technology trends and
developments early enough, or if we do not devote appropriate resources to adapting to such trends and
developments, our business could be harmed.
Sales to customers outside the United States expose us to risks inherent in international sales.
We sell our services throughout the world and are subject to risks and challenges associated with
international business. Historically, sales in Europe and Asia Pacific together have represented approximately
30 percent of our total revenues, and we intend to continue to expand our international sales efforts. The risks and
challenges associated with sales to customers outside the United States include:
• localization of our services, including translation into foreign languages and associated expenses;
• laws and business practices favoring local competitors;
• pressure on the creditworthiness of sovereign nations, particularly in Europe, where we have customers
and a balance of our cash, cash equivalents and marketable securities;
• liquidity issues or political actions by sovereign nations, which could result in decreased values of
these balances;
• foreign currency fluctuations and controls;
• compliance with multiple, conflicting and changing governmental laws and regulations, including
employment, tax, privacy, anti-corruption, import/export, antitrust, data transfer, storage and
protection, and industry-specific laws and regulations, including rules related to compliance by our
third-party resellers;
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• regional data privacy laws and other regulatory requirements that apply to outsourced service providers
and to the transmission of our customers’ data across international borders;
• treatment of revenue from international sources and changes to tax codes, including being subject to
foreign tax laws and being liable for paying withholding income or other taxes in foreign jurisdictions;
• different pricing environments;
• difficulties in staffing and managing foreign operations;
• different or lesser protection of our intellectual property;
• longer accounts receivable payment cycles and other collection difficulties;
• natural disasters, acts of war, terrorism, pandemics or security breaches; and
• regional economic and political conditions.
Any of these factors could negatively impact our business and results of operations.
Additionally, our international subscription fees are paid either in U.S. dollars or local currency. As a result,
fluctuations in the value of the U.S. dollar and foreign currencies may make our services more expensive for
international customers, which could harm our business.
Because we recognize revenue from subscriptions for our services over the term of the subscription,
downturns or upturns in new business may not be immediately reflected in our operating results.
We generally recognize revenue from customers ratably over the terms of their subscription agreements,
which are typically 12 to 36 months. As a result, most of the revenue we report in each quarter is the result of
subscription agreements entered into during previous quarters. Consequently, a decline in new or renewed
subscriptions in any one quarter may not be reflected in our revenue results for that quarter. Any such decline,
however, will negatively affect our revenue in future quarters. Accordingly, the effect of significant downturns in
sales and market acceptance of our services, and potential changes in our attrition rate, may not be fully reflected
in our results of operations until future periods. Our subscription model also makes it difficult for us to rapidly
increase our revenue through additional sales in any period, as revenue from new customers must be recognized
over the applicable subscription term.
If our customers do not renew their subscriptions for our services or reduce the number of paying
subscriptions at the time of renewal, our revenue will decline and our business will suffer. If we cannot
accurately predict subscription renewals or upgrade rates, we may not meet our revenue targets which may
adversely affect the market price of our common stock.
Our customers have no obligation to renew their subscriptions for our services after the expiration of their
initial subscription period, which is typically 12 to 36 months, and in the normal course of business, some
customers have elected not to renew. In addition, our customers may renew for fewer subscriptions, renew for
shorter contract lengths, or switch to lower cost offerings of our services. We cannot accurately predict attrition
rates given our varied customer base of enterprise and small and medium size business customers and the number
of multi-year subscription contracts. Our attrition rates may increase or fluctuate as a result of a number of
factors, including customer dissatisfaction with our services, customers’ spending levels, decreases in the number
of users at our customers, pricing increases or changes and deteriorating general economic conditions.
Our future success also depends in part on our ability to sell additional features and services, more
subscriptions or enhanced editions of our services to our current customers. This may also require increasingly
sophisticated and costly sales efforts that are targeted at senior management. Similarly, the rate at which our
customers purchase new or enhanced services depends on a number of factors, including general economic
conditions and that our customers do not react negatively to any price changes related to these additional features
and services. If our efforts to upsell to our customers are not successful our business may suffer.
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If the market for our technology delivery model and enterprise cloud computing services develops more
slowly than we expect, our business could be harmed.
Our success depends on the willingness of third-party developers to build applications that are
complementary to our services. Without the development of these applications, both current and potential
customers may not find our services sufficiently attractive. In addition, for those customers who authorize a
third-party technology partner access to their data, we do not provide any warranty related to the functionality,
security and integrity of the data transmission or processing. Despite contract provisions to protect us, customers
may look to us to support and provide warranties for the third-party applications, which may expose us to
potential claims, liabilities and obligations for applications we did not develop or sell, all of which could harm
our business.
We are exposed to fluctuations in currency exchange rates that could negatively impact our financial
results and cash flows from changes in the value of the U.S. Dollar versus local currencies.
We conduct our business in the following locations: United States, Europe, Canada, Asia Pacific and Japan.
The expanding global scope of our business exposes us to risk of fluctuations in foreign currency markets. This
exposure is the result of selling in multiple currencies, growth in our international investments, including data
center expansion, additional headcount in foreign locations, and operating in countries where the functional
currency is the local currency. Specifically, our results of operations and cash flows are subject to fluctuations in
the following currencies: the Euro, British Pound Sterling, Canadian Dollar, Australian Dollar and Japanese Yen
against the U.S. Dollar. These exposures may change over time as business practices evolve and economic
conditions change. The fluctuations of currencies in which we conduct business can both increase and decrease
our overall revenue and expenses for any given fiscal period. Such volatility, even when it increases our revenues
or decreases our expenses, impacts our ability to accurately predict our future results and earnings.
Supporting our existing and growing customer base could strain our personnel resources and
infrastructure, and if we are unable to scale our operations and increase productivity, we may not be able to
successfully implement our business plan.
We continue to experience significant growth in our customer base and personnel, which has placed a strain
on our management, administrative, operational and financial infrastructure. We anticipate that additional
investments in our internal infrastructure, data center capacity, research, customer support and development, and
real estate spending will be required to scale our operations and increase productivity, to address the needs of our
customers, to further develop and enhance our services, to expand into new geographic areas, and to scale with
our overall growth. The additional investments we are making will increase our cost base, which will make it
more difficult for us to offset any future revenue shortfalls by reducing expenses in the short term.
We regularly upgrade or replace our various software systems. If the implementations of these new
applications are delayed, or if we encounter unforeseen problems with our new systems or in migrating away
from our existing applications and systems, our operations and our ability to manage our business could be
negatively impacted.
Our success will depend in part upon the ability of our senior management to manage our projected growth
effectively. To do so, we must continue to increase the productivity of our existing employees and to hire, train
and manage new employees as needed. To manage the expected domestic and international growth of our
operations and personnel, we will need to continue to improve our operational, financial and management
controls, our reporting systems and procedures, and our utilization of real estate. If we fail to successfully scale
our operations and increase productivity, we will be unable to execute our business plan.
21
As more of our sales efforts are targeted at larger enterprise customers, our sales cycle may become more
time-consuming and expensive, we may encounter pricing pressure and implementation and customization
challenges, and we may have to delay revenue recognition for some complex transactions, all of which could
harm our business and operating results.
As we target more of our sales efforts at larger enterprise customers, including governmental entities, we
may face greater costs, longer sales cycles, greater competition and less predictability in completing some of our
sales. In this market segment, the customer’s decision to use our services may be an enterprise-wide decision
and, if so, these types of sales would require us to provide greater levels of education regarding the use and
benefits of our services, as well as education regarding privacy and data protection laws and regulations to
prospective customers with international operations. In addition, larger customers and governmental entities may
demand more customization, integration services and features. As a result of these factors, these sales
opportunities may require us to devote greater sales support and professional services resources to individual
customers, driving up costs and time required to complete sales and diverting our own sales and professional
services resources to a smaller number of larger transactions, while potentially requiring us to delay revenue
recognition on some of these transactions until the technical or implementation requirements have been met.
Pricing and packaging strategies for enterprise and other customers for subscriptions to our existing and
future service offerings may not be widely accepted by other new or existing customers. Our adoption of such
new pricing and packaging strategies may harm our business.
For large enterprise customers, professional services may also be performed by a third party or a
combination of our own staff and a third party. Our strategy is to work with third parties to increase the breadth
of capability and depth of capacity for delivery of these services to our customers. If a customer is not satisfied
with the quality of work performed by us or a third party or with the type of services or solutions delivered, then
we could incur additional costs to address the situation, the profitability of that work might be impaired, and the
customer’s dissatisfaction with our services could damage our ability to obtain additional work from that
customer. In addition, negative publicity related to our customer relationships, regardless of its accuracy, may
further damage our business by affecting our ability to compete for new business with current and prospective
customers.
We have been and may in the future be sued by third parties for various claims including alleged
infringement of proprietary rights.
We are involved in various legal matters arising from the normal course of business activities. These may
include claims, suits, government investigations and other proceedings involving alleged infringement of third-
party patents and other intellectual property rights, commercial, corporate and securities, labor and employment,
class actions, wage and hour, and other matters.
The software and Internet industries are characterized by the existence of a large number of patents,
trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of
intellectual property rights. We have received in the past and may receive in the future communications from
third parties, including practicing entities and non-practicing entities, claiming that we have infringed their
intellectual property rights.
In addition, we have been, and may in the future be, sued by third parties for alleged infringement of their
claimed proprietary rights. For example, during fiscal 2015, we received a communication from a large
technology company alleging that we infringed certain of its patents. While we continue to analyze this claim and
no litigation has been filed to date, there can be no assurance that this claim will not lead to litigation in the
future. Our technologies may be subject to injunction if they are found to infringe the rights of a third party or we
may be required to pay damages, or both. Further, many of our subscription agreements require us to indemnify
our customers for third-party intellectual property infringement claims, which would increase the cost to us of an
adverse ruling on such a claim.
22
The outcome of any claims or litigation, regardless of the merits, is inherently uncertain. Any claims and
lawsuits, and the disposition of such claims and lawsuits, whether through settlement or licensing discussions, or
litigation, could be time-consuming and expensive to resolve, divert management attention from executing our
business plan, result in efforts to enjoin our activities, lead to attempts on the part of other parties to pursue
similar claims and, in the case of intellectual property claims, require us to change our technology, change our
business practices, pay monetary damages or enter into short- or long-term royalty or licensing agreements.
Any adverse determination related to intellectual property claims or other litigation could prevent us from
offering our services to others, could be material to our financial condition or cash flows, or both, or could
otherwise adversely affect our operating results. In addition, depending on the nature and timing of any such
dispute, an unfavorable resolution of a legal matter could materially affect our future results of operations or cash
flows or both of a particular quarter.
In addition, our exposure to risks associated with various claims, including the use of intellectual property,
may be increased as a result of acquisitions of other companies. For example, we may have a lower level of
visibility into the development process with respect to intellectual property or the care taken to safeguard against
infringement risks with respect to the acquired company or technology. In addition, third parties may make
infringement and similar or related claims after we have acquired technology that had not been asserted prior to
our acquisition.
Any failure to protect our intellectual property rights could impair our ability to protect our proprietary
technology and our brand.
If we fail to protect our intellectual property rights adequately, our competitors may gain access to our
technology, and our business may be harmed. In addition, defending our intellectual property rights may entail
significant expense. Any of our patents, trademarks or other intellectual property rights may be challenged by
others or invalidated through administrative process or litigation. While we have some U.S. patents and many
U.S. and international patent applications pending, we may be unable to obtain patent protection for the
technology covered in our patent applications or the patent protection may not be obtained quickly enough to
meet our business needs. In addition, our existing patents and any patents issued in the future may not provide us
with competitive advantages, or may be successfully challenged by third parties. Furthermore, legal standards
relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain, and we
also may face proposals to change the scope of protection for some intellectual property rights in the U.S.
Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in
which our services are available. The laws of some foreign countries may not be as protective of intellectual
property rights as those in the U.S., and mechanisms for enforcement of intellectual property rights may be
inadequate. Also, our involvement in standard setting activity or the need to obtain licenses from others may
require us to license our intellectual property. Accordingly, despite our efforts, we may be unable to prevent third
parties from using our intellectual property.
We may be required to spend significant resources to monitor and protect our intellectual property rights
and we may conclude that in at least some instances the benefits of protecting our intellectual property rights may
be outweighed by the expense. We may initiate claims or litigation against third parties for infringement of our
proprietary rights or to establish the validity of our proprietary rights. Any litigation, whether or not it is resolved
in our favor, could result in significant expense to us and divert the efforts of our technical and management
personnel.
Our continued success depends on our ability to maintain and enhance our brands.
We believe that the brand identities we have developed have significantly contributed to the success of our
business. Maintaining and enhancing the Salesforce brand and our other brands are critical to expanding our base
of customers, partners and employees. Our brand strength will depend largely on our ability to remain a
technology leader and continue to provide high-quality innovative products, services, and features. In order to
23
maintain and enhance our brands, we may be required to make substantial investments that may later prove to be
unsuccessful. In addition, positions the Company takes on social issues may be unpopular with some customers
or potential customers, which may impact our ability to attract or retain such customers. If we fail to maintain
and enhance our brands, or if we incur excessive expenses in our efforts to do so, our business, operating results
and financial condition may be materially and adversely affected.
We may lose key members of our management team or development and operations personnel, and may
be unable to attract and retain employees we need to support our operations and growth.
Our success depends substantially upon the continued services of our executive officers and other key
members of management, particularly our Chief Executive Officer. From time to time, there may be changes in
our executive management team resulting from the hiring or departure of executives. Such changes in our
executive management team may be disruptive to our business. We are also substantially dependent on the
continued service of our existing development and operations personnel because of the complexity of our
services and technologies. We do not have employment agreements with any of our executive officers, key
management, development or operations personnel and they could terminate their employment with us at any
time. The loss of one or more of our key employees or groups could seriously harm our business.
In the technology industry, there is substantial and continuous competition for engineers with high levels of
experience in designing, developing and managing software and Internet-related services, as well as competition
for sales executives and operations personnel. We may not be successful in attracting and retaining qualified
personnel. We have from time to time experienced, and we expect to continue to experience, difficulty in hiring
and retaining highly skilled employees with appropriate qualifications. If we fail to attract new personnel or fail
to retain and motivate our current personnel, our business and future growth prospects could be severely harmed.
In addition, we believe in the importance of our corporate culture, or Aloha spirit, which fosters dialogue,
collaboration, recognition and a sense of family. As our organization grows, we may find it increasingly difficult
to maintain the beneficial aspects of our corporate culture. This could negatively impact our future success.
Any failure in our delivery of high-quality technical support services may adversely affect our
relationships with our customers and our financial results.
Our customers depend on our support organization to resolve technical issues relating to our applications.
We may be unable to respond quickly enough to accommodate short-term increases in customer demand for
support services. Increased customer demand for these services, without corresponding revenues, could increase
costs and adversely affect our operating results. In addition, our sales process is highly dependent on our
applications and business reputation and on positive recommendations from our existing customers. Any failure
to maintain high-quality technical support, or a market perception that we do not maintain high-quality support,
could adversely affect our reputation, our ability to sell our enterprise cloud computing solutions to existing and
prospective customers, and our business, operating results and financial position.
Periodic changes to our sales organization can be disruptive and may reduce our rate of growth.
We periodically change and make adjustments to our sales organization in response to market opportunities,
competitive threats, management changes, product introductions or enhancements, acquisitions, sales
performance, increases in sales headcount, cost levels and other internal and external considerations. Any such
future sales organization changes may result in a temporary reduction of productivity, which could negatively
affect our rate of growth. In addition, any significant change to the way we structure our compensation of our
sales organization may be disruptive and may affect our revenue growth.
24
Unanticipated changes in our effective tax rate and additional tax liabilities may impact our financial
results.
We are subject to income taxes in the United States and various jurisdictions outside of the United States.
Our effective tax rate could fluctuate due to changes in the mix of earnings and losses in countries with differing
statutory tax rates. Our tax expense could also be impacted by changes in non-deductible expenses, changes in
excess tax benefits related to exercises and vesting of stock-based expense, changes in the valuation of deferred
tax assets and liabilities and our ability to utilize them and the applicability of withholding taxes.
We are subject to tax examinations in multiple jurisdictions. While we regularly evaluate new information
that may change our judgment resulting in recognition, derecognition or change in measurement of a tax position
taken, there can be no assurance that the final determination of any examinations will not have an adverse effect
on our operating results and financial position.
Our tax provision could also be impacted by changes in U.S federal and state or international tax laws
applicable to corporate multinationals such as the legislation recently enacted in the United Kingdom and
Australia, other fundamental law changes currently being considered by many countries and changes in taxing
jurisdictions’ administrative interpretations, decisions, policies and positions. Additionally, the Organisation for
Economic Co-Operation and Development recently released final guidance covering various topics, including
transfer pricing, country-by-country reporting and definitional changes to permanent establishment which could
ultimately impact our tax liabilities.
We may also be subject to additional tax liabilities due to changes in non-income taxes resulting from
changes in federal, state or international tax laws, changes in taxing jurisdictions’ administrative interpretations,
decisions, policies, and positions, results of tax examinations, settlements or judicial decisions, changes in
accounting principles, changes to the business operations, including acquisitions, as well as the evaluation of new
information that results in a change to a tax position taken in a prior period.
Our debt service obligations and operating lease commitments may adversely affect our financial
condition and cash flows from operations.
We have a high level of debt, including the 0.25% convertible senior notes we issued in March 2013 (the
“0.25% Senior Notes”) due April 1, 2018, the loan we assumed when we purchased 50 Fremont, and capital lease
arrangements. Additionally, we have significant contractual commitments in operating lease arrangements, which
are not reflected on our consolidated balance sheets. In addition, we have a financing obligation for a leased
facility of which we are deemed the owner for accounting purposes. Finally, we have a revolving credit facility
under which we can draw down up to $650.0 million. As of January 31, 2016, we had no outstanding borrowings
under this credit facility. Our maintenance of this indebtedness and any additional issuance of indebtedness
could:
• impair our ability to obtain additional financing in the future for working capital, capital expenditures,
acquisitions, general corporate or other purposes;
• cause us to dedicate a substantial portion of our cash flows from operations towards debt service
obligations and principal repayments;
• make us more vulnerable to downturns in our business, our industry or the economy in general; and
• due to limitations within the revolving credit facility covenants, restrict our ability to incur additional
indebtedness, grant liens, merge or consolidate, dispose of assets, make investments, make
acquisitions, enter into transactions with affiliates, pay dividends or make distributions, repurchase
stock and enter into restrictive agreements, as defined in the credit agreement.
Our ability to meet our expenses and debt obligations will depend on our future performance, which will be
affected by financial, business, economic, regulatory and other factors. We will not be able to control many of
25
these factors, such as economic conditions and governmental regulations. Further, our operations may not
generate sufficient cash to enable us to service our debt or contractual obligations resulting from our leases. If we
fail to make a payment on our debt, we could be in default on such debt. If we are at any time unable to generate
sufficient cash flows from operations to service our indebtedness when payment is due, we may be required to
attempt to renegotiate the terms of the instruments relating to the indebtedness, seek to refinance all or a portion
of the indebtedness or obtain additional financing. There can be no assurance that we would be able to
successfully renegotiate such terms, that any such refinancing would be possible or that any additional financing
could be obtained on terms that are favorable or acceptable to us.
A failure to comply with the covenants and other provisions of our outstanding debt could result in events of
default under such instruments, which could permit acceleration of all of our notes and borrowings under our
revolving credit facility. Any required repayment of our notes or revolving credit facility as a result of a
fundamental change or other acceleration would lower our current cash on hand such that we would not have
those funds available for use in our business.
The new lease accounting guidance places operating lease activity on our consolidated balance sheet in
fiscal 2020, which results in an increase in both our assets and financing obligations. The implementation of this
guidance may impact our ability to obtain the necessary financing from financial institutions at commercially
viable rates or at all as this new guidance will result in a higher financing obligation on our consolidated balance
sheet.
Weakened global economic conditions may adversely affect our industry, business and results of
operations.
Our overall performance depends in part on worldwide economic conditions. The United States and other
key international economies have experienced cyclical downturns from time to time in which economic activity
was impacted by falling demand for a variety of goods and services, restricted credit, poor liquidity, reduced
corporate profitability, volatility in credit, equity and foreign exchange markets, bankruptcies and overall
uncertainty with respect to the economy. These conditions affect the rate of information technology spending and
could adversely affect our customers’ ability or willingness to purchase our enterprise cloud computing services,
delay prospective customers’ purchasing decisions, reduce the value or duration of their subscription contracts, or
affect attrition rates, all of which could adversely affect our operating results.
Natural disasters and other events beyond our control could materially adversely affect us.
Natural disasters or other catastrophic events may cause damage or disruption to our operations,
international commerce and the global economy, and thus could have a strong negative effect on us. Our
business operations are subject to interruption by natural disasters, fire, power shortages, pandemics and other
events beyond our control. Although we maintain crisis management and disaster response plans, such events
could make it difficult or impossible for us to deliver our services to our customers, and could decrease
demand for our services. The majority of our research and development activities, corporate headquarters,
information technology systems, and other critical business operations, are located near major seismic faults in
the San Francisco Bay Area. Because we do not carry earthquake insurance for direct quake-related losses,
with the exception of the building that we own in San Francisco, and significant recovery time could be
required to resume operations, our financial condition and operating results could be materially adversely
affected in the event of a major earthquake or catastrophic event.
26
Risks Relating to Our Convertible Senior Notes and Our Common Stock
The market price of our common stock is likely to be volatile and could subject us to litigation.
The trading prices of the securities of technology companies have been highly volatile. Accordingly, the
market price of our notes and common stock has been and is likely to continue to be subject to wide fluctuations.
Factors affecting the market price of our notes and common stock include:
• variations in our operating results, earnings per share, cash flows from operating activities, deferred
revenue, year-over-year growth rates for individual core service offerings and other financial metrics
and non-financial metrics, and how those results compare to analyst expectations;
• variations in, and limitations of, the various financial and other metrics and modeling used by analysts
in their research and reports about our business;
• forward-looking guidance to industry and financial analysts related to future revenue and earnings per
share;
• changes in the estimates of our operating results or changes in recommendations by securities analysts
that elect to follow our common stock;
• announcements of technological innovations, new services or service enhancements, strategic alliances
or significant agreements by us or by our competitors;
• announcements by us or by our competitors of mergers or other strategic acquisitions, or rumors of
such transactions involving us or our competitors;
• announcements of customer additions and customer cancellations or delays in customer purchases;
• recruitment or departure of key personnel;
• disruptions in our service due to computer hardware, software, network or data center problems;
• the economy as a whole, market conditions in our industry and the industries of our customers;
• trading activity by a limited number of stockholders who together beneficially own a significant
portion of our outstanding common stock;
• the issuance of shares of common stock by us, whether in connection with an acquisition, a capital
raising transaction or upon conversion of some or all of our outstanding convertible senior notes; and
• issuance of debt or other convertible securities.
In addition, if the market for technology stocks or the stock market in general experiences uneven investor
confidence, the market price of our notes and common stock could decline for reasons unrelated to our business,
operating results or financial condition. The market price of our notes and common stock might also decline in
reaction to events that affect other companies within, or outside, our industry even if these events do not directly
affect us. Some companies that have experienced volatility in the trading price of their stock have been the
subject of securities class action litigation. If we are the subject of such litigation, it could result in substantial
costs and a diversion of management’s attention and resources.
We may issue additional shares of our common stock or instruments convertible into shares of our
common stock, including in connection with the conversion of the notes, and thereby materially and adversely
affect the market price of our common stock and the trading price of the notes.
We are not restricted from issuing additional shares of our common stock or other instruments convertible
into, or exchangeable or exercisable for, shares of our common stock during the life of the notes. If we issue
additional shares of our common stock or instruments convertible into shares of our common stock, it may
materially and adversely affect the market price of our common stock and, in turn, the trading price of the notes.
In addition, the conversion of some or all of the notes may dilute the ownership interests of existing holders of
27
our common stock, and any sales in the public market of any shares of our common stock issuable upon such
conversion of the notes could adversely affect the prevailing market price of our common stock. In addition, the
potential conversion of the notes could depress the market price of our common stock.
We may not have the ability to raise the funds necessary to pay the amount of cash due upon conversion
of the notes or the fundamental change purchase price due when a holder submits its notes for purchase upon
the occurrence of a fundamental change.
Upon the occurrence of a fundamental change, holders of the notes may require us to purchase, for cash, all
or a portion of their notes. In addition, if a holder converts its notes, we will generally pay such holder an amount
of cash before delivering to such holder any shares of our common stock.
There can be no assurance that we will have sufficient financial resources, or will be able to arrange
financing, to pay the fundamental change purchase price if holders submit their notes for purchase by us upon the
occurrence of a fundamental change or to pay the amount of cash due if holders surrender their notes for
conversion. In addition, agreements governing any future debt may restrict our ability to make each of the
required cash payments even if we have sufficient funds to make them. Furthermore, our ability to purchase the
notes or to pay cash upon the conversion of the notes may be limited by law or regulatory authority. If we fail to
purchase the notes, to pay interest due on, or to pay the amount of cash due upon conversion, we will be in
default under the indenture, which in turn may result in the acceleration of other indebtedness we may then have.
If the repayment of the other indebtedness were to be accelerated, we may not have sufficient funds to repay that
indebtedness and to purchase the notes or to pay the amount of cash due upon conversion. Our inability to pay for
the notes that are tendered for purchase or upon conversion could result in note holders receiving substantially
less than the principal amount of the notes, which could harm our reputation, financing opportunities and our
business.
The fundamental change provisions may delay or prevent an otherwise beneficial takeover attempt of us.
The fundamental change purchase rights will allow holders of the notes to require us to purchase all or a
portion of their notes upon the occurrence of a fundamental change. The provisions requiring an increase to the
conversion rate for conversions in connection with a make-whole fundamental change may, in certain
circumstances, delay or prevent a takeover of us and the removal of incumbent management that might otherwise
be beneficial to investors.
The convertible note hedges and warrant transactions may affect the trading price of the notes and the
market price of our common stock.
We entered into privately negotiated convertible note hedge transactions with certain hedge counterparties
concurrently with the pricing of the notes. We also entered into privately negotiated warrant transactions with the
hedge counterparties. Taken together, the convertible note hedge transactions and the warrant transactions are
expected, but not guaranteed, to reduce the potential dilution with respect to our common stock upon conversion
of the notes. If, however, the price of our common stock, as measured under the terms of the warrant
transactions, exceeds the exercise price of the warrant transactions, the warrant transactions will have a dilutive
effect on our earnings per share to the extent that the price of our common stock as measured under the warrant
transactions exceeds the strike price of the warrant transactions.
The hedge counterparties and their respective affiliates periodically modify their hedge positions from time
to time following the pricing of the notes (and are particularly likely to do so during any observation period
relating to a conversion of the notes) by entering into or unwinding various over-the-counter derivative
transactions with respect to our common stock, or by purchasing or selling shares of our common stock or the
notes in privately negotiated transactions or open market transactions. The effect, if any, of these transactions and
activities on the market price of our common stock or the trading price of the notes will depend in part on market
conditions and cannot be ascertained at this time. Any of these activities, however, could adversely affect the
market price of our common stock and the trading price of the notes.
28
We do not make any representation or prediction as to the direction or magnitude of any potential effect that
the transactions described above may have on the price of the notes or our common stock. In addition, we do not
make any representation that the counterparties to those transactions will engage in these transactions or
activities or that these transactions and activities, once commenced, will not be discontinued without notice; the
counterparties or their affiliates may choose to engage in, or discontinue engaging in, any of these transactions or
activities with or without notice at any time, and their decisions will be in their sole discretion and not within our
control.
We are subject to counterparty risk with respect to the convertible note hedge transactions.
The hedge counterparties are financial institutions or affiliates of financial institutions, and we will be
subject to the risk that these hedge counterparties may default under the convertible note hedge transactions. Our
exposure to the credit risk of the hedge counterparties will not be secured by any collateral. If one or more of the
hedge counterparties to one or more of our convertible note hedge transactions becomes subject to insolvency
proceedings, we will become an unsecured creditor in those proceedings with a claim equal to our exposure at the
time under those transactions. Our exposure will depend on many factors but, generally, the increase in our
exposure will be correlated to the increase in our stock price and the volatility of our stock. In addition, upon a
default by one of the hedge counterparties, we may suffer adverse tax consequences and dilution with respect to
our common stock. We can provide no assurances as to the financial stability or viability of any of the hedge
counterparties.
Provisions in our amended and restated certificate of incorporation and bylaws and Delaware law might
discourage, delay or prevent a change of control of our company or changes in our management and,
therefore, depress the market price of our common stock.
Our amended and restated certificate of incorporation and bylaws contain provisions that could depress the
market price of our common stock by acting to discourage, delay or prevent a change in control of our company
or changes in our management that the stockholders of our company may deem advantageous. These provisions
among other things:
• permit the board of directors to establish the number of directors;
• provide that directors may only be removed with the approval of holders of 66 2/3 percent of our
outstanding capital stock;
• require super-majority voting to amend some provisions in our amended and restated certificate of
incorporation and bylaws;
• authorize the issuance of “blank check” preferred stock that our board could use to implement a
stockholder rights plan (also known as a “poison pill”);
• prohibit the ability of our stockholders to call special meetings of stockholders;
• prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a
meeting of our stockholders;
• provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; and
• establish advance notice requirements for nominations for election to our board or for proposing
matters that can be acted upon by stockholders at annual stockholder meetings.
In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a
change in control of our company. Section 203 imposes certain restrictions on merger, business combinations
and other transactions between us and holders of 15 percent or more of our common stock.
In addition, the fundamental change purchase rights applicable to the notes, which will allow note holders to
require us to purchase all or a portion of their notes upon the occurrence of a fundamental change, and the
29
provisions requiring an increase to the conversion rate for conversions in connection with a make-whole
fundamental change may in certain circumstances delay or prevent a takeover of us and the removal of incumbent
management that might otherwise be beneficial to investors.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
As of January 31, 2016, our executive and principal offices for sales, marketing, professional services and
development consist of over 1.4 million square feet of leased and owned property in the San Francisco Bay Area.
Of this total, we lease and occupy over 870,000 square feet and own and occupy over 567,000 square feet (out of
the approximately 817,000 square feet of total owned space at 50 Fremont Street, San Francisco). We also lease
space in various locations throughout the United States for local sales and professional services personnel. Our
foreign subsidiaries lease office space in a number of countries in Europe, Canada and Asia Pacific for our
international operations, primarily for local sales and professional services personnel.
In addition, we have entered into the following commitments for additional office space in the San Francisco
Bay Area:
In December 2012, we entered into a lease agreement for approximately 445,000 rentable square feet of
office space at 350 Mission Street in San Francisco, California. The space rented is for the total office space
available in the building, which is in the process of being constructed. As a result of our involvement during the
construction period, we are considered for accounting purposes to be the owner of the construction project. We
expect to begin occupying this office space beginning in our first quarter of fiscal 2017. We have excluded this
square footage from the total leased space in the San Francisco Bay Area stated above.
In April 2014, we entered into a lease agreement for approximately 732,000 rentable square feet of under
construction office space located in San Francisco, California. The lease payments associated with the lease will
be approximately $590.0 million over the 15.5 year term of the lease, beginning in our first quarter of fiscal
2018. We do not currently occupy this property, and we have excluded this square footage from the total leased
space in the San Francisco Bay Area stated above.
We operate data centers in the U.S., Europe and Asia pursuant to various co-location lease arrangements.
We believe that our existing facilities and offices are adequate to meet our current requirements. If we
require additional space, we believe that we will be able to obtain such space on acceptable, commercially
reasonable terms.
ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of business, we are or may be involved in various legal proceedings and claims
related to alleged infringement of third-party patents and other intellectual property rights, commercial, corporate
and securities, labor and employment, class actions, wage and hour, and other claims. We have been, and may in
the future be put on notice or sued by third parties for alleged infringement of their proprietary rights, including
patent infringement.
In July 2015, we and certain of our current and former directors were named as defendants in a purported
shareholder derivative action in the Superior Court for the State of California, County of San Francisco. The
plaintiff filed an amended version of this derivative complaint in November 2015. The derivative complaint
alleged that excessive compensation was paid to such directors for their service and included allegations of
30
breach of fiduciary duty and unjust enrichment, and sought restitution and disgorgement of a portion of the
directors’ compensation as well as reform of our equity plan. Because the complaint was derivative in nature,
it did not seek monetary damages from us. In February 2016, the parties agreed to dismiss the complaint with
prejudice as to the plaintiff and submitted a stipulation to that effect to the Court. In March 2016, the Court
entered the order of dismissal. Neither we nor the individual defendants paid any consideration to the plaintiff.
During fiscal 2015, we received a communication from a large technology company alleging that we
infringed certain of its patents. We continue to analyze this claim and no litigation has been filed to date. There
can be no assurance that this claim will not lead to litigation in the future. The resolution of this claim is not
expected to have a material adverse effect on our financial condition, but it could be material to operating results
or cash flows or both of a particular quarter.
We evaluate all claims and lawsuits with respect to their potential merits, our potential defenses and
counterclaims, settlement or litigation potential and the expected effect on us. Our technologies may be subject to
injunction if they are found to infringe the rights of a third party. In addition, many of our subscription
agreements require us to indemnify our customers for third-party intellectual property infringement claims,
which could increase the cost to us of an adverse ruling on such a claim.
The outcome of any claims or litigation, regardless of the merits, is inherently uncertain. Any claims and
other lawsuits, and the disposition of such claims and lawsuits, whether through settlement or litigation, could be
time-consuming and expensive to resolve, divert our attention from executing our business plan, result in efforts
to enjoin our activities, lead to attempts by third parties to seek similar claims and, in the case of intellectual
property claims, require us to change our technology, change our business practices, pay monetary damages or
enter into short- or long-term royalty or licensing agreements.
In general, the resolution of a legal matter could prevent us from offering our service to others, could be
material to our financial condition or cash flows, or both, or could otherwise adversely affect our operating
results.
We make a provision for a liability relating to legal matters when it is both probable that a liability has been
incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly
and adjusted to reflect the impacts of negotiations, estimated settlements, legal rulings, advice of legal counsel
and other information and events pertaining to a particular matter. In our opinion, resolution of all current matters
is not expected to have a material adverse impact on our consolidated results of operations, cash flows or
financial position. However, depending on the nature and timing of any such dispute, an unfavorable resolution
of a matter could materially affect our future results of operations or cash flows, or both, of a particular quarter.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
31
ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT
The following sets forth certain information regarding our current executive officers as of March 1, 2016 (in
alphabetical order):
Name Age Position
Joe Allanson . . . . . . . . . . . . . . . . . . . 52 Chief Accounting Officer and Corporate Controller
Marc Benioff . . . . . . . . . . . . . . . . . . . 51 Chairman of the Board of Directors and Chief Executive Officer
Keith Block . . . . . . . . . . . . . . . . . . . . 55 Vice Chairman, President and Chief Operating Officer
Alexandre Dayon . . . . . . . . . . . . . . . 48 President, Products
Parker Harris . . . . . . . . . . . . . . . . . . . 49 Co-Founder
Mark Hawkins . . . . . . . . . . . . . . . . . . 56 Chief Financial Officer
Maria Martinez . . . . . . . . . . . . . . . . . 58 President, Sales and Customer Success
Burke Norton . . . . . . . . . . . . . . . . . . . 49 Chief Legal Officer
Cindy Robbins . . . . . . . . . . . . . . . . . . 43 Executive Vice President, Global Employee Success
Amy Weaver . . . . . . . . . . . . . . . . . . . 48 Executive Vice President, General Counsel
Joe Allanson has served as our Chief Accounting Officer and Corporate Controller since February 2014 and
our Senior Vice President, Chief Accountant and Corporate Controller since July 2011. Prior to that,
Mr. Allanson served as our Senior Vice President, Corporate Controller since July 2007, and served in various
other management positions in finance since joining Salesforce in 2003. Prior to Salesforce, Mr. Allanson spent
four years at Autodesk, Inc. and three years at Chiron Corporation in key corporate finance positions. Previously,
he worked at Arthur Andersen LLP for 11 years in its Audit and Business Advisory Services group. Mr. Allanson
graduated from Santa Clara University with a B.S. in Accounting.
Marc Benioff co-founded Salesforce in February 1999 and has served as our Chairman of the Board of
Directors since inception. He has served as our Chief Executive Officer since 2001. From 1986 to 1999,
Mr. Benioff was employed at Oracle Corporation, where he held a number of positions in sales, marketing and
product development, lastly as a Senior Vice President. Mr. Benioff also serves as Chairman of the Board of
Directors of the Salesforce.com Foundation, and as a member of the board of trustees of the World Economic
Forum. In the past five years, Mr. Benioff served as a member of the Board of Directors of Cisco Systems, Inc.
Mr. Benioff received a B.S. in Business Administration from the University of Southern California, where he is
also on the Board of Trustees.
Keith Block has served as our Vice Chairman, President and as a Director since joining Salesforce in June
2013. As of February 1, 2016, Mr. Block additionally became Chief Operating Officer. Prior to that, Mr. Block
was employed at Oracle Corporation from 1986 to June 2012 where he held a number of positions, most recently
Executive Vice President, North America. Mr. Block serves on the Board of Trustees at the Concord Museum,
the Board of Trustees at Carnegie-Mellon University Heinz Graduate School and the President’s Advisory
Council for Carnegie-Mellon University. Mr. Block received both a B.S. in Information Systems and an M.S. in
Management & Policy Analysis from Carnegie-Mellon University.
Alexandre Dayon has served as our President, Products since March 2014. Prior to that, he was President,
Applications and Platform from December 2012 to March 2014, Executive Vice President, Applications from
September 2011 to December 2012, Executive Vice President, Product Management from February 2010 to
December 2012, and Senior Vice President, Product Management from September 2008 to January 2010.
Mr. Dayon joined Salesforce through the acquisition of InStranet, a leading knowledge-base company, where he
was a founder and served as CEO. Prior to InStranet, Mr. Dayon was a founding member of Business Objects SA
where he led the product group for more than 10 years. Mr. Dayon, who holds several patents, is focused on
creating business value out of technology disruption. Mr. Dayon holds a master’s degree in electrical engineering
from Ecole Supérieure d’Electricité (SUPELEC) in France.
32
Parker Harris co-founded Salesforce in February 1999 and has served in senior technical positions since
inception. From December 2004 to February 2013, Mr. Harris served as our Executive Vice President,
Technology. Prior to Salesforce, Mr. Harris was a Vice President at Left Coast Software, a Java consulting firm
he co-founded, from October 1996 to February 1999. Mr. Harris received a B.A. from Middlebury College.
Mark Hawkins has served as our Chief Financial Officer and Executive Vice President since August 2014.
He served as Executive Vice President and Chief Financial Officer and principal financial officer for Autodesk,
Inc., a design software and services company, from April 2009 to July 2014. From April 2006 to April 2009,
Mr. Hawkins served as Senior Vice President, Finance and Information Technology, and Chief Financial Officer
of Logitech International S.A. Previously, Mr. Hawkins held various finance and business-management roles
with Dell Inc. and Hewlett-Packard Company. Mr. Hawkins served on the Board of Directors of BMC Software,
Inc. from May 2010 through September 2013, at which time BMC was taken private. Mr. Hawkins holds a B.A.
in Operations Management from Michigan State University and an M.B.A. in Finance from the University of
Colorado. He also completed the Advanced Management Program at Harvard Business School.
Maria Martinez has served as our President, Sales and Customer Success since February 2013. Prior to that,
Ms. Martinez served as our Executive Vice President, Chief Growth Officer from February 2012 to February
2013 and our Executive Vice President, Customers for Life from February 2010 to February 2012. Prior to
Salesforce, Ms. Martinez was at Microsoft Corporation and served as its Corporate Vice President of Worldwide
Services. In addition to Microsoft, she was president and CEO of Embrace Networks, and also held senior
leadership roles at Motorola, Inc. and AT&T Inc. / Bell Laboratories. Ms. Martinez received a B.S. in Electrical
Engineering from the University of Puerto Rico and an M.S. in Computer Engineering from Ohio State
University.
Burke Norton has served as our Chief Legal Officer since October 2011. Prior to Salesforce, Mr. Norton
was Executive Vice President, General Counsel and Secretary and a member of the office of the chairman at
Expedia, Inc. from October 2006 to October 2011. Previously, Mr. Norton was a partner at the law firm of
Wilson Sonsini Goodrich & Rosati P.C., where he practiced corporate and securities law, representing clients in
the enterprise software, telecommunications, semiconductor, life sciences, entertainment and ecommerce
industries. Mr. Norton holds a J.D. from the University of California, Berkeley School of Law.
Cindy Robbins has served as our Executive Vice President, Global Employee Success since July 2015. She
served as Senior Vice President, Global Employee Success from October 2014 to June 2015 and Vice President,
Global Employee Success from November 2013 to September 2014. Prior to that, Ms. Robbins held various other
positions in Executive Recruiting, Sales and Marketing at the Company since 2006. Ms. Robbins holds a B.S. in
Political Science from Santa Clara University.
Amy Weaver has served as our Executive Vice President and General Counsel since July 2015. She served
as Senior Vice President and General Counsel from October 2013 to July 2015. From December 2010 to June
2013, Ms. Weaver served as Executive Vice President and General Counsel at Univar Inc. Previously,
Ms. Weaver was Senior Vice President and Deputy General Counsel at Expedia, Inc. and before that she
practiced law at two global law firms. Ms. Weaver holds a B.A. in Political Science from Wellesley College and
a J.D. from Harvard Law School.
33
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information for Common Stock
Our common stock is traded on the New York Stock Exchange under the symbol “CRM.”
The following table sets forth for the indicated periods the high and low sales prices of our common stock as
reported by the New York Stock Exchange.
High Low
Fiscal year ending January 31, 2016
First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $74.65 $57.28
Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $75.71 $69.16
Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $78.77 $65.17
Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $82.14 $65.69
Fiscal year ending January 31, 2015
First quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $67.00 $48.18
Second quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $59.49 $49.18
Third quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $64.60 $51.04
Fourth quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $64.74 $53.44
Dividend Policy
We have never paid any cash dividends on our common stock. Our board of directors currently intends to
retain any future earnings to support operations and to finance the growth and development of our business and
does not intend to pay cash dividends on our common stock for the foreseeable future. Any future determination
related to our dividend policy will be made at the discretion of our board and if the board chooses to declare a
cash dividend it will be in compliance with the consolidated leverage ratio covenant associated with our
revolving credit facility.
Stockholders
As of January 31, 2016 there were 210 registered stockholders of record of our common stock, including
The Depository Trust Company, which holds shares of Salesforce common stock on behalf of an indeterminate
number of beneficial owners.
Securities Authorized for Issuance under Equity Compensation Plans
The information concerning our equity compensation plans is incorporated by reference herein to the section
of the Proxy Statement entitled “Equity Compensation Plan Information.”
Outstanding Convertible Senior Notes and Warrants
In March 2013, we issued at par value $1.15 billion of 0.25% convertible senior notes (the “0.25% Senior
Notes”) due April 1, 2018 and we issued 17.3 million warrants to purchase our common stock. See Note 5
“Debt” in the Notes to the Consolidated Financial Statements for more information.
34
Stock Performance Graph
The following shall not be deemed incorporated by reference into any of our other filings under the Securities
Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended.
The graph below compares the cumulative total stockholder return on our common stock with the
cumulative total return on the Standard & Poor’s 500 Index and the Nasdaq Computer & Data Processing Index
for each of the last five fiscal years ended January 31, 2016, assuming an initial investment of $100. Data for the
Standard & Poor’s 500 Index and the Nasdaq Computer & Data Processing Index assume reinvestment of
dividends.
The comparisons in the graph below are based upon historical data and are not indicative of, nor intended to
forecast, future performance of our common stock.
Comparison of Cumulative Total Return of salesforce.com, inc.
0
50
FY
11
FY
12
FY
13
FY
14
FY
15
FY
16
100
150
250
200
D
O
L
L
A
R
S
salesforce.com Nasdaq ComputerS&P 500 Index
1/31/2011 1/31/2012 1/31/2013 1/31/2014 1/31/2015 1/31/2016
salesforce.com . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.00 90.00 133.00 187.00 175.00 211.00
S&P 500 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.00 102.00 116.00 139.00 155.00 151.00
Nasdaq Computer & Data Processing Index . . . . . 100.00 106.00 111.00 142.00 168.00 176.00
Recent Sales of Unregistered Securities
As previously disclosed on a Form 8-K filed on December 23, 2015, the Company entered into an Agreement
and Plan of Reorganization to acquire SteelBrick, Inc. (“SteelBrick”), a quote-to-cash platform. Upon closing the
transaction on February 1, 2016, the Company issued 4,812,325 shares of Company common stock in exchange for
the outstanding shares of SteelBrick capital stock. The issuance of shares was made in reliance on the registration
exemption in Section 4(a)(2) of the Securities Act of 1933, as amended.
35
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with our audited
consolidated financial statements and related notes thereto and with Management’s Discussion and Analysis of
Financial Condition and Results of Operations, which are included elsewhere in this Form 10-K. The
consolidated statement of operations data for fiscal 2016, 2015 and 2014, and the selected consolidated balance
sheet data as of January 31, 2016 and 2015 are derived from, and are qualified by reference to, the audited
consolidated financial statements and are included in this Form 10-K. The consolidated statement of operations
data for fiscal 2013 and 2012 and the consolidated balance sheet data as of January 31, 2014, 2013 and 2012 are
derived from audited consolidated financial statements which are not included in this Form 10-K.
Fiscal Year Ended January 31,
(in thousands, except per share data) 2016 2015 2014 2013 2012
Consolidated Statement of Operations
Revenues:
Subscription and support . . . . . . . . . . . . $6,205,599 $5,013,764 $3,824,542 $2,868,808 $2,126,234
Professional services and other . . . . . . . 461,617 359,822 246,461 181,387 140,305
Total revenues . . . . . . . . . . . . . . . . 6,667,216 5,373,586 4,071,003 3,050,195 2,266,539
Cost of revenues (1)(2):
Subscription and support . . . . . . . . . . . . 1,188,967 924,638 711,880 494,187 360,758
Professional services and other . . . . . . . 465,581 364,632 256,548 189,392 128,128
Total cost of revenues . . . . . . . . . . 1,654,548 1,289,270 968,428 683,579 488,886
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . 5,012,668 4,084,316 3,102,575 2,366,616 1,777,653
Operating expenses (1)(2):
Research and development . . . . . . . . . . 946,300 792,917 623,798 429,479 295,347
Marketing and sales . . . . . . . . . . . . . . . . 3,239,824 2,757,096 2,168,132 1,614,026 1,169,610
General and administrative . . . . . . . . . . 748,238 679,936 596,719 433,821 347,781
Operating lease termination resulting
from purchase of 50 Fremont . . . . . . (36,617) 0 0 0 0
Total operating expenses . . . . . . . . 4,897,745 4,229,949 3,388,649 2,477,326 1,812,738
Income (loss) from operations . . . . . . . . . . . 114,923 (145,633) (286,074) (110,710) (35,085)
Investment income . . . . . . . . . . . . . . . . . . . . 15,341 10,038 10,218 19,562 23,268
Interest expense . . . . . . . . . . . . . . . . . . . . . . . (72,485) (73,237) (77,211) (30,948) (17,045)
Other expense . . . . . . . . . . . . . . . . . . . . . . . . (15,292) (19,878) (4,868) (5,698) (4,455)
Gain on sales of land and building
improvements . . . . . . . . . . . . . . . . . . . . . . 21,792 15,625 0 0 0
Income (loss) before benefit from (provision
for) income taxes . . . . . . . . . . . . . . . . . . . . 64,279 (213,085) (357,935) (127,794) (33,317)
Benefit from (provision for) income taxes . . (111,705) (49,603) 125,760 (142,651) 21,745
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (47,426) $ (262,688) $ (232,175) $ (270,445) $ (11,572)
Net earnings per share-basic and diluted (3):
Basic net loss per share . . . . . . . . . . . . . $ (0.07) $ (0.42) $ (0.39) $ (0.48) $ (0.02)
Diluted net loss per share . . . . . . . . . . . $ (0.07) $ (0.42) $ (0.39) $ (0.48) $ (0.02)
Shares used in computing basic net loss
per share . . . . . . . . . . . . . . . . . . . . . . 661,647 624,148 597,613 564,896 541,208
Shares used in computing diluted net
loss per share . . . . . . . . . . . . . . . . . . . 661,647 624,148 597,613 564,896 541,208
36
(1) Amounts include amortization of purchased
intangibles from business combinations, as
follows:
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,918 $ 90,300 $109,356 $ 77,249 $ 60,069
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . 77,152 64,673 37,179 10,922 7,250
Other non-operating expense . . . . . . . . . . . . . . . . 3,636 0 0 0 0
(2) Amounts include stock-based expenses, as
follows:
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . $ 69,443 $ 53,812 $ 45,608 $ 33,757 $ 17,451
Research and development . . . . . . . . . . . . . . . . . . 129,434 121,193 107,420 76,333 45,894
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . 289,152 286,410 258,571 199,284 115,730
General and administrative . . . . . . . . . . . . . . . . . 105,599 103,350 91,681 69,976 50,183
(3) Fiscal 2013 and 2012 have been adjusted to reflect the four-for-one stock split effected through a stock
dividend which occurred in April 2013.
As of January 31,
(in thousands) 2016 2015 2014 2013 2012
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable
securities (4) . . . . . . . . . . . . . . . . . . . . . $ 2,725,377 $ 1,890,284 $ 1,321,017 $1,758,285 $1,447,174
(Negative) working capital (5) . . . . . . . . . (1,269,678) (875,559) (1,349,215) (899,434) (659,631)
Total assets (5) . . . . . . . . . . . . . . . . . . . . . 12,770,772 10,665,127 9,112,136 5,518,794 4,164,154
Long-term obligations excluding
deferred revenue (5)(6) . . . . . . . . . . . . 2,127,012 2,265,160 2,018,323 175,201 109,349
Retained earnings (deficit) . . . . . . . . . . . . (653,271) (605,845) (343,157) (110,982) 159,463
Total stockholders’ equity . . . . . . . . . . . . 5,002,869 3,975,183 3,038,510 2,317,633 1,587,360
(4) Excludes the restricted cash balance of $115.0 million as of January 31, 2015.
(5) In November 2015, the FASB issued Accounting Standards Update No. 2015-17, “Income Taxes (Topic 740):
Balance Sheet Classification of Deferred Taxes” (“ASU 2015-17”), which simplifies the presentation of
deferred income taxes by requiring all deferred tax assets and liabilities be classified as noncurrent on the
balance sheet. We early adopted this standard retrospectively and reclassified all of our current deferred tax
assets and liabilities to noncurrent deferred tax assets and liabilities on our consolidated balance sheets for all
periods presented. As a result of the reclassifications, certain noncurrent deferred tax liabilities as of
January 31, 2015, 2014, 2013, and 2012 were netted with noncurrent deferred tax assets.
(6) Long-term obligations primarily excludes deferred revenue and includes the loan assumed on 50 Fremont,
the 0.75% convertible senior notes issued in January 2010, the 0.25% convertible senior notes issued in
March 2013, the term loan entered into in July 2013, and the revolving credit facility entered into in October
2014. At January 31, 2015, the 0.75% notes had matured and were no longer outstanding. At January 31,
2014, 2013 and 2012, the 0.75% notes were convertible and accordingly were classified as a current
liability.
37
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion contains forward-looking statements, including, without limitation, our
expectations and statements regarding our outlook and future revenues, expenses, results of operations, liquidity,
plans, strategies and objectives of management and any assumptions underlying any of the foregoing. Our actual
results may differ significantly from those projected in the forward-looking statements. Our forward-looking
statements and factors that might cause future actual results to differ materially from our recent results or those
projected in the forward-looking statements include, but are not limited to, those discussed in the section titled
“Forward-Looking Information” and “Risk Factors” of this Annual Report on Form 10-K. Except as required by
law, we assume no obligation to update the forward-looking statements or our risk factors for any reason.
Overview
We are a leading provider of enterprise cloud computing solutions, with a focus on customer relationship
management, or CRM. We introduced our first CRM solution in February 2000, and we have since expanded our
service offerings with new editions, solutions, features and platform capabilities.
Our mission is to help our customers transform themselves into customer-centric companies by empowering
them to connect with their customers in entirely new ways. Our Customer Success Platform, including sales force
automation, customer service and support, marketing automation, community management, analytics, application
development, Internet of Things integration and our professional cloud services, provide the next-generation
platform of enterprise applications and services to enable customer success. Key elements of our strategy
include:
• strengthening our market-leading solutions;
• expanding strategic relationships with customers;
• extending distribution into new and high-growth product categories;
• expanding our world-class sales organization;
• reducing customer attrition;
• building our business in top software markets globally, which includes building partnerships that help
add customers; and
• encouraging the development of third-party applications on our cloud computing platforms.
We believe the factors that will influence our ability to achieve our objectives include: our prospective
customers’ willingness to migrate to enterprise cloud computing services; the availability, performance and
security of our service; our ability to continue to release, and gain customer acceptance of, new and improved
features; our ability to successfully integrate acquired businesses and technologies; successful customer adoption
and utilization of our service; acceptance of our service in markets where we have few customers; the emergence
of additional competitors in our market and improved product offerings by existing and new competitors; the
location of new data centers; third-party developers’ willingness to develop applications on our platforms; our
ability to attract new personnel and retain and motivate current personnel; and general economic conditions
which could affect our customers’ ability and willingness to purchase our services, delay the customers’
purchasing decision or affect attrition rates.
To address these factors, we will need to, among other things, continue to add substantial numbers of paying
subscriptions, upgrade our customers to fully featured versions or arrangements such as an Enterprise License
Agreement, provide high quality technical support to our customers, encourage the development of third-party
applications on our platforms and continue to focus on retaining customers at the time of renewal. Our plans to
invest for future growth include the continuation of the expansion of our data center capacity, the hiring of
38
additional personnel, particularly in direct sales, other customer-related areas and research and development, the
expansion of domestic and international selling and marketing activities, specifically in our top markets,
continuing to develop our brands, the addition of distribution channels, the upgrade of our service offerings, the
development of new services such as the announcement of our Analytics Cloud, Community Cloud, and Internet
of Things, or IoT, Cloud, the integration of acquired technologies, the expansion of our Marketing Cloud and
App Cloud core service offerings, and the additions to our global infrastructure to support our growth.
We also regularly evaluate acquisitions or investment opportunities in complementary businesses, joint
ventures, services and technologies and intellectual property rights in an effort to expand our service offerings.
We expect to continue to make such investments and acquisitions in the future and we plan to reinvest a
significant portion of our incremental revenue in future periods to grow our business and continue our leadership
role in the cloud computing industry. As a result of our aggressive growth plans, specifically our hiring plan and
acquisition activities, we have incurred significant expenses from equity awards and amortization of purchased
intangibles which have resulted in net losses on a U.S. generally accepted accounting principles (“GAAP”) basis.
As we continue with our growth plan, we may continue to have net losses on a GAAP basis in some future
quarters. We remained focused on improving operating margins in fiscal 2016 and expect to remain similarly
focused in fiscal 2017. Our operating margin for fiscal 2016 was $114.9 million compared to a $145.6 million
loss during the same period a year ago.
Our typical subscription contract term is 12 to 36 months, although terms range from one to 60 months, so
during any fiscal reporting period only a subset of active subscription contracts is eligible for renewal. We
calculate our attrition rate as of the end of each month. Our current attrition rate calculation does not include the
Marketing Cloud service offerings. Our attrition rate was between eight and nine percent during the fiscal year
ended January 31, 2016, which is favorable compared to the nine to ten percent attrition rate as of January 31,
2015. We expect our attrition rate to remain in this range as we continue to expand our enterprise business and
invest in customer success and related programs.
We expect marketing and sales costs, which were 49 percent of our total revenues for the fiscal year ended
January 31, 2016 and 51 percent for the same period a year ago, to continue to represent a substantial portion of
total revenues in the future as we seek to grow our customer base, sell more products to existing customers, and
build greater brand awareness.
Fiscal Year
Our fiscal year ends on January 31. References to fiscal 2016, for example, refer to the fiscal year ending
January 31, 2016.
Operating Segments
We operate as one operating segment. Operating segments are defined as components of an enterprise for
which separate financial information is evaluated regularly by the chief operating decision maker, who in our
case is the chief executive officer, in deciding how to allocate resources and assess performance. Over the past
few years, we have completed several acquisitions. These acquisitions have allowed us to expand our offerings,
presence and reach in various market segments of the enterprise cloud computing market. While we have
offerings in multiple enterprise cloud computing market segments, our business operates in one operating
segment because all of our offerings operate on a single platform and are deployed in an identical way, and our
chief operating decision maker evaluates our financial information and resources and assesses the performance of
these resources on a consolidated basis. Since we operate as one operating segment, all required financial
segment information can be found in the consolidated financial statements.
39
Sources of Revenues
We derive our revenues from two sources: (1) subscription revenues, which are comprised of subscription
fees from customers accessing our enterprise cloud computing services and from customers paying for additional
support beyond the standard support that is included in the basic subscription fees; and (2) related professional
services such as process mapping, project management, implementation services and other revenue. “Other
revenue” consists primarily of training fees. Subscription and support revenues accounted for approximately 93
percent of our total revenues for fiscal 2016. Subscription revenues are driven primarily by the number of paying
subscribers, varying service types, the price of our service and renewals. We define a “customer” as a separate
and distinct buying entity (e.g., a company, a distinct business unit of a large corporation, a partnership, etc.) that
has entered into a contract to access our enterprise cloud computing services. We define a “subscription” as a
unique user account purchased by a customer for use by its employees or other customer-authorized users, and
we refer to each such user as a “subscriber.” The number of paying subscriptions at each of our customers ranges
from one to hundreds of thousands. None of our customers accounted for more than five percent of our revenues
during fiscal 2016, 2015 or 2014.
Subscription and support revenues are recognized ratably over the contract terms beginning on the
commencement dates of each contract. The typical subscription and support term is 12 to 36 months, although
terms range from one to 60 months. Our subscription and support contracts are non-cancelable, though customers
typically have the right to terminate their contracts for cause if we materially fail to perform. We generally
invoice our customers in advance, in annual installments, and typical payment terms provide that our customers
pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable and in
deferred revenue, or in revenue depending on whether the revenue recognition criteria have been met. In general,
we collect our billings in advance of the subscription service period.
Professional services and other revenues consist of fees associated with consulting and implementation
services and training. Our consulting and implementation engagements are typically billed on a time and
materials basis. We also offer a number of training classes on implementing, using and administering our service
that are billed on a per person, per class basis. Our typical professional services payment terms provide that our
customers pay us within 30 days of invoice.
In determining whether professional services can be accounted for separately from subscription and support
revenues, we consider a number of factors, which are described in “Critical Accounting Estimates—Revenue
Recognition” below.
Revenue by Cloud Service Offering
We are providing the information below on a supplemental basis to give additional insight into the revenue
performance of our individual core service offerings.
Subscription and support revenues consisted of the following by core service offering (in millions):
Fiscal Year Ended
January 31, 2016
Fiscal Year Ended
January 31, 2015 Variance-Percent
Sales Cloud . . . . . . . . . . . . . . . . . . . $2,699.0 $2,443.0 10%
Service Cloud . . . . . . . . . . . . . . . . . 1,817.8 1,320.2 38%
App Cloud and Other . . . . . . . . . . . 1,034.7 745.3 39%
Marketing Cloud . . . . . . . . . . . . . . . 654.1 505.3 29%
Total . . . . . . . . . . . . . . . . . . . . $6,205.6 $5,013.8
Subscription and support revenues from the Analytics Cloud and Communities Cloud were not significant
for fiscal 2016. Since the launch of IoT Cloud in September 2015, we have been piloting this offering with
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several enterprises. Analytics Cloud revenue is included with App Cloud and Other in the table above.
Communities Cloud revenue is included in either Sales Cloud, Service Cloud or App Cloud and Other revenue
depending on the primary service offering purchased.
In situations where a customer purchases multiple cloud offerings, such as through an Enterprise License
Agreement, we allocate the contract value to each core service offering based on the customer’s estimated
product demand plan and the service that was provided at the inception of the contract. We do not update these
allocations based on actual product usage during the term of the contract. We have allocated approximately 10
percent of our total subscription and support revenues for fiscal 2016 and 2015, based on customers’ estimated
product demand plans and these allocated amounts are included in the table above.
Additionally, some of our service offerings have similar features and functions. For example, customers
may use the Sales Cloud, the Service Cloud or our App Cloud to record account and contact information, which
are similar features across these core service offerings. Depending on a customer’s actual and projected business
requirements, more than one core service offering may satisfy the customer’s current and future needs. We
record revenue based on the individual products ordered by a customer, and not according to the customer’s
business requirements and usage. In addition, as we introduce new features and functions within each offering
and refine our allocation methodology for changes in our business, we do not expect it to be practical to adjust
historical revenue results by core service offering for comparability. Accordingly, comparisons of revenue
performance by service offering over time may not be meaningful.
Our Sales Cloud service offering is our most widely distributed service offering and has historically been
the largest contributor of subscription and support revenues. As a result, Sales Cloud has the most international
exposure and foreign exchange rate exposure, relative to the other cloud service offerings. Conversely, revenue
for Marketing Cloud is primarily derived from the Americas, with little impact from foreign exchange rate
movement. We estimate that for fiscal 2017, subscription and support revenues from the Sales Cloud service
offering will continue to be the largest contributor of subscription and support revenues, and foreign currency
will continue to have a more pronounced impact on Sales Cloud subscription and support revenues than revenues
from our other cloud service offerings.
Seasonal Nature of Deferred Revenue, Accounts Receivable and Operating Cash Flow
Deferred revenue primarily consists of billings to customers for our subscription service. Over 90 percent of
the value of our billings to customers is for our subscription and support service. We generally invoice our
customers in annual cycles. Approximately 80 percent of all subscription and support invoices were issued with
annual terms during fiscal 2016, which is consistent with fiscal 2015. Occasionally, we bill customers for their
multi-year contract on a single invoice which results in an increase in noncurrent deferred revenue. We typically
issue renewal invoices in advance of the renewal service period, and depending on timing, the initial invoice for
the subscription and services contract and the subsequent renewal invoice may occur in different quarters. This
may result in an increase in deferred revenue and accounts receivable. There is a disproportionate weighting
towards annual billings in the fourth quarter, primarily as a result of large enterprise account buying patterns. Our
fourth quarter has historically been our strongest quarter for new business and renewals. The year on year
compounding effect of this seasonality in both billing patterns and overall new and renewal business causes the
value of invoices that we generate in the fourth quarter for both new business and renewals to increase as a
proportion of our total annual billings. Accordingly, because of this billing activity, our first quarter is our largest
collections and operating cash flow quarter.
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The sequential quarterly changes in accounts receivable, related deferred revenue and operating cash flow
during the first three quarters of our fiscal year are not necessarily indicative of the billing activity that occurs in
the fourth quarter as displayed below (in thousands, except unbilled deferred revenue):
April 30,
2015
July 31,
2015
October 31,
2015
January 31,
2016
Fiscal 2016
Accounts receivable, net . . . . . . . . . . . . . . . $ 926,381 $1,067,799 $1,060,726 $2,496,165
Deferred revenue, current and
noncurrent . . . . . . . . . . . . . . . . . . . . . . . . 3,056,820 3,034,991 2,846,510 4,291,553
Operating cash flow (1) . . . . . . . . . . . . . . . . 730,857 304,411 117,907 459,410
Unbilled deferred revenue, a non-GAAP
measure . . . . . . . . . . . . . . . . . . . . . . . . . . 6.0 bn 6.2 bn 6.7 bn 7.1 bn
April 30,
2014
July 31,
2014
October 31,
2014
January 31,
2015
Fiscal 2015
Accounts receivable, net . . . . . . . . . . . . . . . $ 684,155 $ 834,323 $ 794,590 $1,905,506
Deferred revenue, current and
noncurrent . . . . . . . . . . . . . . . . . . . . . . . . 2,324,615 2,352,904 2,223,977 3,321,449
Operating cash flow (1) . . . . . . . . . . . . . . . . 473,087 245,893 122,511 332,223
Unbilled deferred revenue, a non-GAAP
measure . . . . . . . . . . . . . . . . . . . . . . . . . . 4.8 bn 5.0 bn 5.4 bn 5.7 bn
April 30,
2013
July 31,
2013
October 31,
2013
January 31,
2014
Fiscal 2014
Accounts receivable, net . . . . . . . . . . . . . . . $ 502,609 $ 599,543 $ 604,045 $1,360,837
Deferred revenue, current and
noncurrent . . . . . . . . . . . . . . . . . . . . . . . . 1,733,160 1,789,648 1,734,619 2,522,115
Operating cash flow (1) . . . . . . . . . . . . . . . . 283,189 183,183 137,859 271,238
Unbilled deferred revenue, a non-GAAP
measure . . . . . . . . . . . . . . . . . . . . . . . . . . 3.6 bn 3.8 bn 4.2 bn 4.5 bn
(1) Operating cash flow represents net cash provided by operating activities for the three months ended in the
periods stated above.
Unbilled Deferred Revenue, a Non-GAAP Measure
The GAAP deferred revenue balance on our consolidated balance sheet does not represent the total contract
value of annual or multi-year, non-cancelable subscription agreements. Unbilled deferred revenue is a non-
GAAP operational measure that represents future billings under our subscription agreements that have not been
invoiced and, accordingly, are not recorded in deferred revenue. Unbilled deferred revenue was approximately
$7.1 billion as of January 31, 2016 and approximately $5.7 billion as of January 31, 2015. Our typical contract
length is between 12 and 36 months. We expect that the amount of unbilled deferred revenue will change from
quarter to quarter for several reasons, including the specific timing, duration and size of large customer
subscription agreements, varying billing cycles of subscription agreements, the specific timing of customer
renewals, foreign currency fluctuations, the timing of when unbilled deferred revenue is to be recognized as
revenue, and changes in customer financial circumstances. For multi-year subscription agreements billed
annually, the associated unbilled deferred revenue is typically high at the beginning of the contract period, zero
just prior to renewal, and increases if the agreement is renewed. Low unbilled deferred revenue attributable to a
particular subscription agreement is often associated with an impending renewal and may not be an indicator of
the likelihood of renewal or future revenue from such customer. Accordingly, we expect that the amount of
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aggregate unbilled deferred revenue will change from year-to-year depending in part upon the number and dollar
amount of subscription agreements at particular stages in their renewal cycle. Such fluctuations are not a reliable
indicator of future revenues. Unbilled deferred revenue does not include minimum revenue commitments from
indirect sales channels, as we recognize revenue, deferred revenue, and any unbilled deferred revenue upon sell-
through to an end user customer.
Cost of Revenues and Operating Expenses
Cost of Revenues. Cost of subscription and support revenues primarily consists of expenses related to delivering
our service and providing support, the costs of data center capacity, depreciation or operating lease expense associated
with computer equipment and software, allocated overhead, amortization expense associated with capitalized software
related to our services and acquired developed technologies and certain fees paid to various third parties for the use of
their technology, services and data. We allocate overhead such as information technology infrastructure, rent and
occupancy charges based on headcount. Employee benefit costs and taxes are allocated based upon a percentage of
total compensation expense. As such, general overhead expenses are reflected in each cost of revenue and operating
expense category. Cost of professional services and other revenues consists primarily of employee-related costs
associated with these services, including stock-based expenses, the cost of subcontractors and allocated overhead. The
cost of providing professional services is significantly higher as a percentage of the related revenue than for our
enterprise cloud computing subscription service due to the direct labor costs and costs of subcontractors.
We intend to continue to invest additional resources in our enterprise cloud computing services. For
example, we have invested in additional database software and we plan to increase the capacity that we are able
to offer globally through data centers and third party infrastructure providers. As we acquire new businesses and
technologies, the amortization expense associated with this activity will be included in cost of revenues.
Additionally, as we enter into new contracts with third parties for the use of their technology, services or data, or
as our sales volume grows, the fees paid to use such technology or services may increase. The timing of these
additional expenses will affect our cost of revenues, both in terms of absolute dollars and as a percentage of
revenues, in the affected periods.
Research and Development. Research and development expenses consist primarily of salaries and related
expenses, including stock-based expenses, the costs of our development and test data center and allocated
overhead. We continue to focus our research and development efforts on adding new features and services,
integrating acquired technologies, increasing the functionality and security and enhancing the ease of use of our
enterprise cloud computing services. Our proprietary, scalable and secure multi-tenant architecture enables us to
provide all of our customers with a service based on a single version of our application. As a result, we do not
have to maintain multiple versions, which enables us to have relatively lower research and development expenses
as compared to traditional enterprise software companies.
We expect that in the future, research and development expenses will increase in absolute dollars and may
increase as a percentage of total revenues as we invest in building the necessary employee and system
infrastructure required to support the development of new, and improve existing, technologies and the integration
of acquired businesses and technologies.
Marketing and Sales. Marketing and sales expenses are our largest cost and consist primarily of salaries and
related expenses, including stock-based expenses, for our sales and marketing staff, including commissions,
payments to partners, marketing programs and allocated overhead. Marketing programs consist of advertising,
events, corporate communications, brand building and product marketing activities.
We plan to continue to invest in marketing and sales by expanding our domestic and international selling
and marketing activities, building brand awareness, attracting new customers and sponsoring additional
marketing events. The timing of these marketing events, such as our annual and largest event, Dreamforce, will
affect our marketing costs in a particular quarter. We expect that in the future, marketing and sales expenses will
increase in absolute dollars and continue to be our largest cost.
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General and Administrative. General and administrative expenses consist of salaries and related expenses,
including stock-based expenses, for finance and accounting, legal, internal audit, human resources and management
information systems personnel, legal costs, professional fees, other corporate expenses and allocated overhead. We
expect that in the future, general and administrative expenses will increase in absolute dollars as we invest in our
infrastructure and we incur additional employee related costs, professional fees and insurance costs related to the
growth of our business and international expansion. We expect general and administrative costs as a percentage of
total revenues to either remain flat or decrease for the next several quarters.
Stock-Based Expenses. Our cost of revenues and operating expenses include stock-based expenses related to
equity plans for employees and non-employee directors. We recognize our stock-based compensation as an
expense in the statement of operations based on their fair values and vesting periods. These charges have been
significant in the past and we expect that they will increase as our stock price increases, as we acquire more
companies, as we hire more employees and seek to retain existing employees.
During fiscal 2016, we recognized stock-based expense of $593.6 million. As of January 31, 2016, the
aggregate stock compensation remaining to be amortized to costs and expenses was $1.6 billion. We expect this
stock compensation balance to be amortized as follows: $626.1 million during fiscal 2017 ; $481.0 million during
fiscal 2018 ; $340.6 million during fiscal 2019 and $157.1 million during fiscal 2020. The expected amortization
reflects only outstanding stock awards as of January 31, 2016 and assumes no forfeiture activity. We expect to
continue to issue stock-based awards to our employees in future periods.
Amortization of Purchased Intangibles from Business Combinations. Our cost of revenues and operating
expenses include amortization of acquisition-related intangible assets, such as the amortization of the cost
associated with an acquired company’s research and development efforts, trade names, customer lists and
customer relationships. We expect this expense to increase as we acquire more companies.
Critical Accounting Estimates
Our consolidated financial statements are prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these consolidated financial statements requires us to make
estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses,
and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may
differ from these estimates under different assumptions or conditions.
We believe that of our significant accounting policies, which are described in Note 1 “Summary of Business
and Significant Accounting Policies” to our consolidated financial statements, the following accounting policies
involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most
critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.
Revenue Recognition. We derive our revenues from two sources: (1) subscription revenues, which are
comprised of subscription fees from customers accessing our enterprise cloud computing services and from
customers purchasing additional support beyond the standard support that is included in the basic subscription
fee; and (2) related professional services such as process mapping, project management, implementation services
and other revenue. “Other revenue” consists primarily of training fees.
We commence revenue recognition when all of the following conditions are satisfied:
• there is persuasive evidence of an arrangement;
• the service has been or is being provided to the customer;
• the collection of the fees is reasonably assured; and
• the amount of fees to be paid by the customer is fixed or determinable.
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Our subscription service arrangements are non-cancelable and do not contain refund-type provisions.
Subscription and Support Revenues
Subscription and support revenues are recognized ratably over the contract terms beginning on the
commencement date of each contract, which is the date our service is made available to customers. Amounts that
have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on
whether the revenue recognition criteria have been met.
Professional Services and Other Revenues
The majority of our professional services contracts are on a time and material basis. When these services are
not combined with subscription revenues as a single unit of accounting, as discussed below, these revenues are
recognized as the services are rendered for time and material contracts, and when the milestones are achieved and
accepted by the customer for fixed price contracts. Training revenues are recognized after the services are
performed.
Multiple Deliverable Arrangements
We enter into arrangements with multiple deliverables that generally include multiple subscriptions,
premium support, and professional services. If the deliverables have standalone value upon delivery, we account
for each deliverable separately. Subscription services have standalone value as such services are often sold
separately. In determining whether professional services have standalone value, we consider the following
factors for each professional services agreement: availability of the services from other vendors, the nature of the
professional services, the timing of when the professional services contract was signed in comparison to the
subscription service start date, and the contractual dependence of the subscription service on the customer’s
satisfaction with the professional services work. To date, we have concluded that all of the professional services
included in multiple deliverable arrangements executed have standalone value.
Multiple deliverables included in an arrangement are separated into different units of accounting and the
arrangement consideration is allocated to the identified separate units based on a relative selling price hierarchy.
We determine the relative selling price for a deliverable based on its vendor-specific objective evidence of selling
price (“VSOE”), if available, or our best estimate of selling price (“BESP”), if VSOE is not available. We have
determined that third-party evidence (“TPE”) is not a practical alternative due to differences in our service
offerings compared to other parties and the availability of relevant third-party pricing information. The amount of
revenue allocated to delivered items is limited by contingent revenue, if any.
For certain professional services, we have established VSOE as a consistent number of standalone sales of
this deliverable have been priced within a reasonably narrow range. We have not established VSOE for our
subscription services due to lack of pricing consistency, the introduction of new services and other factors.
Accordingly, we use our BESP to determine the relative selling price.
We determined BESP by considering our overall pricing objectives and market conditions. Significant
pricing practices taken into consideration include our discounting practices, the size and volume of our
transactions, the customer demographic, the geographic area where our services are sold, our price lists, our go-
to-market strategy, historical standalone sales and contract prices. The determination of BESP is made through
consultation with and approval by management, taking into consideration the go-to-market strategy. As our go-
to-market strategies evolve, we may modify our pricing practices in the future, which could result in changes in
relative selling prices, including both VSOE and BESP.
Deferred Revenue. The deferred revenue balance does not represent the total contract value of annual or
multi-year, non-cancelable subscription agreements. Deferred revenue primarily consists of billings or payments
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received in advance of revenue recognition from subscription services described above and is recognized as the
revenue recognition criteria are met. We generally invoice customers in annual installments. The deferred
revenue balance is influenced by several factors, including seasonality, the compounding effects of renewals,
invoice duration, invoice timing, size and new business linearity within the quarter.
Deferred revenue that will be recognized during the succeeding twelve month period is recorded as current
deferred revenue and the remaining portion is recorded as noncurrent.
Deferred Commissions. We defer commission payments to our direct sales force. The commissions are
deferred and amortized to sales expense over the non-cancelable terms of the related subscription contracts with
our customers, which are typically 12 to 36 months. The commission payments, which are paid in full the month
after the customer’s service commences, are a direct and incremental cost of the revenue arrangements. The
deferred commission amounts are recoverable through the future revenue streams under the non-cancelable
customer contracts. We believe this is the preferable method of accounting as the commission charges are so
closely related to the revenue from the non-cancelable customer contracts that they should be recorded as an
asset and charged to expense over the same period that the subscription revenue is recognized.
During fiscal 2016, we deferred $380.0 million of commission expenditures and we amortized $319.1 million
to sales expense. During the same period a year ago, we deferred $320.9 million of commission expenditures and
we amortized $257.6 million to sales expense. Deferred commissions on our consolidated balance sheets totaled
$449.1 million at January 31, 2016 and $388.2 million at January 31, 2015.
Capitalized Internal-Use Software Costs. We are required to follow the guidance of Accounting Standards
Codification 350 (“ASC 350”), Intangibles- Goodwill and Other in accounting for the cost of computer software
developed for internal-use and the accounting for web-based product development costs. ASC 350 requires
companies to capitalize qualifying computer software costs, which are incurred during the application
development stage, and amortize these costs on a straight-line basis over the estimated useful life of the
respective asset. We deliver our enterprise cloud computing solutions as a service via all the major Internet
browsers and on leading major mobile device operating systems. As a result of this software as a service delivery
model, we believe we have larger capitalized costs as compared to traditional enterprise software companies as
they are required to use a different accounting standard.
Costs related to preliminary project activities and post implementation activities are expensed as incurred.
Internal-use software is amortized on a straight-line basis over its estimated useful life. We evaluate the useful
lives of these assets on an annual basis and test for impairment whenever events or changes in circumstances
occur that could impact the recoverability of these assets.
Business Combinations. Accounting for business combinations requires us to make significant estimates and
assumptions, especially at the acquisition date with respect to tangible and intangible assets acquired and
liabilities assumed and pre-acquisition contingencies. We use our best estimates and assumptions to accurately
assign fair value to the tangible and intangible assets acquired and liabilities assumed at the acquisition date.
Examples of critical estimates in valuing certain of the intangible assets and goodwill we have acquired
include but are not limited to:
• future expected cash flows from subscription and support contracts, professional services contracts,
other customer contracts and acquired developed technologies and patents;
• the acquired company’s trade name, trademark and existing customer relationship, as well as
assumptions about the period of time the acquired trade name and trademark will continue to be used in
our offerings;
• uncertain tax positions and tax related valuation allowances assumed; and
• discount rates.
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Unanticipated events and circumstances may occur that may affect the accuracy or validity of such
assumptions, estimates or actual results.
Goodwill and Intangibles. We make estimates, assumptions, and judgments when valuing goodwill and
other intangible assets in connection with the initial purchase price allocation of an acquired entity, as well as
when evaluating the recoverability of our goodwill and other intangible assets on an ongoing basis. These
estimates are based upon a number of factors, including historical experience, market conditions, and information
obtained from the management of acquired companies. Critical estimates in valuing certain intangible assets
include, but are not limited to, historical and projected attrition rates, discount rates, anticipated growth in
revenue from the acquired customers and acquired technology, and the expected use of the acquired assets. These
factors are also considered in determining the useful life of acquired intangible assets. The amounts and useful
lives assigned to identified intangible assets impacts the amount and timing of future amortization expense.
Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method,
deferred tax assets and liabilities are determined based on temporary differences between the financial statement
and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are
expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the
consolidated statements of operations in the period that includes the enactment date. At each of the interim
financial reporting periods, we compute our tax provision by applying an estimated annual effective tax rate to
year to date ordinary income and adjust the provision for discrete tax items recorded in the same period. The
estimated annual effective tax rate at each interim period represents the best estimate based on evaluations of
possible future transactions and may be subject to subsequent refinement or revision.
Our tax positions are subject to income tax audits by multiple tax jurisdictions throughout the world. We
recognize the tax benefit of an uncertain tax position only if it is more likely than not that the position is
sustainable upon examination by the taxing authority, based on the technical merits. The tax benefit recognized is
measured as the largest amount of benefit which is greater than 50 percent likely to be realized upon settlement
with the taxing authority. We recognize interest accrued and penalties related to unrecognized tax benefits in our
income tax provision.
Valuation allowances are established when necessary to reduce deferred tax assets to the amounts that are
more likely than not expected to be realized based on the weighting of positive and negative evidence. Future
realization of deferred tax assets ultimately depends on the existence of sufficient taxable income of the
appropriate character (for example, ordinary income or capital gain) within the carryback or carryforward periods
available under the applicable tax law. We regularly review the deferred tax assets for recoverability based on
historical taxable income, projected future taxable income, the expected timing of the reversals of existing
temporary differences and tax planning strategies. Our judgment regarding future profitability may change due to
many factors, including future market conditions and the ability to successfully execute the business plans and/or
tax planning strategies. Should there be a change in the ability to recover deferred tax assets, our income tax
provision would increase or decrease in the period in which the assessment is changed.
Strategic Investments. We hold strategic investments in marketable equity securities and non-marketable
debt and equity securities in which we do not have a controlling interest or significant influence, as defined in
Accounting Standards Codification 323 (“ASC 323”), Investments—Equity Method and Joint Ventures.
Marketable equity securities are measured using quoted prices in their respective active markets and non-
marketable debt and equity securities are recorded at cost and presented in the consolidated balance sheet. If,
based on the terms of our ownership of these marketable and non-marketable securities, we determine that we
exercise significant influence on the entity to which these marketable and non-marketable securities relate, we
apply the requirements of ASC 323 to account for such investments.
We determine the fair value of our marketable equity securities and non-marketable debt and equity
securities quarterly for impairment and disclosure purposes; however, the non-marketable debt and equity
47
securities are recorded at fair value only if an impairment is recognized. The measurement of fair value requires
significant judgment and includes a qualitative and quantitative analysis of events and circumstances that impact
the fair value of the investment. Our assessment of the severity and duration of the impairment and qualitative
and quantitative analysis includes the investee’s financial metrics, the investee’s products and technologies
meeting or exceeding predefined milestones, market acceptance of the product or technology, other competitive
products or technology in the market, general market conditions, management and governance structure of the
investee, investee’s liquidity, debt ratios and the rate at which the investee is using its cash, and investee’s receipt
of additional funding at a lower valuation. In determining the estimated fair value of our strategic investments in
privately held companies, we utilize the most recent data available to us. Valuations of privately held companies
are inherently complex due to the lack of readily available market data.
If the fair value of an investment is below our cost, we determine whether the investment is other-than-
temporarily impaired based on our qualitative and quantitative analysis, which includes the severity and duration
of the impairment. If the investment is considered to be other-than-temporarily impaired, we record the
investment at fair value by recognizing an impairment through the income statement and establishing a new cost
basis for the investment.
Results of Operations
The following tables set forth selected data for each of the periods indicated (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Revenues:
Subscription and support . . . . . . . . . . . . . . . $6,205,599 $5,013,764 $3,824,542
Professional services and other . . . . . . . . . . 461,617 359,822 246,461
Total revenues . . . . . . . . . . . . . . . . . . . 6,667,216 5,373,586 4,071,003
Cost of revenues (1)(2):
Subscription and support . . . . . . . . . . . . . . . 1,188,967 924,638 711,880
Professional services and other . . . . . . . . . . 465,581 364,632 256,548
Total cost of revenues . . . . . . . . . . . . . 1,654,548 1,289,270 968,428
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,012,668 4,084,316 3,102,575
Operating expenses (1)(2):
Research and development . . . . . . . . . . . . . 946,300 792,917 623,798
Marketing and sales . . . . . . . . . . . . . . . . . . . 3,239,824 2,757,096 2,168,132
General and administrative . . . . . . . . . . . . . 748,238 679,936 596,719
Operating lease termination resulting from
purchase of 50 Fremont . . . . . . . . . . . . . . (36,617) 0 0
Total operating expenses . . . . . . . . . . . 4,897,745 4,229,949 3,388,649
Income (loss) from operations . . . . . . . . . . . . . . 114,923 (145,633) (286,074)
Investment income . . . . . . . . . . . . . . . . . . . . . . . 15,341 10,038 10,218
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . (72,485) (73,237) (77,211)
Other expense (1) . . . . . . . . . . . . . . . . . . . . . . . . (15,292) (19,878) (4,868)
Gain on sales of land and building
improvements . . . . . . . . . . . . . . . . . . . . . . . . . 21,792 15,625 0
Income (loss) before benefit from (provision
for) income taxes . . . . . . . . . . . . . . . . . . . . . . . 64,279 (213,085) (357,935)
Benefit from (provision for) income taxes . . . . . (111,705) (49,603) 125,760
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (47,426) $ (262,688) $ (232,175)
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(1) Cost of revenues and marketing and sales expenses include the following amounts related to amortization of
purchased intangibles from business combinations (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . $80,918 $90,300 $109,356
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . 77,152 64,673 37,179
Other non-operating expense . . . . . . . . . . . . . . . . . . 3,636 0 0
(2) Cost of revenues and operating expenses include the following amounts related to stock-based expenses (in
thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . $ 69,443 $ 53,812 $ 45,608
Research and development . . . . . . . . . . . . . . . . . 129,434 121,193 107,420
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . 289,152 286,410 258,571
General and administrative . . . . . . . . . . . . . . . . . 105,599 103,350 91,681
Revenues by geography were as follows (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Americas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,910,745 $3,868,329 $2,899,837
Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,162,808 984,919 741,220
Asia Pacific . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593,663 520,338 429,946
$6,667,216 $5,373,586 $4,071,003
Americas revenue attributed to the United States was approximately 95 percent, 94 percent and 96 percent
for fiscal 2016, 2015 and 2014, respectively. No other country represented more than ten percent of total revenue
during fiscal 2016, 2015 or 2014.
49
The following tables set forth selected consolidated statements of operations data for each of the periods
indicated as a percentage of total revenues:
Fiscal Year Ended January 31,
2016 2015 2014
Revenues:
Subscription and support . . . . . . . . . . . . . . . . . . . . . . 93% 93% 94%
Professional services and other . . . . . . . . . . . . . . . . . 7 7 6
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . 100 100 100
Cost of revenues:
Subscription and support . . . . . . . . . . . . . . . . . . . . . . 18 17 18
Professional services and other . . . . . . . . . . . . . . . . . 7 7 6
Total cost of revenues . . . . . . . . . . . . . . . . . . . . 25 24 24
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 76 76
Operating expenses:
Research and development . . . . . . . . . . . . . . . . . . . . 14 15 15
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . . 49 51 53
General and administrative . . . . . . . . . . . . . . . . . . . . 11 13 15
Operating lease termination resulting from purchase
of 50 Fremont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) 0 0
Total operating expenses . . . . . . . . . . . . . . . . . . 73 79 83
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . . 2 (3) (7)
Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1) (1) (2)
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Gain on sales of land and building improvements . . . . . . . 0 0 0
Income (loss) before benefit from (provision for) income
taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 (4) (9)
Benefit from (provision for) income taxes . . . . . . . . . . . . . (2) (1) 3
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1)% (5)% (6)%
Fiscal Year Ended January 31,
2016 2015 2014
Amortization of purchased intangibles:
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1% 2% 3%
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 1
Other non-operating expense . . . . . . . . . . . . . . . . . . . 0 0 0
Fiscal Year Ended January 31,
2016 2015 2014
Stock-based expenses:
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1% 1% 1%
Research and development . . . . . . . . . . . . . . . . . . . . . 2 2 3
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . . 4 5 6
General and administrative . . . . . . . . . . . . . . . . . . . . 2 2 2
50
Fiscal Year Ended January 31,
2016 2015 2014
Revenues by geography:
Americas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74% 72% 71%
Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 18 18
Asia Pacific . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 10 11
100% 100% 100%
Revenue constant
currency growth rates
(as compared to the
comparable prior periods)
Fiscal Year Ended
January 31, 2016
compared to
Fiscal Year Ended
January 31, 2015
Fiscal Year Ended
January 31, 2015
compared to
Fiscal Year Ended
January 31, 2014
Fiscal Year Ended
January 31, 2014
compared to
Fiscal Year Ended
January 31, 2013
Americas . . . . . . . . . . . . . . . . . . . 27% 33% 37%
Europe . . . . . . . . . . . . . . . . . . . . . 29% 34% 36%
Asia Pacific . . . . . . . . . . . . . . . . . 26% 26% 19%
Total growth . . . . . . . . . . . . . . . . 27% 33% 34%
We present constant currency information to provide a framework for assessing how our underlying
business performed excluding the effect of foreign currency rate fluctuations. To present this information, current
and comparative prior period results for entities reporting in currencies other than United States dollars are
converted into United States dollars at the weighted average exchange rate for the year being compared to for
growth rate calculations presented, rather than the actual exchange rates in effect during that period.
As of January 31,
2016 2015
Selected Balance Sheet Data (in thousands):
Cash, cash equivalents and marketable securities,
excluding restricted cash . . . . . . . . . . . . . . . . . . . . . $2,725,377 $1,890,284
Deferred revenue, current and noncurrent . . . . . . . . . 4,291,553 3,321,449
Principal due on our outstanding debt obligations . . . 1,350,000 1,450,000
Unbilled deferred revenue was approximately $7.1 billion as of January 31, 2016 and $5.7 billion as of
January 31, 2015. Unbilled deferred revenue represents future billings under our non-cancelable subscription
agreements that have not been invoiced and, accordingly, are not recorded in deferred revenue.
Fiscal Years Ended January 31, 2016 and 2015
Revenues.
Fiscal Year Ended
January 31, Variance
(in thousands) 2016 2015 Dollars Percent
Subscription and support . . . . . . . . . . . . . . . . $6,205,599 $5,013,764 $1,191,835 24%
Professional services and other . . . . . . . . . . . . 461,617 359,822 101,795 28%
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . $6,667,216 $5,373,586 $1,293,630 24%
Total revenues were $6.7 billion for fiscal 2016, compared to $5.4 billion during the same period a year ago, an
increase of $1.3 billion, or 24 percent. On a constant currency basis, total revenues grew 27 percent. Subscription
and support revenues were $6.2 billion, or 93 percent of total revenues, for fiscal 2016, compared to $5.0 billion, or
93 percent of total revenues, during the same period a year ago, an increase of $1.2 billion, or 24 percent. The
increase in subscription and support revenues in fiscal 2016 was primarily attributable to volume-driven increases
51
from new business, which includes new customers, upgrades and additional subscriptions from existing customers.
Our attrition rate, which is favorable compared to the prior year, also played a role in the increase in subscription
and support revenues. We continue to invest in a variety of customer programs and initiatives, which, along with
increasing enterprise adoption, have helped improve our attrition rate. Changes in the net price per user per month
have not been a significant driver of revenue growth for the periods presented. Professional services and other
revenues were $461.6 million, or seven percent of total revenues, for fiscal 2016, compared to $359.8 million, or
seven percent of total revenues, for the same period a year ago, an increase of $101.8 million, or 28 percent.
Revenues in Europe and Asia Pacific accounted for $1.8 billion, or 26 percent of total revenues, for fiscal
2016, compared to $1.5 billion, or 28 percent of total revenues, during the same period a year ago, an increase of
$251.2 million, or 17 percent. The increase in revenues on a total dollar basis outside of the Americas was the
result of the increasing acceptance of our service, our focus on marketing our services internationally, additional
resources and consistent attrition rates as a result of the reasons stated above. Revenues outside of the Americas
increased on a total dollar basis in fiscal 2016 despite an overall strengthening of the U.S. dollar, which reduced
aggregate international revenues by $170.5 million compared to fiscal 2015. We expect revenues outside of the
Americas to continue to be negatively impacted in fiscal 2017 by the strengthening of the U.S. dollar relative to
the Euro, British pound, Japanese yen and Australian dollar.
Cost of Revenues.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Subscription and support . . . . . . . . . . . . . . . . . . . . $1,188,967 $ 924,638 $264,329
Professional services and other . . . . . . . . . . . . . . . 465,581 364,632 100,949
Total cost of revenues . . . . . . . . . . . . . . . . . . . . . . $1,654,548 $1,289,270 $365,278
Percent of total revenues . . . . . . . . . . . . . . . . . . . . 25% 24%
Cost of revenues was $1.7 billion, or 25 percent of total revenues, for fiscal 2016, compared to $1.3 billion,
or 24 percent of total revenues, during the same period a year ago, an increase of $365.3 million. The increase in
absolute dollars was primarily due to an increase of $127.9 million in employee-related costs, an increase of
$15.6 million in stock-based expenses, an increase of $137.2 million in service delivery costs, primarily due to
our efforts to increase data center capacity, an increase of $40.6 million in professional and outside services, an
increase in depreciation of equipment and an increase in allocated overhead, offset by a decrease of $9.4 million
in amortization of purchased intangibles. We have increased our headcount by 34 percent since January 31, 2015
to meet the higher demand for services from our customers. We intend to continue to invest additional resources
in our enterprise cloud computing services and data center capacity. Additionally, the amortization of purchased
intangible assets may increase as we acquire additional businesses and technologies. We also plan to add
additional employees in our professional services group to facilitate the adoption of our services. The timing of
these expenses will affect our cost of revenues, both in terms of absolute dollars and as a percentage of revenues
in future periods.
The cost of professional services and other revenues exceeded the related revenue during fiscal 2016 by
$4.0 million as compared to $4.8 million during the same period a year ago. We expect the cost of professional
services to continue to exceed revenue from professional services in future fiscal years. We believe that this
investment in professional services facilitates the adoption of our service offerings.
52
Research and Development.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Research and development . . . . . . . . . . . . . . . . . . . . . . $946,300 $792,917 $153,383
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . 14% 15%
Research and development expenses were $946.3 million, or 14 percent of total revenues, for fiscal 2016,
compared to $792.9 million, or 15 percent of total revenues, during the same period a year ago, an increase of
$153.4 million. The increase in absolute dollars was primarily due to an increase of $114.0 million in employee-
related costs, an increase of $8.2 million in stock-based expense, an increase of $18.2 million in development and
test data center expense, and an increase in allocated overhead. We increased our research and development
headcount by 16 percent since January 31, 2015 in order to improve and extend our service offerings and develop
new technologies. We expect that research and development expenses will increase in absolute dollars and may
increase as a percentage of revenues in future periods as we continue to add employees and invest in technology
to support the development of new, and improve existing, technologies and the integration of acquired
technologies.
Marketing and Sales.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . $3,239,824 $2,757,096 $482,728
Percent of total revenues . . . . . . . . . . . . . . . . . . . . 49% 51%
Marketing and sales expenses were $3.2 billion, or 49 percent of total revenues, for fiscal 2016, compared to
$2.8 billion, or 51 percent of total revenues, during the same period a year ago, an increase of $482.7 million.
The increase in absolute dollars was primarily due to increases of $304.7 million in employee-related costs,
including amortization of deferred commissions, $112.0 million in advertising expense costs, $12.5 million in
amortization of purchased intangibles, $2.7 million stock-based expense and $40.4 million in allocated overhead.
Our marketing and sales headcount increased by 21 percent since January 31, 2015. The increase in headcount
was primarily attributable to hiring additional sales personnel to focus on adding new customers and increasing
penetration within our existing customer base.
General and Administrative.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
General and administrative . . . . . . . . . . . . . . . . . . . . . . $748,238 $679,936 $68,302
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . . 11% 13%
General and administrative expenses were $748.2 million, or 11 percent of total revenues, for fiscal 2016,
compared to $679.9 million, or 13 percent of total revenues, during the same period a year ago, an increase of
$68.3 million. The increase was primarily due to an increase of $39.0 million in employee-related costs, an
increase of $8.1 million in bad debt expense, an increase of $2.2 million in stock-based expense and an increase
in professional and outside services. Our general and administrative headcount increased by 16 percent since
January 31, 2015 as we added personnel to support our growth.
53
Operating lease termination resulting from purchase of 50 Fremont.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Operating lease termination resulting from purchase of 50
Fremont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(36,617) $0 (36,617)
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1)% 0%
Operating lease termination resulting from purchase of 50 Fremont for fiscal 2016 was $36.6 million. In
connection with the purchase, we recognized a net non-cash gain totaling approximately $36.6 million on the
termination of the lease signed in January 2012.
Income (loss) from operations.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Income (loss) from operations . . . . . . . . . . . . . . . . . . $114,923 $(145,633) $260,556
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . 2% (3)%
Income (loss) from operations for fiscal 2016 was $114.9 million and included $593.6 million of stock-
based expenses and $158.1 million of amortization of purchased intangibles. During the same period a year ago,
loss from operations was $145.6 million and included $564.8 million of stock-based expenses and $155.0 million
of amortization of purchased intangibles. The increase in income from operations is primarily due to a higher
revenue growth rate compared to the operating expense growth rate.
Investment income.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,341 $10,038 $5,303
Investment income consists of income on our cash and marketable securities balances. Investment income
was $15.3 million for fiscal 2016 and was $10.0 million during the same period a year ago. The increase was
primarily due to the increase in cash, cash equivalent and marketable securities balances.
Interest expense.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(72,485) $(73,237) $752
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . . . (1)% (1)%
Interest expense consists of interest on our convertible senior notes, capital leases, term loan and revolving
credit facility. Interest expense, net of interest costs capitalized, was $72.5 million for fiscal 2016 and was $73.2
million during the same period a year ago. The decrease was primarily due to the payment of our revolving credit
facility in 2015.
54
Other expense.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(15,292) $(19,878) $4,586
Other expense primarily consists of non-operating costs such as strategic investments fair market
adjustments, foreign exchange rate fluctuations, real estate transactions and losses on derecognition of debt. The
decrease in other expense for fiscal 2016 was primarily due to losses totaling $ 10.3 million related to the
extinguishment of the 0.75% Senior Notes converted by noteholders in fiscal 2015.
Gain on sales of land and building improvements.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Gain on sales of land and building improvements . . . . . . . $21,792 $15,625 $6,167
Gain on sales of land and building improvements consists of the gain the company recognized from sales of
undeveloped real estate and a portion of associated perpetual parking rights in San Francisco, California. Gain on
sales of land and building improvements, net of closing costs, was $21.8 million for fiscal 2016 and was
$15.6 million during the same period a year ago.
Provision for income taxes.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2016 2015
Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . $(111,705) $(49,603) $(62,102)
Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174% (23)%
We reported a tax provision of $111.7 million on a pretax income of $64.3 million, which resulted in an
effective tax rate of 174 percent for the fiscal 2016. We had a tax provision in profitable jurisdictions outside the
United States and current tax expense in the United States. We had U.S. current tax expense as a result of taxable
income before considering certain excess tax benefits from stock options and vesting of restricted stock.
We recorded a tax provision of $49.6 million with a pretax loss of $213.1 million, which resulted in an
negative effective tax rate of 23 percent for fiscal 2015. We had a tax provision primarily due to income taxes in
profitable jurisdictions outside the United States, which was partially offset by tax benefits from losses incurred
by ExactTarget in certain state jurisdictions.
We regularly assess the realizability of our deferred tax assets and establish a valuation allowance if it is
more-likely-than-not that some or all of our deferred tax assets will not be realized. We evaluate and weigh all
available positive and negative evidence such as historic results, future reversals of existing deferred tax
liabilities, projected future taxable income, as well as prudent and feasible tax-planning strategies. Generally,
more weight is given to objectively verifiable evidence, such as the cumulative loss in recent years. We had a
valuation allowance against our U.S. deferred tax assets as we considered our cumulative loss in recent years as a
significant piece of negative evidence that is difficult to overcome. We will adjust our valuation allowance in the
event sufficient positive evidence overcomes the negative evidence of losses in recent years. Due to our valuation
allowance, the effective tax rate could be volatile and is therefore difficult to forecast in future periods.
55
Fiscal Years Ended January 31, 2015 and 2014
Revenues.
Fiscal Year Ended
January 31, Variance
(in thousands) 2015 2014 Dollars Percent
Subscription and support . . . . . . . . . . . . . . . . . . $5,013,764 $3,824,542 $1,189,222 31%
Professional services and other . . . . . . . . . . . . . . 359,822 246,461 113,361 46%
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,373,586 $4,071,003 $1,302,583 32%
Total revenues were $5.4 billion for fiscal 2015, compared to $4.1 billion during fiscal 2014, an increase of
$1.3 billion, or 32 percent. On a constant currency basis, total revenues grew 33 percent. Subscription and support
revenues were $5.0 billion, or 93 percent of total revenues, for fiscal 2015, compared to $3.8 billion, or 94 percent
of total revenues, during fiscal 2014, an increase of $1.2 billion, or 31 percent. The increase in subscription and
support revenues was primarily attributable to the impact of, in fiscal 2015, including ExactTarget revenue for the
full fiscal year, as compared to fiscal 2014, which only included ExactTarget revenue as of its acquisition date in
July 2013. Additionally, volume-driven increases from new business, which includes new customers, upgrades and
additional subscriptions from existing customers contributed to the increase in subscription and support revenues.
Our attrition rate, which was consistent with the prior year, also played a role in the increase in subscription and
support revenues. We invest in a variety of customer programs and initiatives, which, along with increasing
enterprise adoption, have helped maintain our attrition rate. The net price per user per month for our three primary
offerings, Professional Edition, Enterprise Edition and Unlimited Edition, varies from period to period, but has
remained within a consistent range over the past eight quarters. Changes in the net price per user per month has not
been a significant driver of revenue growth for the periods presented. Professional services and other revenues were
$359.8 million, or seven percent of total revenues, for fiscal 2015, compared to $246.5 million, or six percent of
total revenues, for fiscal 2014, an increase of $113.4 million, or 46 percent. The increase in professional services
and other revenues was primarily attributable to the impact of, in fiscal 2015, including ExactTarget revenue for the
full fiscal year, as compared to fiscal 2014, which only included ExactTarget revenue as of its acquisition date in
July 2013.
Revenues in Europe and Asia Pacific accounted for $1.5 billion, or 28 percent of total revenues, for fiscal
2015, compared to $1.2 billion, or 29 percent of total revenues, during fiscal 2014, an increase of $334.1 million,
or 29 percent. The increase in revenues on a total dollar basis outside of the Americas was the result of the
increasing acceptance of our service, our focus on marketing our services internationally, additional resources
and consistent attrition rates as a result of the reasons stated above. Revenues outside of the Americas increased
on a total dollar basis in fiscal 2015 despite an overall strengthening of the U.S. dollar, which reduced aggregate
international revenues by $31.5 million compared to fiscal 2014.
Cost of Revenues.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Subscription and support . . . . . . . . . . . . . . . . . . . . . . $ 924,638 $711,880 $212,758
Professional services and other . . . . . . . . . . . . . . . . . 364,632 256,548 108,084
Total cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . $1,289,270 $968,428 $320,842
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . 24% 24%
56
Cost of revenues was $1.3 billion, or 24 percent of total revenues, for fiscal 2015, compared to $968.4 million,
or 24 percent of total revenues, during fiscal 2014, an increase of $320.8 million. The increase in absolute dollars
was primarily due to an increase of $122.3 million in employee-related costs, an increase of $8.2 million in stock-
based expenses, an increase of $100.6 million in service delivery costs, primarily due to our efforts to increase data
center capacity, an increase of $29.9 million in professional and outside services, an increase of $18.8 million in
allocated overhead and an increase of $44.7 million in depreciation of property and equipment, offset by a decrease
of $19.1 million in amortization of purchased intangibles. We increased our headcount by 30 percent in fiscal 2015
to meet the higher demand for services from our customers.
The cost of professional services and other revenues exceeded the related revenue during fiscal 2015 by
$4.8 million as compared to $10.1 million during fiscal 2014, primarily due to the impact of including
ExactTarget revenue for the full fiscal 2015, as described above, offset by an increase in the cost related to
professional services headcount. This investment in professional services facilitated the adoption of our service
offerings.
Research and Development.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Research and development . . . . . . . . . . . . . . . . . . . . . . $792,917 $623,798 $169,119
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . 15% 15%
Research and development expenses were $792.9 million, or 15 percent of total revenues, for fiscal 2015,
compared to $623.8 million, or 15 percent of total revenues, during fiscal 2014, an increase of $169.1 million.
The increase in absolute dollars was primarily due to an increase of $132.3 million in employee-related costs, an
increase of $13.8 million in stock-based expense, an increase of $14.8 million in development and test data
center expense, and an increase in allocated overhead. We increased our research and development headcount by
25 percent in fiscal 2015 in order to improve and extend our service offerings and develop new technologies.
Marketing and Sales.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . $2,757,096 $2,168,132 $588,964
Percent of total revenues . . . . . . . . . . . . . . . . . . . . 51% 53%
Marketing and sales expenses were $2.8 billion, or 51 percent of total revenues, for fiscal 2015, compared to
$2.2 billion, or 53 percent of total revenues, during fiscal 2014, an increase of $589.0 million. The increase in
absolute dollars was primarily due to increases of $439.0 million in employee-related costs, including
amortization of deferred commissions, $56.4 million in advertising expenses and event costs, $27.8 million
stock-based expense, $5.2 million in professional and outside services and $28.0 million in allocated overhead.
Our marketing and sales headcount increased by 22 percent in fiscal 2015. The increase in headcount was
primarily attributable to hiring additional sales personnel to focus on adding new customers and increasing
penetration within our existing customer base.
General and Administrative.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
General and administrative . . . . . . . . . . . . . . . . . . . . . . $679,936 $596,719 $83,217
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . . 13% 15%
57
General and administrative expenses were $679.9 million, or 13 percent of total revenues, for fiscal 2015,
compared to $596.7 million, or 15 percent of total revenues, during fiscal 2014, a increase of $83.2 million. The
increase was primarily due to an increase of $53.1 million in employee-related costs, an increase of $18.9 million
in equipment costs and an increase of $11.7 million in stock-based expense, offset by a decrease of $3.0 million
in professional and outside services. Our general and administrative headcount increased by 9 percent in fiscal
2015 as we added personnel to support our growth.
Loss from operations.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Loss from operations . . . . . . . . . . . . . . . . . . . . . . . . . $(145,633) $(286,074) $140,441
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . (3)% (7)%
Loss from operations for fiscal 2015 was $145.6 million and included $564.8 million of stock-based
expenses and $155.0 million of amortization of purchased intangibles. During fiscal 2014, loss from operations
was $286.1 million and included $503.3 million of stock-based expenses and $146.5 million of amortization of
purchased intangibles.
Investment income.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,038 $10,218 $(180)
Investment income consists of income on our cash and marketable securities balances. Investment income
was $10.0 million for fiscal 2015 and was $10.2 million during fiscal 2014.
Interest expense.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(73,237) $(77,211) $3,974
Percent of total revenues . . . . . . . . . . . . . . . . . . . . . . . . . (1)% (2)%
Interest expense consists of interest on our convertible senior notes, capital leases, term loan and revolving
credit facility. Interest expense, net of interest costs capitalized, was $73.2 million for fiscal 2015 and was $77.2
million during fiscal 2014. The decrease was primarily due to the reduced principal balance on our 0.75%
convertible senior notes as a result of early note conversions during fiscal 2015. These notes fully matured on
January 15, 2015.
Gain on sales of land and building improvements.
During fiscal 2015, we sold two separate portions of our undeveloped real estate, including a portion of our
perpetual parking rights, in San Francisco, California. We recognized a gain of $15.6 million during fiscal 2015,
net of closing costs, as a result of this activity.
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Other expense.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(19,878) $(4,868) $(15,010)
Other expense primarily consists of non-operating costs such as foreign currency transaction gains and
losses, costs associated with real estate transactions and losses on derecognition of debt. The increase in other
expense for fiscal 2015 was primarily due to losses totaling $10.3 million related to the extinguishment of the
0.75% Senior Notes converted by noteholders.
Benefit from (provision for) Income Taxes.
Fiscal Year Ended
January 31, Variance
Dollars(in thousands) 2015 2014
Benefit from (provision for) income taxes . . . . . . . . . $(49,603) $125,760 $(175,363)
Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (23)% 35%
We reported a tax provision of $49.6 million on a pretax loss of $213.1 million, which resulted in a negative
effective tax rate of 23 percent for the fiscal 2015. We had a tax provision primarily due to income taxes in
profitable jurisdictions outside the United States, which was partially offset by tax benefits from losses incurred
by ExactTarget in certain state jurisdictions.
We recorded a tax benefit of $125.8 million with a pretax loss of $357.9 million, which resulted in an
effective tax rate of 35 percent for fiscal 2014. Due to the ExactTarget acquisition, a deferred tax liability was
established for the book-tax basis difference related to purchased intangibles. The net deferred tax liability from
acquisitions provided an additional source of income to support the realizability of our pre-existing deferred tax
assets. As a result, we released a portion of the valuation allowance that was established in fiscal 2013 and
recorded a tax benefit of $143.1 million for fiscal 2014.
We had a valuation allowance against our U.S. deferred tax assets as we considered our cumulative loss in
recent years as a significant piece of negative evidence.
Liquidity and Capital Resources
At January 31, 2016, our principal sources of liquidity were cash, cash equivalents and marketable securities
totaling $2.7 billion and accounts receivable of $2.5 billion.
Net cash provided by operating activities was $1.6 billion during fiscal 2016 and $1.2 billion during the
same period a year ago. Cash provided by operating activities were affected by the amount of net loss adjusted
for non-cash expense items such as depreciation and amortization, loss on the conversions of convertible senior
notes, amortization of purchased intangibles from business combinations, amortization of debt discount, the
expense associated with stock-based awards, and specifically for fiscal 2016 gains related to the termination of
50 Fremont lease and the additional sales of our land in Mission Bay; and the reclassification of excess tax
benefits from employee stock plans to cash flows from financing activities; the timing of employee related costs
including commissions and bonus payments; the timing of payments against accounts payable, accrued expenses
and other current liabilities; the timing of collections from our customers, which is our largest source of operating
cash flows; and changes in working capital accounts.
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Our working capital accounts consist of accounts receivables and prepaid assets and other current assets.
Claims against working capital include accounts payable, accrued expenses and other current liabilities and our
convertible notes. Our working capital may be impacted by factors in future periods, certain amounts and timing
of which are seasonal, such as billings to customers for subscriptions and support services and the subsequent
collection of those billings.
As described above in “Seasonal Nature of Deferred Revenue and Accounts Receivable,” our fourth quarter
has historically been our strongest quarter for new business and renewals. The year on year compounding effect
of this seasonality in both billing patterns and overall business causes the value of invoices that we generate in
the fourth quarter to increase as a proportion of our total annual billings.
We generally invoice our customers for our subscription and services contracts in advance in annual
installments. We typically issue renewal invoices in advance of the renewal service period, and depending on
timing, the initial invoice for the subscription and services contract and the subsequent renewal invoice may
occur in different quarters. Such invoice amounts are initially reflected in accounts receivable and deferred
revenue, which is reflected on the balance sheet. The operating cash flow benefit of increased billing activity
generally occurs in the subsequent quarter when we collect from our customers. As such, our first quarter is our
largest collections and operating cash flow quarter.
Net cash used in investing activities was $1.5 billion during fiscal 2016 and $698.4 million during the same
period a year ago. The net cash used in investing activities during fiscal 2016 primarily related to capital
expenditures, including strategic investments, business combinations, purchase of 50 Fremont land and building,
new office build-outs, investment of cash balances and strategic investments offset by proceeds from sales and
maturities of marketable securities and proceeds from sales of Mission Bay land, the use of restricted cash to
purchase 50 Fremont land and building. Net cash used in investing activities during fiscal 2016 increased by
approximately $789.5 million over the same period a year ago primarily due to cash used for the acquisition of
50 Fremont land and building and strategic investments.
Net cash provided by financing activities was $132.6 million during fiscal 2016 as compared to net cash used
in financing activities of $310.5 million during the same period a year ago. Net cash provided by financing activities
during fiscal 2016 consisted primarily of $455.5 million from proceeds from equity plan offset by $82.3 million of
principal payments on capital leases and $300.0 million payment of our revolving credit facility. Net cash flows
used in financing activities during fiscal 2015 changed $443.1 million from the same period a year ago primarily
due to $568.9 million payment on convertible senior notes, $285.0 million payment on term loan, offset by
$297.3 million proceeds from revolving credit facility and $309.0 million of proceeds from our equity plans.
In January 2010, we issued $575.0 million of 0.75% convertible senior notes due January 15, 2015 (the
“0.75% Senior Notes”) and concurrently entered into convertible notes hedges (the “0.75% Note Hedges”) and
separate warrant transactions (the “0.75% Warrants”). On January 15, 2015, the 0.75% Senior Notes matured.
Upon maturity of the 0.75% Senior Notes, we delivered cash up to the remaining principal amount of the 0.75%
Senior Notes and shares of our common stock for the excess conversion value greater than the principal amount
of the 0.75% Senior Notes. As a result of the conversions and maturity of the 0.75% Senior Notes during fiscal
2015, the Company exercised its rights on the 0.75% Note Hedges, and the 0.75% Note Hedges expired.
Additionally, in fiscal 2015 the Company entered into agreements with each of the 0.75% Warrant counterparties
to amend and settle the 0.75% Warrants prior to their scheduled expiration beginning in April 2015. As a result,
the Company issued, in the aggregate, approximately 13.3 million shares to the counterparties to settle, via a net
share settlement, the entirety of the 0.75% Warrants.
The 0.25% Senior Notes will be convertible if during any 20 trading days during the 30 consecutive trading
days of any fiscal quarter, our common stock trades at a price exceeding 130% of the conversion price of $66.44
per share applicable to the 0.25% Senior Notes. The 0.25% Senior Notes have not yet been convertible at the
holders’ option. The 0.25% Senior Notes are classified as a noncurrent liability on our consolidated balance sheet
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as of January 31, 2016. Our common stock did not trade at a price exceeding 130% of the conversion price of
$66.44 per share applicable to the 0.25% Senior Notes during the fiscal quarter ended January 31, 2016.
Accordingly, the 0.25% Senior Notes were not convertible at the holders’ option for the quarter ending January 31,
2016.
In October 2014, we entered into a credit agreement (the “Credit Agreement”) which provides for a
$650.0 million unsecured revolving credit facility (the “Credit Facility”) that matures in October 2019.
Immediately upon closing, we borrowed $300.0 million under the Credit Facility, approximately $262.5 million
of which was used to repay in full the indebtedness under our Term Loan. In March 2015, we paid down the
$300.0 million of outstanding borrowings held under the Credit Facility and related interest in full. We may use
any future borrowings under the Credit Facility for working capital, capital expenditures and other general
corporate purposes, including permitted acquisitions. We may borrow amounts under the Credit Facility at any
time during the term of the Credit Agreement. We may also prepay the borrowings under the Credit Facility, in
whole or in part, at any time without premium or penalty, subject to certain conditions, and amounts repaid or
prepaid may be reborrowed. As of January 31, 2016, outstanding borrowings under the Credit Facility were $0.
Borrowings under the Credit Facility bear interest, at our option at either a base rate formula or a LIBOR
based formula, each as set forth in the Credit Agreement. Additionally, we are obligated to pay an ongoing
commitment fee at a rate between 0.125% and 0.25%. Interest and the commitment fee are payable in arrears
quarterly.
The Credit Agreement contains certain customary affirmative and negative covenants, including a consolidated
leverage ratio covenant, a consolidated interest coverage ratio covenant, a limit on our ability to incur additional
indebtedness, dispose of assets, make certain acquisition transactions, pay dividends or distributions, and certain
other restrictions on our activities each defined specifically in the Credit Agreement. We were in compliance with
the Credit Agreement’s covenants as of January 31, 2016.
In August 2014, we sold approximately 3.7 net acres of our undeveloped real estate in San Francisco for a
total of $72.5 million. Separately, in September 2014, we sold approximately 1.5 net acres of our undeveloped
real estate for a total of $125.0 million. In October 2015, we sold approximately 8.8 net acres of undeveloped real
estate and the associated perpetual parking rights in San Francisco, California, which were classified as held for
sale. The total proceeds from the sale were $157.1 million, of which the Company received $127.1 million during
fiscal 2016 and previously received a nonrefundable deposit in the amount of $30.0 million during the fiscal
quarter ended April 30, 2014.
In February 2015, we acquired 50 Fremont Street, a 41-story building totaling approximately
817,000 rentable square feet located in San Francisco, California (“50 Fremont”). We acquired 50 Fremont for
the purpose of expanding our global headquarters in San Francisco. See Note 4, “Business Combinations” in the
Notes to the Consolidated Financial Statements. The total purchase price for 50 Fremont was $637.6 million. To
pay for 50 Fremont, we used $115.0 million of restricted cash and assumed a $200.0 million loan secured by the
property with the remainder paid in cash.
Our cash, cash equivalents and marketable securities are comprised primarily of corporate notes and
obligations, U.S. treasury securities, U.S. agency obligations, commercial paper, asset backed securities,
mortgage backed securities obligations, time deposits, money market mutual funds and municipal securities.
As of January 31, 2016, we have a total of $81.9 million in letters of credit outstanding in favor of certain
landlords for office space. To date, no amounts have been drawn against the letters of credit, which renew
annually and expire at various dates through December 2030.
We do not have any special purpose entities, and other than operating leases for office space and computer
equipment, we do not engage in off-balance sheet financing arrangements.
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Our principal commitments consist of obligations under leases for office space, co-location data center
facilities, and our development and test data center, as well as leases for computer equipment, software, furniture
and fixtures. At January 31, 2016, the future non-cancelable minimum payments under these commitments were
as follows (in thousands):
Contractual Obligations
Payments Due by Period
Total
Less than
1 Year 1-3 Years 3-5 Years
More than
5 Years
Capital lease obligations, including interest . . . . $ 558,411 $118,820 $ 238,048 $201,543 $ 0
Operating lease obligations:
Facilities space . . . . . . . . . . . . . . . . . . . . . . 1,986,694 191,879 404,022 391,944 998,849
Computer equipment and furniture and
fixtures . . . . . . . . . . . . . . . . . . . . . . . . . . . 332,153 164,648 167,505 0 0
0.25% Convertible Senior Notes, including
interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,157,188 2,875 1,154,313 0 0
Financing obligation—building in progress—
leased facility . . . . . . . . . . . . . . . . . . . . . . . . . . 334,047 16,877 42,658 44,435 230,077
Contractual commitments . . . . . . . . . . . . . . . . . . 25,177 11,702 7,263 5,964 248
$4,393,670 $506,801 $2,013,809 $643,886 $1,229,174
The majority of our operating lease agreements provide us with the option to renew. Our future operating
lease obligations would change if we exercised these options and if we entered into additional operating lease
agreements as we expand our operations. The financing obligation above represents the total obligation for our
lease of approximately 445,000 rentable square feet of office space in San Francisco, California. As of
January 31, 2016, $196.7 million of the total obligation noted above was recorded to financing obligation,
building in progress—leased facility, which is included in “Other noncurrent liabilities” on the consolidated
balance sheets.
In April 2014, we entered into an office lease agreement to lease approximately 732,000 rentable square feet
of an office building located in San Francisco, California that is under construction. The lease payments
associated with the lease will be approximately $590.0 million over the 15.5 year term of the lease, beginning in
our first quarter of fiscal 2018, which is reflected above under Operating Leases.
In February 2016, we entered into an agreement to sublease additional office space. The amounts associated
with the agreement will be approximately $311.0 million over the approximately 12 year term of the agreement,
beginning in the first quarter of fiscal 2018.
During fiscal 2016 and in future fiscal years, we have made and expect to continue to make additional
investments in our infrastructure to scale our operations and increase productivity. We plan to upgrade or replace
various internal systems to scale with the overall growth of the Company. Additionally, we expect capital
expenditures to be higher in absolute dollars and remain consistent as a percentage of total revenues in future
periods as a result of continued office build-outs, other leasehold improvements and data center investments.
In the future, we may enter into arrangements to acquire or invest in complementary businesses or joint
ventures, services and technologies, and intellectual property rights. We may be required to seek additional
equity or debt financing. Additional funds may not be available on terms favorable to us or at all.
We believe our existing cash, cash equivalents and short-term marketable securities and cash provided by
operating activities will be sufficient to meet our working capital, capital expenditure and debt repayment needs
over the next 12 months.
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New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update
No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”), which amended the
existing FASB Accounting Standards Codification. This standard establishes a principle for recognizing revenue
upon the transfer of promised goods or services to customers, in an amount that reflects the expected
consideration received in exchange for those goods or services. The standard also provides guidance on the
recognition of costs related to obtaining and fulfilling customer contracts. The FASB deferred the effective date
for the new revenue reporting standard for entities reporting under U.S. GAAP for one year. In accordance with
the deferral, ASU 2014-09 will be effective for fiscal 2019, including interim periods within that reporting
period. We are currently in the process of assessing the adoption methodology, which allows the amendment to
be applied retrospectively to each prior period presented, or with the cumulative effect recognized as of the date
of initial application. We are also evaluating the impact of the adoption of ASU 2014-09 on our consolidated
financial statements and have not determined whether the effect will be material to either our revenue results or
our deferred commission balances.
In September 2015, the FASB issued Accounting Standards Update No. 2015-16, “Simplifying the
Accounting for Measurement-Period Adjustments (Topic 805)” (“ASU 2015-16”) which eliminates the
requirement to restate prior period financial statements for measurement period adjustments in business
combinations. ASU 2015-16 requires that the cumulative impact of a measurement period adjustment (including
the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. The new
standard is effective for interim and annual periods beginning after December 15, 2015 and early adoption is
permitted. We are evaluating the impact of the adoption of ASU 2015-16 on our consolidated financial
statements.
In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases (Topic 842)”
(“ASU 2016-02”), which requires lessees to put most leases on their balance sheets but recognize the expenses
on their income statements in a manner similar to current practice. ASU 2016-02 states that a lessee would
recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use
the underlying asset for the lease term. The new standard is effective for interim and annual periods beginning
after December 15, 2018 and early adoption is permitted. We are currently evaluating the impact to our
consolidated financial statements.
Non-GAAP Financial Measures for Statement of Operations and Sharecount Information
Regulation S-K Item 10(e), “Use of Non-GAAP Financial Measures in Commission Filings,” defines and
prescribes the conditions for use of non-GAAP financial information. Our measures of non-GAAP net income,
non-GAAP gross profit, non-GAAP operating profit, non-GAAP free cash flow, and non-GAAP earnings per
share each meet the definition of a non-GAAP financial measure. We use the below non-GAAP financial
measures to provide an additional view of operational performance by excluding expenses and benefits that are
not directly related to performance in any particular period. In addition to our GAAP measures, we use these
non-GAAP measures when planning, monitoring, and evaluating our performance. We believe that these non-
GAAP measures reflect our ongoing business in a manner that allows for meaningful period-to-period
comparisons and analysis of trends in our business, as they exclude certain expenses and benefits. These items
are excluded because the decisions which gave rise to them are not made to increase revenue in a particular
period, but are made for our long-term benefit over multiple periods and we are not able to change or affect these
items in any particular period.
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Non-GAAP net income
We define non-GAAP net income as our total net income excluding the components described below, which
we believe are not reflective of our core, ongoing operating results. In each case, for the reasons set forth below,
we believe that excluding the component provides useful information to investors and others in understanding
and evaluating the impact of certain items to our operating results and future prospects in the same manner as we
do, in comparing financial results across accounting periods and to those of peer companies and in better
understanding the impact of these items on our gross margin and operating performance.
• Stock-Based Expense. The Company’s compensation strategy includes the use of stock-based
compensation to attract and retain employees and executives. It is principally aimed at aligning their
interests with those of our stockholders and at long-term employee retention, rather than to motivate or
reward operational performance for any particular period. Thus, stock-based expense varies for reasons
that are generally unrelated to operational decisions and performance in any particular period.
• Amortization of Purchased Intangibles and Acquired Leases. The Company views amortization of
acquisition-related intangible assets, such as the amortization of the cost associated with an acquired
company’s research and development efforts, trade names, customer lists, customer relationships and
acquired lease intangibles, as items arising from pre-acquisition activities determined at the time of an
acquisition. While these intangible assets are continually evaluated for impairment, amortization of the
cost of purchased intangibles is a static expense, one that is not typically affected by operations during
any particular period.
• Amortization of Debt Discount. Under GAAP, certain convertible debt instruments that may be settled
in cash (or other assets) on conversion are required to be separately accounted for as liability (debt) and
equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-
convertible debt borrowing rate. Accordingly, for GAAP purposes we are required to recognize
imputed interest expense on the Company’s $1.15 billion of convertible senior notes due 2018 that
were issued in a private placement in March 2013. The imputed interest rate was approximately 2.53%
for the convertible notes due 2018, while the actual coupon interest rate of the notes was 0.25%. The
difference between the imputed interest expense and the coupon interest expense, net of the interest
amount capitalized, is excluded from management’s assessment of the Company’s operating
performance because management believes that this non-cash expense is not indicative of its core,
ongoing operating performance. Management believes that the exclusion of the non-cash interest
expense provides investors an enhanced view of the Company’s operational performance.
• Non-Cash Gains/Losses on Conversion of Debt. Upon settlement of the Company’s convertible senior
notes, we attribute the fair value of the consideration transferred to the liability and equity components
of the convertible senior notes. The difference between the fair value of consideration attributed to the
liability component and the carrying value of the liability as of settlement date is recorded as a non-
cash gain or loss on the statement of operations. Management believes that the exclusion of the non-
cash gain/loss provides investors an enhanced view of the company’s operational performance.
• Gain on Sales of Land and Building Improvements. The Company views the non-operating gains
associated with the sales of the land and building improvements at Mission Bay to be a discrete
item. The difference between the cash proceeds received and the carrying value of the land and the
building improvements as of the settlement date is recorded as a one-time gain on the statement of
operations. Management believes that the exclusion of the gains provides investors an enhanced view
of the Company’s operational performance.
• Lease Termination Resulting from Purchase of Office Building. The Company views the non-cash, one-
time gain associated with the termination of its lease at 50 Fremont to be a discrete item. Management
believes that the exclusion of the gains provides investors an enhanced view of the Company’s
operational performance.
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• Income Tax Effects and Adjustments. Since fiscal 2015, the Company has utilized a fixed long-term
projected non-GAAP tax rate in order to provide better consistency across the interim reporting periods
by eliminating the effects of non-recurring and period-specific items such as changes in the tax
valuation allowance and tax effects of acquisitions-related costs, since each of these can vary in size
and frequency. When projecting this long-term rate, the Company evaluated a three-year financial
projection that excludes the direct impact of the following non-cash items: stock-based expenses,
amortization of purchased intangibles, amortization of acquired leases, amortization of debt discount,
gains/losses on the sales of land and building improvements, gains/losses on conversions of debt, and
termination of office leases. The projected rate also assumes no new acquisitions in the three-year
period, and considers other factors including the Company’s tax structure, its tax positions in various
jurisdictions and key legislation in major jurisdictions where the company operates. This long-term rate
could be subject to change for a variety of reasons, such as significant changes in the geographic
earnings mix including acquisition activity, or fundamental tax law changes in major jurisdictions
where the company operates. The Company re-evaluates this long-term rate on an annual basis and, as
appropriate, if a significant event materially affects it. Our fiscal 2016 non-GAAP tax provision was
35.5 percent which reflected the related tax impact from the recent Tax Court decision in Altera
Corporation’s litigation with the Internal Revenue Service (“IRS”).
Additionally, as significant, unusual or discrete events occur, or as other events occur that are not related to
the Company’s core, ongoing operating results, we may exclude the financial results of these events from non-
GAAP net income in the period in which such events occur. For example, we could in the future recognize a
significant gain or loss in connection with one or more of our strategic investments, which may not be viewed by
management as reflective of our core, ongoing operating results. Similarly, the financial effects of significant
facilities-related transactions may in the future be excluded from non-GAAP net income in the period in which
such events may occur, if they are not viewed by management as reflective of our core, ongoing operating
results.
Non-GAAP gross profit
We define non-GAAP gross profit as our total revenues less cost of revenues, as reported on our
consolidated statement of operations, excluding the portions of stock-based expenses and amortization of
purchased intangibles that are included in cost of revenues.
Non-GAAP operating profit
We define non-GAAP operating profit as our non-GAAP gross profit less operating expenses, as reported
on our consolidated statement of operations, excluding the portions of stock-based expenses, amortization of
purchased intangibles and gain resulting from termination of our office lease that are included in operating
expenses.
Non-GAAP earnings per share
Management uses the non-GAAP earnings per share to provide an additional view of performance by
excluding items that are not directly related to performance in any particular period in the earnings per share
calculation.
We define non-GAAP earnings per share as our non-GAAP net income divided by basic or diluted shares
outstanding.
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Non-GAAP free cash flow
We define the non-GAAP measure free cash flow as GAAP net cash provided by operating activities, less
capital expenditures. For this purpose, capital expenditures does not include our strategic investments, nor does it
include any costs or activities related to our purchase of 50 Fremont land and building, and building in
progress—leased facilities.
Limitations on the use of non-GAAP financial measures
A limitation of our non-GAAP financial measures of non-GAAP gross profit, non-GAAP operating profit,
non-GAAP net income, non-GAAP earnings per share and non-GAAP free cash flow is that they do not have
uniform definitions. Our definitions will likely differ from the definitions used by other companies, including
peer companies, and therefore comparability may be limited. Thus, our non-GAAP measures of non-GAAP gross
profit, non-GAAP operating profit, non-GAAP net income, non-GAAP earnings per share and non-GAAP free
cash flow should be considered in addition to, not as a substitute for, or in isolation from, measures prepared in
accordance with GAAP. Additionally, in the case of stock-based expense, if we did not pay a portion of
compensation in the form of stock-based expense, the cash salary expense included in costs of revenues and
operating expenses would be higher which would affect our cash position.
We compensate for these limitations by reconciling our non-GAAP financial measures to the most
comparable GAAP financial measure. We encourage investors and others to review our financial information in
its entirety, not to rely on any single financial measure, and to view our non-GAAP financial measures in
conjunction with the most comparable GAAP financial measures.
Our reconciliation of the non-GAAP financial measures are as follows (in thousands, except for share
numbers):
Fiscal Year Ended January 31,
Non-GAAP gross profit 2016 2015 2014
GAAP gross profit . . . . . . . . . . . . . . . . . . . . . . . . $5,012,668 $4,084,316 $3,102,575
Plus:
Amortization of purchased intangibles . . . . 80,918 90,300 109,356
Stock-based expenses . . . . . . . . . . . . . . . . . 69,443 53,812 45,608
Non-GAAP gross profit . . . . . . . . . . . . . . . . . . . $5,163,029 $4,228,428 $3,257,539
Fiscal Year Ended January 31,
Non-GAAP income from operations 2016 2015 2014
GAAP income (loss) from operations . . . . . . . . . . . . $114,923 $(145,633) $(286,074)
Plus:
Amortization of purchased intangibles . . . . . . . 158,070 154,973 146,535
Stock-based expenses . . . . . . . . . . . . . . . . . . . . 593,628 564,765 503,280
Less:
Operating lease termination resulting from
purchase of 50 Fremont . . . . . . . . . . . . . . . . . (36,617) 0 0
Non-GAAP operating profit . . . . . . . . . . . . . . . . . . . $830,004 $ 574,105 $ 363,741
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Fiscal Year Ended January 31,
Non-GAAP net income 2016 2015 2014
GAAP net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (47,426) $(262,688) $(232,175)
Plus:
Amortization of purchased intangibles . . . . . . 158,070 154,973 146,535
Amortization of acquired lease intangible . . . . 3,636 0 0
Stock-based expenses . . . . . . . . . . . . . . . . . . . . 593,628 564,765 503,280
Amortization of debt discount, net . . . . . . . . . . 24,504 36,575 46,728
Loss on conversion of debt . . . . . . . . . . . . . . . . 0 10,326 214
Less:
Operating lease termination resulting from
purchase of 50 Fremont . . . . . . . . . . . . . . . . (36,617) 0 0
Gain on sales of land and building
improvements . . . . . . . . . . . . . . . . . . . . . . . . (21,792) (15,625) 0
Income tax effects and adjustments of Non-
GAAP items . . . . . . . . . . . . . . . . . . . . . . . . . (167,221) (146,741) (242,729)
Non-GAAP net income . . . . . . . . . . . . . . . . . . . . . . $ 506,782 $ 341,585 $ 221,853
Fiscal Year Ended January 31,
Non-GAAP diluted earnings per share 2016 2015 2014
GAAP diluted loss per share (a) . . . . . . . . . . . . . . . . . . $ (0.07) $ (0.42) $ (0.39)
Plus:
Amortization of purchased intangibles . . . . . . . . 0.23 0.24 0.23
Amortization of acquired lease intangible . . . . . . 0.01 0.00 0.00
Stock-based expenses . . . . . . . . . . . . . . . . . . . . . . 0.88 0.87 0.79
Amortization of debt discount, net . . . . . . . . . . . . 0.04 0.06 0.07
Loss on conversion of debt . . . . . . . . . . . . . . . . . . 0.00 0.02 0.00
Less:
Operating lease termination resulting from
purchase of 50 Fremont . . . . . . . . . . . . . . . . . . (0.05) 0.00 0.00
Gain on sales of land and building
improvements . . . . . . . . . . . . . . . . . . . . . . . . . . (0.03) (0.02) 0.00
Income tax effects and adjustments of Non-
GAAP items . . . . . . . . . . . . . . . . . . . . . . . . . . . (0.26) (0.23) (0.35)
Non-GAAP diluted earnings per share . . . . . . . . . . . . . $ 0.75 $ 0.52 $ 0.35
Shares used in computing diluted net income per
share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676,830 651,534 635,688
a) Reported GAAP loss per share was calculated using the basic share count. Non-GAAP diluted earnings per
share was calculated using the diluted share count.
Non-GAAP operating profit for the year ended January 31, 2016 was $830.0 million and $574.1 million for
the same period a year ago, an improvement of $255.9 million or 45 percent. During fiscal 2016 we remained
focused on improving non-GAAP operating profit and expect to remain similarly focused in fiscal 2017.
67
The effects of dilutive securities were not included in the GAAP calculation of diluted earnings/loss per
share for the years ended January 31, 2016, 2015 and 2014 because we had a net loss for those periods and the
effect would have been anti-dilutive. The following table reflects the effect of the dilutive securities on the basic
share count used in the GAAP earnings/loss per share calculation to derive the share count used for the non-
GAAP diluted earnings per share:
Fiscal Year Ended January 31,
Supplemental Diluted Sharecount Information (in thousands): 2016 2015 2014
Weighted-average shares outstanding for GAAP basic
earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661,647 624,148 597,613
Effect of dilutive securities (1):
Convertible senior notes (2) . . . . . . . . . . . . . . . . . . . . 1,302 5,381 14,550
Warrants associated with the convertible senior note
hedges (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 9,536 9,658
Employee stock awards . . . . . . . . . . . . . . . . . . . . . . . 13,881 12,469 13,867
Adjusted weighted-average shares outstanding and
assumed conversions for Non-GAAP diluted earnings
per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676,830 651,534 635,688
(1) The effects of these dilutive securities were not included in the GAAP calculation of diluted net loss per
share because the effect would have been anti-dilutive.
(2) Upon maturity in fiscal 2015, the convertible 0.75% senior notes and associated warrants were settled. The
0.25% senior notes were not convertible, however, there is a dilutive effect for shares outstanding for the
fiscal 2016.
Fiscal Year Ended January 31,
Free cash flow analysis: 2016 2015 2014
Operating cash flow
GAAP net cash provided by operating
activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,612,585 $1,173,714 $ 875,469
Less:
Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . (284,476) (290,454) (299,110)
Free cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,328,109 $ 883,260 $ 576,359
Supplemental Tax Expense (Benefit) Information:
As described above, beginning in February 2014, which was the start of our fiscal 2015, we changed the
methodology used to calculate our non-GAAP tax expense. We computed and utilized a fixed long-term
projected non-GAAP tax rate of 36.5 percent for fiscal 2015. We moved to this long-term projected non-GAAP
tax rate in order to provide better consistency across the interim reporting periods by eliminating the effects of
non-recurring and period-specific items. As a result, we believe that starting in fiscal 2015, providing a tabular
reconciliation of the non-GAAP financial measure of tax expense (benefit) to the comparable GAAP measure is
not appropriate given our new methodology.
68
During the third quarter of fiscal 2013, we recorded for GAAP purposes a valuation allowance against a
significant portion of our U.S. deferred tax assets. During fiscal 2014, we recorded a partial valuation allowance
release, primarily in connection with the acquisition of ExactTarget. The increasing number of tax adjustments
reflected below was the result of the GAAP valuation allowance and the Company’s increasing acquisition
activities. The following table for fiscal 2014 reflects the calculation of our non-GAAP tax expense:
Fiscal Year Ended January 31,
Non-GAAP tax expense (in thousands): 2014
GAAP tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(125,760)
GAAP to Non-GAAP adjustments—tax effects of:
Stock-based expenses, amortization of purchased
intangibles and amortization of debt discount, net (1) . . 229,277
Deferred tax asset partial valuation release . . . . . . . . . . . . 25,048
State income tax credits not benefited (2) . . . . . . . . . . . . . . 5,325
Acquisitions-related costs (3) . . . . . . . . . . . . . . . . . . . . . . . (19,708)
Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,787
Total adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242,729
Non-GAAP tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 116,969
(1) The Company excluded stock-based expenses, amortization of purchased intangibles, and amortization of
debt discount, net, in reporting its non-GAAP net income. Accordingly, the Company excluded the related
tax effects of these items. The related tax effects were computed by applying the relevant statutory tax rate
to these items for each respective jurisdiction.
(2) During fiscal 2014, California mandated a change to the way it apportioned income to the state, which
significantly reduced the Company’s California income tax expense. Accordingly, for computing non-
GAAP tax expense, the Company did not recognize tax benefits related to certain California research and
development tax credits as the Company believed these credits may not be realized given the lowered
California income tax expense.
(3) During fiscal 2014, the Company excluded certain tax effects related to acquisitions in computing its non-
GAAP tax expense. The majority of this adjustment was attributable to non-cash tax costs associated with
the transfer of purchased intangibles. This non-cash tax item was excluded because the decisions which
gave rise to these non-cash tax costs were neither made to increase revenue nor directly related to
performance in any particular period, but were made for the Company’s long term benefit over multiple
periods. The remainder of this adjustment included the tax effects of legal and accounting fees incurred to
facilitate transactions, which amount was not material. The related tax effects were computed by applying
the relevant statutory tax rate to these items for each respective jurisdiction.
69
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Risk
Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency
exchange rates, particularly changes in the Euro, British Pound Sterling, Canadian Dollar, Australian Dollar and
Japanese Yen. We seek to minimize the impact of certain foreign currency fluctuations by hedging certain
balance sheet exposures with foreign currency forward contracts. Any gain or loss from settling these contracts is
offset by the loss or gain derived from the underlying balance sheet exposures. In accordance with our policy, the
hedging contracts we enter into have maturities of less than three months. Additionally, by policy, we do not
enter into any hedging contracts for trading or speculative purposes.
Interest Rate Sensitivity
We had cash, cash equivalents and marketable securities totaling $2.7 billion at January 31, 2016. This
amount was invested primarily in money market funds, time deposits, corporate notes and bonds, government
securities and other debt securities with credit ratings of at least BBB or better. The cash, cash equivalents and
short-term marketable securities are held for general corporate purposes including possible acquisitions of, or
investments in, complementary businesses, services or technologies, working capital and capital expenditures.
Our investments are made for capital preservation purposes. We do not enter into investments for trading or
speculative purposes.
Our cash equivalents and our portfolio of marketable securities are subject to market risk due to changes in
interest rates. Fixed rate securities may have their market value adversely impacted due to a rise in interest rates,
while floating rate securities may produce less income than expected if interest rates fall. Due in part to these
factors, our future investment income may fall short of expectation due to changes in interest rates or we may
suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest
rates. However because we classify our debt securities as “available for sale,” no gains or losses are recognized
due to changes in interest rates unless such securities are sold prior to maturity or declines in fair value are
determined to be other-than-temporary. Our fixed-income portfolio is subject to interest rate risk.
An immediate increase or decrease in interest rates of 100-basis points at January 31, 2016 could result in a
$20.9 million market value reduction or increase of the same amount. This estimate is based on a sensitivity
model that measures market value changes when changes in interest rates occur. Fluctuations in the value of our
investment securities caused by a change in interest rates (gains or losses on the carrying value) are recorded in
other comprehensive income, and are realized only if we sell the underlying securities.
At January 31, 2015, we had cash, cash equivalents and marketable securities totaling $1.9 billion. The
fixed-income portfolio was also subject to interest rate risk. Changes in interest rates of 100-basis points would
have resulted in market value changes of $13.5 million.
Market Risk and Market Interest Risk
In March 2013, we issued the 0.25% Senior Notes. Holders of the 0.25% Senior Notes may convert the
0.25% Senior Notes prior to maturity upon the occurrence of certain circumstances. Upon conversion, we would
pay the holder an amount of cash equal to the principal amounts of the 0.25% Senior Notes and the amounts in
excess of the principal amounts, if any, may be paid in cash or stock at our option. Concurrent with the issuance
of the 0.25% Senior Notes, we entered into separate note hedging transactions and the sale of warrants. These
separate transactions were completed to reduce the potential economic dilution from the conversion of the 0.25%
Senior Notes.
The 0.25% Senior Notes have a fixed annual interest rate of 0.25%, and therefore we do not have economic
interest rate exposure on the 0.25% Senior Notes. However, the value of the 0.25% Senior Notes are exposed to
70
interest rate risk. Generally, the fair values of our fixed interest rate 0.25% Senior Notes will increase as interest
rates fall and decrease as interest rates rise. In addition, the fair value of our 0.25% Senior Notes is affected by
our stock price. The principal balance of our 0.25% Senior Notes was $1.15 billion as of January 31, 2016. The
total estimated fair value of our 0.25% Senior Notes at January 31, 2016 was $1.4 billion. The fair value was
determined based on the closing trading price per $100 of the 0.25% Senior Notes as of the last day of trading for
the fourth quarter of fiscal 2016, which was $119.24.
In October 2014, we entered into the Credit Agreement, which provides for the $650.0 million Credit
Facility that matures in October 2019. Borrowings under the Credit Facility bear interest, at our option, at either a
base rate formula, as defined in the Credit Agreement, or a LIBOR based formula, each as set forth in the Credit
Agreement. Additionally, we are obligated to pay an ongoing commitment fee at a rate between 0.125% and
0.25%. Interest and the commitment fees are payable in arrears quarterly. As of January 31, 2016 there was no
outstanding borrowing amount under the Credit Agreement.
By entering into the Credit Agreement, we have assumed risks associated with variable interest rates based
upon a variable base rate, as defined in the Credit Agreement, or LIBOR. Changes in the overall level of interest
rates affect the interest expense that we recognize in our statements of operations.
We deposit our cash with multiple financial institutions, therefore our deposits, at times, may exceed
federally insured limits.
The bank counterparties to the derivative contracts potentially expose us to credit-related losses in the event
of their nonperformance. To mitigate that risk, we only contract with counterparties who meet the minimum
requirements under our counterparty risk assessment process. We monitor ratings, credit spreads and potential
downgrades on at least a quarterly basis. Based on our on-going assessment of counterparty risk, we adjust our
exposure to various counterparties. We generally enter into master netting arrangements, which reduce credit risk
by permitting net settlement of transactions with the same counterparty. However, we do not have any master
netting arrangements in place with collateral features.
Our strategic investments portfolio consists of investments in over 150 privately held companies, primarily
comprised of independent software vendors and system integrators. We invest in early-to-late stage technology
and professional cloud service companies across the globe to support our key business initiatives, which include,
among other things, extending the capabilities of our platform and CRM offerings, increasing the ecosystem of
enterprise cloud companies and partners, accelerating the adoption of cloud technologies and creating the next-
generation of mobile applications and connected products. We invest in both domestic and international
companies and currently hold investments in all of our regions: the Americas, Europe and Asia Pacific. Our
investments in these companies range from $0.2 million to over $70.0 million, with 14 investments individually
equal to or in excess of $10 million. As of January 31, 2016 and January 31, 2015 the carrying value of our
investments in privately held companies was $504.5 million and $158.0 million, respectively. The estimated fair
value of our investments in privately held companies was $714.1 million and $280.0 million as of January 31,
2016 and January 31, 2015, respectively. The financial success of our investment in any company is typically
dependent on a liquidity event, such as a public offering, acquisition or other favorable market event reflecting
appreciation to the cost of our initial investment. If we determine that any of our investments in such companies
have experienced a decline in fair value, we may be required to record an impairment that is other than
temporary, which could be material. We have in the past written off the full value of specific investments.
Similar situations could occur in the future and negatively impact our financial results. All of our investments are
subject to a risk of partial or total loss of investment capital.
71
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
The following financial statements are filed as part of this Annual Report on Form 10-K:
Page No.
Reports of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Consolidated Balance Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Consolidated Statements of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
Consolidated Statements of Comprehensive Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Consolidated Statements of Stockholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
72
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of salesforce.com, inc.
We have audited the accompanying consolidated balance sheets of salesforce.com, inc. as of January 31,
2016 and 2015, and the related consolidated statements of operations, comprehensive loss, stockholders’ equity
and cash flows for each of the three years in the period ended January 31, 2016. Our audits also included the
financial statement schedule listed in the Index at Item 15(c). These financial statements and schedule are the
responsibility of the company’s management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the
consolidated financial position of salesforce.com, inc. at January 31, 2016 and 2015, and the consolidated results
of its operations and its cash flows for each of the three years in the period ended January 31, 2016, in conformity
with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States), salesforce.com inc.’s internal control over financial reporting as of January 31, 2016, based on
criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission 2013 framework and our report dated March 4, 2016 expressed an
unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
San Jose, California
March 4, 2016
73
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of salesforce.com, inc.
We have audited salesforce.com, inc.’s internal control over financial reporting as of January 31, 2016,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission 2013 framework (the COSO criteria). Salesforce.com, inc.’s
management is responsible for maintaining effective internal control over financial reporting, and for its
assessment of the effectiveness of internal control over financial reporting included in the accompanying
Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion
on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether effective internal control over financial reporting was maintained in all material respects. Our
audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a
material weakness exists, testing and evaluating the design and operating effectiveness of internal control based
on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We
believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company’s internal control over financial reporting
includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable
assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the
company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.
In our opinion, salesforce.com, inc. maintained, in all material respects, effective internal control over
financial reporting as of January 31, 2016, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board
(United States), the consolidated balance sheets of salesforce.com, inc. as of January 31, 2016 and 2015, and the
related consolidated statements of operations, comprehensive loss, stockholders’ equity and cash flows for each
of the three years in the period ended January 31, 2016 of salesforce.com, inc. and our report dated March 4,
2016 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
San Jose, California
March 4, 2016
74
salesforce.com, inc.
Consolidated Balance Sheets
(in thousands, except per share data)
January 31,
2016
January 31,
2015
Assets
Current assets:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,158,363 $ 908,117
Short-term marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183,018 87,312
Accounts receivable, net of allowance for doubtful accounts of $10,488 and
$8,146 at January 31, 2016 and 2015, respectively . . . . . . . . . . . . . . . . . . . . 2,496,165 1,905,506
Deferred commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259,187 225,386
Prepaid expenses and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,594 245,026
Land and building improvements held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . 0 143,197
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,347,327 3,514,544
Marketable securities, noncurrent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,383,996 894,855
Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,715,828 1,125,866
Deferred commissions, noncurrent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189,943 162,796
Capitalized software, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384,258 433,398
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,849,937 3,782,660
Strategic investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520,721 175,774
Other assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378,762 460,219
Restricted cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 115,015
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,770,772 $10,665,127
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable, accrued expenses and other liabilities . . . . . . . . . . . . . . . . . $ 1,349,338 $ 1,103,335
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,267,667 3,286,768
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,617,005 4,390,103
Convertible 0.25% senior notes, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,095,059 1,070,692
Loan assumed on 50 Fremont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198,888 0
Revolving credit facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 300,000
Deferred revenue, noncurrent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,886 34,681
Other noncurrent liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 833,065 894,468
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,767,903 6,689,944
Stockholders’ equity:
Preferred stock, $0.001 par value; 5,000 shares authorized and none issued
and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0
Common stock, $0.001 par value; 1,600,000 shares authorized, 670,929 and
650,596 issued and outstanding at January 31, 2016 and 2015,
respectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 671 651
Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,705,386 4,604,485
Accumulated other comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (49,917) (24,108)
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (653,271) (605,845)
Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,002,869 3,975,183
Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,770,772 $10,665,127
See accompanying Notes.
75
salesforce.com, inc.
Consolidated Statements of Operations
(in thousands, except per share data)
Fiscal Year Ended January 31,
2016 2015 2014
Revenues:
Subscription and support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,205,599 $5,013,764 $3,824,542
Professional services and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 461,617 359,822 246,461
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,667,216 5,373,586 4,071,003
Cost of revenues (1)(2):
Subscription and support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,188,967 924,638 711,880
Professional services and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465,581 364,632 256,548
Total cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,654,548 1,289,270 968,428
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,012,668 4,084,316 3,102,575
Operating expenses (1)(2):
Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 946,300 792,917 623,798
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,239,824 2,757,096 2,168,132
General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 748,238 679,936 596,719
Operating lease termination resulting from purchase of
50 Fremont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (36,617) 0 0
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,897,745 4,229,949 3,388,649
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,923 (145,633) (286,074)
Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,341 10,038 10,218
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (72,485) (73,237) (77,211)
Other expense (1)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (15,292) (19,878) (4,868)
Gain on sales of land and building improvements . . . . . . . . . . . . . . . . . . 21,792 15,625 0
Income (loss) before benefit from (provision for) income taxes . . . . . . . 64,279 (213,085) (357,935)
Benefit from (provision for) income taxes . . . . . . . . . . . . . . . . . . . . . . . . (111,705) (49,603) 125,760
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (47,426) $ (262,688) $ (232,175)
Basic net loss per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.07) $ (0.42) $ (0.39)
Diluted net loss per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (0.07) $ (0.42) $ (0.39)
Shares used in computing basic net loss per share . . . . . . . . . . . . . . . . . . 661,647 624,148 597,613
Shares used in computing diluted net loss per share . . . . . . . . . . . . . . . . . 661,647 624,148 597,613
(1) Amounts include amortization of purchased intangibles from business combinations, as follows:
Fiscal Year Ended January 31,
2016 2015 2014
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,918 $ 90,300 $ 109,356
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . . 77,152 64,673 37,179
Other non-operating expense . . . . . . . . . . . . . . . . . . . 3,636 0 0
(2) Amounts include stock-based expenses, as follows:
Fiscal Year Ended January 31,
2016 2015 2014
Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 69,443 $ 53,812 $ 45,608
Research and development . . . . . . . . . . . . . . . . . . . . . . 129,434 121,193 107,420
Marketing and sales . . . . . . . . . . . . . . . . . . . . . . . . . . . 289,152 286,410 258,571
General and administrative . . . . . . . . . . . . . . . . . . . . . 105,599 103,350 91,681
(3) Amount includes approximately $10.3 million loss on conversions of our convertible 0.75% senior notes
due January 2015 recognized during fiscal 2015.
See accompanying Notes.
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salesforce.com, inc.
Consolidated Statements of Comprehensive Loss
(in thousands)
Fiscal Year Ended January 31,
2016 2015 2014
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(47,426) $(262,688) $(232,175)
Other comprehensive income (loss), before tax and net of reclassification
adjustments:
Foreign currency translation and other losses . . . . . . . . . . . . . . . . . . . . . (16,616) (43,276) (4,930)
Unrealized gains (losses) on investments . . . . . . . . . . . . . . . . . . . . . . . . (9,193) 1,488 8,120
Other comprehensive income (loss), before tax . . . . . . . . . . . . . . . . . . . . . . . . (25,809) (41,788) 3,190
Tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 (2,647)
Other comprehensive income (loss), net of tax . . . . . . . . . . . . . . . . . . . . . . . . (25,809) (41,788) 543
Comprehensive loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(73,235) $(304,476) $(231,632)
See accompanying Notes.
77
salesforce.com, inc.
Consolidated Statements of Stockholders’ Equity
(in thousands)
Common Stock Additional
Paid-in
Capital
Accumulated
Other
Comprehensive
Income/(Loss)
Accumulated
Deficit
Total
Stockholders’
EquityShares Amount
Balances at January 31, 2013 . . . . . . . . . . . . . . . 585,627 $586 $2,410,892 $ 17,137 $(110,982) $2,317,633
Exercise of stock options and stock grants
to board members for board services . . . 9,952 10 197,012 0 0 197,022
Vested restricted stock units converted to
shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,265 9 0 0 0 9
Shares issued related to business
combinations . . . . . . . . . . . . . . . . . . . . . . 2,367 2 81,191 0 0 81,193
Shares issued under employee stock
plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,932 3 92,482 0 0 92,485
Tax benefits from employee stock plans . . 0 0 8,048 0 0 8,048
Stock-based expenses . . . . . . . . . . . . . . . . . 0 0 494,615 0 0 494,615
Temporary equity reclassification . . . . . . . 0 0 26,907 0 0 26,907
Equity component of the convertible notes
issuance, net . . . . . . . . . . . . . . . . . . . . . . 0 0 121,230 0 0 121,230
Purchase of convertible note hedges . . . . . 0 0 (153,800) 0 0 (153,800)
Issuance of warrants . . . . . . . . . . . . . . . . . . 0 0 84,800 0 0 84,800
Other comprehensive income, net of tax . . 0 0 0 543 0 543
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 0 (232,175) (232,175)
Balances at January 31, 2014 . . . . . . . . . . . . . . . 610,143 $610 $3,363,377 $ 17,680 $(343,157) $3,038,510
Exercise of stock options and stock grants
to board members for board services . . . 7,413 8 182,270 0 0 182,278
Vested restricted stock units converted to
shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,259 9 0 0 0 9
Shares issued related to business
combinations . . . . . . . . . . . . . . . . . . . . . . 7,185 7 339,076 0 0 339,083
Shares issued under employee stock
plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,264 4 127,816 0 0 127,820
Tax benefits from employee stock plans . . 0 0 7,730 0 0 7,730
Settlement of 0.75% convertible notes and
related warrants . . . . . . . . . . . . . . . . . . . . 13,332 13 22,736 0 0 22,749
Stock-based expenses . . . . . . . . . . . . . . . . . 0 0 561,480 0 0 561,480
Other comprehensive loss, net of tax . . . . . 0 0 0 (41,788) 0 (41,788)
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 0 (262,688) (262,688)
Balances at January 31, 2015 . . . . . . . . . . . . . . . 650,596 $651 $4,604,485 $(24,108) $(605,845) $3,975,183
Exercise of stock options and stock grants
to board members for board services . . . 8,278 8 296,493 0 0 296,501
Vested restricted stock units converted to
shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,933 9 0 0 0 9
Shares issued related to business
combinations . . . . . . . . . . . . . . . . . . . . . . 117 0 0 0 0 0
Shares issued under employee stock
plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,005 3 154,957 0 0 154,960
Tax benefits from employee stock plans . . 0 0 59,496 0 0 59,496
Stock-based expenses . . . . . . . . . . . . . . . . . 0 0 589,955 0 0 589,955
Other comprehensive loss, net of tax . . . . . 0 0 0 (25,809) 0 (25,809)
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0 0 (47,426) (47,426)
Balances at January 31, 2016 . . . . . . . . . . . . . . . 670,929 $671 $5,705,386 $(49,917) $(653,271) $5,002,869
See accompanying Notes.
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salesforce.com, inc.
Consolidated Statements of Cash Flows
(in thousands)
Fiscal Year Ended January 31,
2016 2015 2014
Operating activities:
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (47,426) $ (262,688) $ (232,175)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525,750 448,296 369,423
Amortization of debt discount and transaction costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,467 39,620 49,582
Gain on sales of land and building improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (21,792) (15,625) 0
50 Fremont lease termination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (36,617) 0 0
Loss on conversions of convertible senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 10,326 214
Amortization of deferred commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319,074 257,642 194,553
Expenses related to employee stock plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593,628 564,765 503,280
Excess tax benefits from employee stock plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (59,496) (7,730) (8,144)
Changes in assets and liabilities, net of business combinations:
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (582,425) (544,610) (424,702)
Deferred commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (380,022) (320,904) (265,080)
Prepaid expenses and other current assets and other assets . . . . . . . . . . . . . . . . . . . . . . . 50,772 45,819 105,218
Accounts payable, accrued expenses and other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 253,986 159,973 (29,043)
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 969,686 798,830 612,343
Net cash provided by operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,612,585 1,173,714 875,469
Investing activities:
Business combinations, net of cash acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (58,680) 38,071 (2,617,302)
Proceeds from land and building improvements held for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127,066 223,240 0
Purchase of 50 Fremont land and building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (425,376) 0 0
Deposit and withdrawal for purchase of 50 Fremont land and building . . . . . . . . . . . . . . . . . . . . . . 115,015 (126,435) 0
Non-refundable amounts received for sale of land and building . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,284 0 0
Strategic investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (366,519) (93,725) (31,160)
Purchases of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,139,267) (780,540) (558,703)
Sales of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,264 243,845 1,038,284
Maturities of marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,811 87,638 36,436
Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (284,476) (290,454) (299,110)
Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,487,878) (698,360) (2,431,555)
Financing activities:
Proceeds from borrowings on convertible senior notes, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 1,132,750
Proceeds from issuance of warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 84,800
Purchase of convertible note hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 (153,800)
Proceeds from (payments on) revolving credit facility, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300,000) 297,325 0
Proceeds from (payments on) term loan, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 (285,000) 283,500
Proceeds from employee stock plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455,482 308,989 289,931
Excess tax benefits from employee stock plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,496 7,730 8,144
Payments on convertible senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 (568,862) (5,992)
Principal payments on capital lease obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (82,330) (70,663) (41,099)
Net cash provided by (used in) financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,648 (310,481) 1,598,234
Effect of exchange rate changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,109) (38,391) (7,758)
Net increase in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,246 126,482 34,390
Cash and cash equivalents, beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 908,117 781,635 747,245
Cash and cash equivalents, end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,158,363 $ 908,117 $ 781,635
Supplemental cash flow disclosure:
Cash paid during the period for:
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 37,954 $ 24,684 $ 21,503
Income taxes, net of tax refunds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 31,462 $ 36,219 $ 28,870
Non-cash financing and investing activities:
Fixed assets acquired under capital leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,948 $ 124,099 $ 492,810
Building in progress—leased facility acquired under financing obligation . . . . . . . . . . . . . . . $ 77,057 $ 85,118 $ 40,171
Fair value of equity awards assumed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 1,050 $ 19,037
Fair value of common stock issued as consideration for business combinations . . . . . . . . . . . $ 0 $ 338,033 $ 69,533
Fair value of loan assumed on 50 Fremont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 198,751 $ 0 $ 0
See accompanying Notes.
79
salesforce.com, inc.
Notes to Consolidated Financial Statements
1. Summary of Business and Significant Accounting Policies
Description of Business
Salesforce.com, inc. (the “Company”) is a leading provider of enterprise cloud computing solutions, with a
focus on customer relationship management, or CRM. The Company introduced its first CRM solution in
February 2000, and has since expanded its service offerings with new editions, solutions, features and platform
capabilities.
The Company’s mission is to help its customers transform themselves into customer-centric companies by
empowering them to connect with their customers in entirely new ways. The Company’s Customer Success
Platform, including sales force automation, customer service and support, marketing automation, community
management, analytics, application development, Internet of Things integration and the Company’s professional
cloud services, provide the next-generation platform of enterprise applications and services to enable customer
success.
Fiscal Year
The Company’s fiscal year ends on January 31. References to fiscal 2016, for example, refer to the fiscal
year ending January 31, 2016.
Basis of Presentation
On March 20, 2013, the Company’s certificate of incorporation was amended to increase the number of
authorized shares of common stock from 400.0 million to 1.6 billion in order to provide for a four-for-one stock
split of the common stock effected in the form of a stock dividend. The record date for the stock split was
April 3, 2013, and the additional shares were distributed on April 17, 2013. Each stockholder of record on the
close of business on the record date received three additional shares of common stock for each share held. All
share and per share data presented herein reflect the impact of the increase in authorized shares and the stock
split, as appropriate.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles
(“U.S. GAAP”) requires management to make estimates and assumptions in the Company’s consolidated
financial statements and notes thereto.
Significant estimates and assumptions made by management include the determination of:
• the best estimate of selling price of the deliverables included in multiple deliverable revenue
arrangements,
• the fair value of assets acquired and liabilities assumed for business combinations,
• the recognition, measurement and valuation of current and deferred income taxes,
• the fair value of convertible notes,
• the fair value of stock awards issued and related forfeiture rates,
• the useful lives of intangible assets, property and equipment and building and structural components, and
• the valuation of strategic investments and the determination of other-than-temporary impairments.
80
Actual results could differ materially from those estimates. The Company bases its estimates on historical
experience and on various other assumptions that are believed to be reasonable, the result of which forms the
basis for making judgments about the carrying values of assets and liabilities.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned
subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Segments
The Company operates as one operating segment. Operating segments are defined as components of an
enterprise for which separate financial information is evaluated regularly by the chief operating decision maker,
who is the chief executive officer, in deciding how to allocate resources and assessing performance. Over the past
few years, the Company has completed several acquisitions. These acquisitions have allowed the Company to
expand its offerings, presence and reach in various market segments of the enterprise cloud computing market.
While the Company has offerings in multiple enterprise cloud computing market segments, the Company’s
business operates in one operating segment because all of the Company’s offerings operate on a single platform
and are deployed in an identical way, and the Company’s chief operating decision maker evaluates the
Company’s financial information and resources and assesses the performance of these resources on a
consolidated basis. Since the Company operates in one operating segment, all required financial segment
information can be found in the consolidated financial statements.
Concentrations of Credit Risk and Significant Customers
The Company’s financial instruments that are exposed to concentrations of credit risk consist primarily of
cash and cash equivalents, marketable securities and trade accounts receivable. Although the Company deposits
its cash with multiple financial institutions, its deposits, at times, may exceed federally insured limits. Collateral
is not required for accounts receivable. The Company maintains an allowance for doubtful accounts receivable
balances. This allowance is based upon historical loss patterns, the number of days that billings are past due and
an evaluation of the potential risk of loss associated with delinquent accounts.
No single customer accounted for more than five percent of accounts receivable at January 31, 2016 and
2015. No single customer accounted for five percent or more of total revenue during fiscal 2016, 2015 and 2014.
Geographic Locations
As of January 31, 2016 and 2015, assets located outside the Americas were 11 percent and 12 percent of
total assets, respectively.
Revenues by geographical region are as follows (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Americas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,910,745 $3,868,329 $2,899,837
Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,162,808 984,919 741,220
Asia Pacific . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593,663 520,338 429,946
$6,667,216 $5,373,586 $4,071,003
Americas revenue attributed to the United States was approximately 95 percent, 94 percent and 96 percent
in fiscal 2016, 2015 and 2014, respectively. No other country represented more than ten percent of total revenue
during fiscal 2016, 2015 or 2014.
81
Revenue Recognition
The Company derives its revenues from two sources: (1) subscription revenues, which are comprised of
subscription fees from customers accessing the Company’s enterprise cloud computing services and from
customers paying for additional support beyond the standard support that is included in the basic subscription
fees; and (2) related professional services such as process mapping, project management, implementation
services and other revenue. “Other revenue” consists primarily of training fees.
The Company commences revenue recognition when all of the following conditions are satisfied:
• there is persuasive evidence of an arrangement;
• the service has been or is being provided to the customer;
• the collection of the fees is reasonably assured; and
• the amount of fees to be paid by the customer is fixed or determinable.
The Company’s subscription service arrangements are non-cancelable and do not contain refund-type
provisions.
Subscription and Support Revenues
Subscription and support revenues are recognized ratably over the contract terms beginning on the
commencement date of each contract, which is the date the Company’s service is made available to customers.
Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue,
depending on whether the revenue recognition criteria have been met.
Professional Services and Other Revenues
The majority of the Company’s professional services contracts are on a time and material basis. When these
services are not combined with subscription revenues as a single unit of accounting, as discussed below, these
revenues are recognized as the services are rendered for time and material contracts, and when the milestones are
achieved and accepted by the customer for fixed price contracts. Training revenues are recognized as the services
are performed.
Multiple Deliverable Arrangements
The Company enters into arrangements with multiple deliverables that generally include multiple subscriptions,
premium support and professional services. If the deliverables have standalone value upon delivery, the Company
accounts for each deliverable separately. Subscription services have standalone value as such services are often sold
separately. In determining whether professional services have standalone value, the Company considers the following
factors for each professional services agreement: availability of the services from other vendors, the nature of the
professional services, the timing of when the professional services contract was signed in comparison to the
subscription service start date and the contractual dependence of the subscription service on the customer’s satisfaction
with the professional services work. To date, the Company has concluded that all of the professional services included
in multiple deliverable arrangements executed have standalone value.
Multiple deliverables included in an arrangement are separated into different units of accounting and the
arrangement consideration is allocated to the identified separate units based on a relative selling price hierarchy.
The Company determines the relative selling price for a deliverable based on its vendor-specific objective
evidence of selling price (“VSOE”), if available, or its best estimate of selling price (“BESP”), if VSOE is not
available. The Company has determined that third-party evidence of selling price (“TPE”) is not a practical
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alternative due to differences in its service offerings compared to other parties and the availability of relevant
third-party pricing information. The amount of revenue allocated to delivered items is limited by contingent
revenue, if any.
For certain professional services, the Company has established VSOE as a consistent number of standalone
sales of these deliverables have been priced within a reasonably narrow range. The Company has not established
VSOE for its subscription services due to lack of pricing consistency, the introduction of new services and other
factors. Accordingly, the Company uses its BESP to determine the relative selling price for its subscription
services.
The Company determines BESP by considering its overall pricing objectives and market conditions.
Significant pricing practices taken into consideration include the Company’s discounting practices, the size and
volume of the Company’s transactions, the customer demographic, the geographic area where services are sold,
price lists, its go-to-market strategy, historical standalone sales and contract prices. The determination of BESP is
made through consultation with and approval by the Company’s management, taking into consideration the go-to-
market strategy. As the Company’s go-to-market strategies evolve, the Company may modify its pricing practices
in the future, which could result in changes in relative selling prices, including both VSOE and BESP.
Deferred Revenue
The deferred revenue balance does not represent the total contract value of annual or multi-year, non-
cancelable subscription agreements. Deferred revenue primarily consists of billings or payments received in
advance of revenue recognition from subscription services described above and is recognized as the revenue
recognition criteria are met. The Company generally invoices customers in annual installments. The deferred
revenue balance is influenced by several factors, including seasonality, the compounding effects of renewals,
invoice duration, invoice timing, size and new business linearity within the quarter.
Deferred revenue that will be recognized during the succeeding twelve month period is recorded as current
deferred revenue and the remaining portion is recorded as noncurrent.
Deferred Commissions
Deferred commissions are the incremental costs that are directly associated with non-cancelable
subscription contracts with customers and consist of sales commissions paid to the Company’s direct sales force.
The commissions are deferred and amortized over the non-cancelable terms of the related customer
contracts, which are typically 12 to 36 months. The commission payments are paid in full the month after the
customer’s service commences. The deferred commission amounts are recoverable through the future revenue
streams under the non-cancelable customer contracts. The Company believes this is the preferable method of
accounting as the commission charges are so closely related to the revenue from the non-cancelable customer
contracts that they should be recorded as an asset and charged to expense over the same period that the
subscription revenue is recognized. Amortization of deferred commissions is included in marketing and sales
expense in the accompanying consolidated statements of operations.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months
or less to be cash equivalents. Cash and cash equivalents are stated at fair value.
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Marketable Securities
Management determines the appropriate classification of marketable securities at the time of purchase and
reevaluates such determination at each balance sheet date. Securities are classified as available for sale and are
carried at fair value, with the change in unrealized gains and losses, net of tax, reported as a separate component
on the consolidated statements of comprehensive loss. Fair value is determined based on quoted market rates
when observable or utilizing data points that are observable, such as quoted prices, interest rates and yield curves.
Declines in fair value judged to be other-than-temporary on securities available for sale are included as a
component of investment income. In order to determine whether a decline in value is other-than-temporary, the
Company evaluates, among other factors: the duration and extent to which the fair value has been less than the
carrying value and its intent and ability to retain the investment for a period of time sufficient to allow for any
anticipated recovery in fair value. The cost of securities sold is based on the specific-identification method.
Interest on securities classified as available for sale is also included as a component of investment income.
Fair Value Measurement
The Company measures its cash equivalents, marketable securities and foreign currency derivative contracts
at fair value.
The additional disclosures regarding the Company’s fair value measurements are included in Note 2
“Investments”.
Property and Equipment
Property and equipment are stated at cost. Depreciation is calculated on a straight-line basis over the
estimated useful lives of those assets as follows:
Computer, equipment and software . . . 3 to 9 years
Furniture and fixtures . . . . . . . . . . . . . . 5 years
Leasehold improvements . . . . . . . . . . . Shorter of the estimated lease
term or 10 years
Building and structural components . . . Average weighted useful life
of 32 years
Building improvements . . . . . . . . . . . . . 10 years
When assets are retired or otherwise disposed of, the cost and accumulated depreciation and amortization
are removed from their respective accounts and any loss on such retirement is reflected in operating expenses.
Capitalized Internal-Use Software Costs
The Company capitalizes costs related to its enterprise cloud computing services and certain projects for
internal use incurred during the application development stage. Costs related to preliminary project activities and
post implementation activities are expensed as incurred. Internal-use software is amortized on a straight-line
basis over its estimated useful life, which is generally three to five years. Management evaluates the useful lives
of these assets on an annual basis and tests for impairment whenever events or changes in circumstances occur
that could impact the recoverability of these assets.
Goodwill and Intangible Assets Impairment Assessments
The Company evaluates and tests the recoverability of its goodwill for impairment at least annually during
the fourth quarter or more often if and when circumstances indicate that goodwill may not be recoverable.
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Intangible assets are amortized over their useful lives. Each period the Company evaluates the estimated
remaining useful life of its intangible assets and whether events or changes in circumstances warrant a revision to
the remaining period of amortization. The carrying amounts of these assets are periodically reviewed for
impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not
be recoverable. Recoverability of these assets is measured by comparison of the carrying amount of each asset to
the future undiscounted cash flows the asset is expected to generate. If the undiscounted cash flows used in the
test for recoverability are less than the carrying amount of these assets, then the carrying amount of such assets is
reduced to fair value.
Long- Lived Assets and Impairment Assessment
The Company evaluates long-lived assets for possible impairment whenever events or circumstances
indicate that the carrying amount of such assets may not be recoverable. This includes but is not limited to
significant adverse changes in business climate, market conditions, or other events that indicate an asset’s
carrying amount may not be recoverable. If such review indicates that the carrying amount of long-lived assets is
not recoverable, the carrying amount of such assets is reduced to fair value. There was no impairment of long-
lived assets during fiscal 2016, 2015 or 2014.
Business Combinations
The Company uses its best estimates and assumptions to accurately assign fair value to the tangible and
intangible assets acquired and liabilities assumed at the acquisition date. The Company’s estimates are inherently
uncertain and subject to refinement. During the measurement period, which may be up to one year from the
acquisition date, the Company may record adjustments to the fair value of these tangible and intangible assets
acquired and liabilities assumed, with the corresponding offset to goodwill. In addition, uncertain tax positions
and tax-related valuation allowances are initially established in connection with a business combination as of the
acquisition date. The Company continues to collect information and reevaluates these estimates and assumptions
quarterly and records any adjustments to the Company’s preliminary estimates to goodwill provided that the
Company is within the measurement period. Upon the conclusion of the measurement period or final
determination of the fair value of assets acquired or liabilities assumed, whichever comes first, any subsequent
adjustments are recorded to the Company’s consolidated statements of operations.
Leases and Asset Retirement Obligations
The Company categorizes leases at their inception as either operating or capital leases. In certain lease
agreements, the Company may receive rent holidays and other incentives. The Company recognizes lease costs
on a straight-line basis once control of the space is achieved, without regard to deferred payment terms such as
rent holidays that defer the commencement date of required payments. Additionally, incentives received are
treated as a reduction of costs over the term of the agreement.
The Company establishes assets and liabilities for the present value of estimated future costs to retire long-
lived assets at the termination or expiration of a lease. Such assets are depreciated over the lease period into
operating expense, and the recorded liabilities are accreted to the future value of the estimated retirement costs.
The Company records assets and liabilities for the estimated construction costs incurred under build-to-suit
lease arrangements to the extent it is involved in the construction of structural improvements or takes
construction risk prior to commencement of a lease.
Accounting for Stock-Based Expense
The Company recognizes stock-based expenses related to stock options and restricted stock awards on a
straight-line basis over the requisite service period of the awards, which is generally the vesting term of four
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years. The aggregate stock compensation remaining to be amortized to costs and expenses will be recognized
over a weighted average period of 2.0 years. The Company recognizes stock-based expenses related to shares
issued pursuant to its 2004 Employee Stock Purchase Plan (“ESPP”) on a straight-line basis over the offering
period, which is 12 months. Stock-based expenses are recognized net of estimated forfeiture activity. The
estimated forfeiture rate applied is based on historical forfeiture rates. The Company does not anticipate paying
any cash dividends in the foreseeable future and therefore uses an expected dividend yield of zero in the option
pricing model.
The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option
pricing model with the following assumptions and fair value per share:
Fiscal Year Ended January 31,
Stock Options 2016 2015 2014
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 – 37% 37% 37 – 43%
Estimated life . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 years 3.6 years 3.4 years
Risk-free interest rate . . . . . . . . . . . . . . . . . . . 1.09 – 1.42% 1.12 – 1.53% 0.48 – 1.21%
Weighted-average fair value per share of
grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20.22 $ 17.20 $ 14.08
Fiscal Year Ended January 31,
ESPP 2016 2015 2014
Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 – 34% 32 – 35% 31 – 35%
Estimated life . . . . . . . . . . . . . . . . . . . . . . . . . 0.75 years 0.75 years 0.75 years
Risk-free interest rate . . . . . . . . . . . . . . . . . . . 0.06 – 0.76% 0.07 – 0.23% 0.07 – 0.10%
Weighted-average fair value per share of
grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19.49 $ 14.56 $ 10.30
The Company estimated its future stock price volatility considering both its observed option-implied
volatilities and its historical volatility calculations. Management believes this is the best estimate of the expected
volatility over the expected life of its stock options and stock purchase rights.
The estimated life for the stock options was based on an analysis of historical exercise activity. The
estimated life of the ESPP was based on the two purchase periods within each offering period. The risk-free
interest rate is based on the rate for a U.S. government security with the same estimated life at the time of the
option grant and the stock purchase rights.
Advertising Expenses
Advertising is expensed as incurred. Advertising expense was $315.6 million, $203.6 million and
$155.8 million for fiscal 2016, 2015 and 2014, respectively.
Income Taxes
The Company uses the asset and liability method of accounting for income taxes. Under this method,
deferred tax assets and liabilities are determined based on temporary differences between the financial statement
and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are
expected to reverse. The effect on deferred tax assets and liabilities of a change in tax laws is recognized in the
consolidated statement of operations in the period that includes the enactment date.
The Company’s tax positions are subject to income tax audits by multiple tax jurisdictions throughout the
world. The Company recognizes the tax benefit of an uncertain tax position only if it is more likely than not that
the position is sustainable upon examination by the taxing authority, solely based on its technical merits. The tax
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benefit recognized is measured as the largest amount of benefit which is greater than 50 percent likely to be
realized upon settlement with the taxing authority. The Company recognizes interest accrued and penalties
related to unrecognized tax benefits in the income tax provision.
Valuation allowances are established when necessary to reduce deferred tax assets to the amounts that are more
likely than not expected to be realized based on the weighting of positive and negative evidence. Future realization
of deferred tax assets ultimately depends on the existence of sufficient taxable income of the appropriate character
(for example, ordinary income or capital gain) within the carryback or carryforward periods available under the
applicable tax law. The Company regularly reviews the deferred tax assets for recoverability based on historical
taxable income, projected future taxable income, the expected timing of the reversals of existing temporary
differences and tax planning strategies. The Company’s judgments regarding future profitability may change due to
many factors, including future market conditions and the ability to successfully execute its business plans and/or tax
planning strategies. Should there be a change in the ability to recover deferred tax assets, the tax provision would
increase or decrease in the period in which the assessment is changed.
Foreign Currency Translation
The functional currency of the Company’s major foreign subsidiaries is generally the local currency.
Adjustments resulting from translating foreign functional currency financial statements into U.S. dollars are
recorded as a separate component on the consolidated statements of comprehensive loss. Foreign currency
transaction gains and losses are included in net loss for the period. All assets and liabilities denominated in a
foreign currency are translated into U.S. dollars at the exchange rate on the balance sheet date. Revenues and
expenses are translated at the average exchange rate during the period. Equity transactions are translated using
historical exchange rates.
Warranties and Indemnification
The Company’s enterprise cloud computing services are typically warranted to perform in a manner
consistent with general industry standards that are reasonably applicable and materially in accordance with the
Company’s online help documentation under normal use and circumstances.
The Company’s arrangements generally include certain provisions for indemnifying customers against
liabilities if its products or services infringe a third party’s intellectual property rights. To date, the Company has
not incurred any material costs as a result of such obligations and has not accrued any liabilities related to such
obligations in the accompanying consolidated financial statements.
The Company has also agreed to indemnify its directors and executive officers for costs associated with any
fees, expenses, judgments, fines and settlement amounts incurred by any of these persons in any action or
proceeding to which any of those persons is, or is threatened to be, made a party by reason of the person’s service
as a director or officer, including any action by the Company, arising out of that person’s services as the
Company’s director or officer or that person’s services provided to any other company or enterprise at the
Company’s request. The Company maintains director and officer insurance coverage that would generally enable
the Company to recover a portion of any future amounts paid. The Company may also be subject to
indemnification obligations by law with respect to the actions of its employees under certain circumstances and
in certain jurisdictions.
New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update
No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” (“ASU 2014-09”) which amended the existing
FASB Accounting Standards Codification. This standard establishes a principle for recognizing revenue upon the
transfer of promised goods or services to customers, in an amount that reflects the expected consideration received
87
in exchange for those goods or services. The standard also provides guidance on the recognition of costs related to
obtaining and fulfilling customer contracts. The FASB deferred the effective date for the new revenue reporting
standard for entities reporting under U.S. GAAP for one year. In accordance with the deferral, ASU 2014-09 will be
effective for fiscal 2019, including interim periods within that reporting period. The Company is currently in the
process of assessing the adoption methodology, which allows the amendment to be applied retrospectively to each
prior period presented, or with the cumulative effect recognized as of the date of initial application. The Company is
also evaluating the impact of the adoption of ASU 2014-09 on its condensed consolidated financial statements and
has not determined whether the effect will be material to either its revenue results or its deferred commissions
balances.
In September 2015, the FASB issued Accounting Standards Update No. 2015-16, “Simplifying the
Accounting for Measurement-Period Adjustments (Topic 805)” (“ASU 2015-16”) which eliminates the
requirement to restate prior period financial statements for measurement period adjustments in business
combinations. ASU 2015-16 requires that the cumulative impact of a measurement period adjustment (including
the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. The new
standard is effective for interim and annual periods beginning after December 15, 2015 and early adoption is
permitted. The Company is evaluating the impact of the adoption of ASU 2015-16 on its consolidated financial
statements.
In November 2015, the FASB issued Accounting Standards Update No. 2015-17, “Income Taxes
(Topic 740): Balance Sheet Classification of Deferred Taxes” (“ASU 2015-17”) which requires all deferred
income taxes to be classified as noncurrent on the balance sheet. The amendments would be effective for annual
periods beginning after December 15, 2016. The Company early adopted this standard retrospectively for all
prior periods and reclassified all current deferred tax assets and liabilities to noncurrent deferred tax assets and
liabilities on the consolidated balance sheets for all periods presented.
In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases (Topic 842)”
(“ASU 2016-02”), which requires lessees to put most leases on their balance sheets but recognize the expenses
on their income statements in a manner similar to current practice. ASU 2016-02 states that a lessee would
recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use
the underlying asset for the lease term. The new standard is effective for interim and annual periods beginning
after December 15, 2018 and early adoption is permitted. The Company is currently evaluating the impact to its
consolidated financial statements.
Reclassifications
Certain reclassifications to the fiscal 2015 balances were made to conform to the current period presentation
in the Balance Sheet. These reclassifications include strategic investments and other assets, net.
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2. Investments
Marketable Securities
At January 31, 2016, marketable securities consisted of the following (in thousands):
Investments classified as Marketable Securities
Amortized
Cost
Unrealized
Gains
Unrealized
Losses Fair Value
Corporate notes and obligations . . . . . . . . . . . . $ 949,266 $1,398 $(2,983) $ 947,681
U.S. treasury securities . . . . . . . . . . . . . . . . . . . 157,625 375 (56) 157,944
Mortgage backed obligations . . . . . . . . . . . . . . 104,242 106 (323) 104,025
Asset backed securities . . . . . . . . . . . . . . . . . . . 271,292 186 (226) 271,252
Municipal securities . . . . . . . . . . . . . . . . . . . . . 44,934 209 (6) 45,137
Foreign government obligations . . . . . . . . . . . . 18,014 42 (5) 18,051
U.S. agency obligations . . . . . . . . . . . . . . . . . . . 16,076 16 (6) 16,086
Covered bonds . . . . . . . . . . . . . . . . . . . . . . . . . . 6,690 148 0 6,838
Total marketable securities . . . . . . . . . . . . . . . . $1,568,139 $2,480 $(3,605) $1,567,014
At January 31, 2015, marketable securities consisted of the following (in thousands):
Investments classified as Marketable Securities
Amortized
Cost
Unrealized
Gains
Unrealized
Losses Fair Value
Corporate notes and obligations . . . . . . . . . . . . . . . $605,724 $3,031 $(481) $608,274
U.S. treasury securities . . . . . . . . . . . . . . . . . . . . . . 73,226 257 (1) 73,482
Mortgage backed obligations . . . . . . . . . . . . . . . . . 44,181 159 (415) 43,925
Asset backed securities . . . . . . . . . . . . . . . . . . . . . . 120,049 131 (43) 120,137
Municipal securities . . . . . . . . . . . . . . . . . . . . . . . . 36,447 115 (25) 36,537
Foreign government obligations . . . . . . . . . . . . . . . 12,023 278 0 12,301
U.S. agency obligations . . . . . . . . . . . . . . . . . . . . . . 19,488 26 (4) 19,510
Covered bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,816 1,185 0 68,001
Total marketable securities . . . . . . . . . . . . . . . . . . . $977,954 $5,182 $(969) $982,167
The duration of the investments classified as marketable securities is as follows (in thousands):
As of
January 31,
2016
January 31,
2015
Recorded as follows:
Short-term (due in one year or less) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 183,018 $ 87,312
Long-term (due after one year) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,383,996 894,855
$1,567,014 $982,167
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As of January 31, 2016, the following marketable securities were in an unrealized loss position (in
thousands):
Less than 12 Months 12 Months or Greater Total
Fair Value
Unrealized
Losses Fair Value
Unrealized
Losses Fair Value
Unrealized
Losses
Corporate notes and obligations . . . . $531,258 $(2,472) $48,047 $(511) $579,305 $(2,983)
U.S. treasury securities . . . . . . . . . . . 50,434 (56) 0 0 50,434 (56)
Mortgage backed obligations . . . . . . . 61,055 (274) 4,780 (49) 65,835 (323)
Asset backed securities . . . . . . . . . . . 135,917 (199) 5,490 (27) 141,407 (226)
Municipal securities . . . . . . . . . . . . . . 4,553 (4) 1,959 (2) 6,512 (6)
U.S. agency obligations . . . . . . . . . . . 5,989 (6) 0 0 5,989 (6)
Foreign government obligations . . . . 5,523 (5) 0 0 5,523 (5)
$794,729 $(3,016) $60,276 $(589) $855,005 $(3,605)
The unrealized loss for each individual fixed rate marketable securities was less than $115,000. The
Company does not believe any of the unrealized losses represent an other-than-temporary impairment based on
its evaluation of available evidence as of January 31, 2016. The Company expects to receive the full principal
and interest on all of these marketable securities.
Fair Value Measurement
All of the Company’s cash equivalents, marketable securities and foreign currency derivative contracts are
classified within Level 1 or Level 2 because the Company’s cash equivalents, marketable securities and foreign
currency derivative contracts are valued using quoted market prices or alternative pricing sources and models
utilizing observable market inputs.
The Company uses a three-tier fair value hierarchy, which prioritizes the inputs used in the valuation
methodologies in measuring fair value:
Level 1. Quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level 2. Other inputs that are directly or indirectly observable in the marketplace.
Level 3. Unobservable inputs which are supported by little or no market activity.
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The following table presents information about the Company’s assets and liabilities that are measured at fair
value as of January 31, 2016 and indicates the fair value hierarchy of the valuation (in thousands):
Description
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
Significant Other
Observable
Inputs
(Level 2)
Significant
Unobservable
Inputs
(Level 3)
Balances as of
January 31,
2016
Cash equivalents (1):
Time deposits . . . . . . . . . . . . . . . . . . . $ 0 $ 236,798 $ 0 $ 236,798
Money market mutual funds . . . . . . . . 216,107 0 0 216,107
Commercial Paper . . . . . . . . . . . . . . . . 0 159,230 0 159,230
Agency and sovereign paper . . . . . . . . 0 13,599 0 13,599
Marketable securities:
Corporate notes and obligations . . . . . 0 947,681 0 947,681
U.S. treasury securities . . . . . . . . . . . . 0 157,944 0 157,944
Mortgage backed obligations . . . . . . . 0 104,025 0 104,025
Asset backed securities . . . . . . . . . . . . 0 271,252 0 271,252
Municipal securities . . . . . . . . . . . . . . 0 45,137 0 45,137
Foreign government obligations . . . . . 0 18,051 0 18,051
U.S. agency obligations . . . . . . . . . . . . 0 16,086 0 16,086
Covered bonds . . . . . . . . . . . . . . . . . . . 0 6,838 0 6,838
Foreign currency derivative
contracts (2) . . . . . . . . . . . . . . . . . . . . . . . 0 4,731 0 4,731
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . $216,107 $1,981,372 $ 0 $2,197,479
Liabilities
Foreign currency derivative
contracts (3) . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 14,025 $ 0 $ 14,025
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 14,025 $ 0 $ 14,025
(1) Included in “cash and cash equivalents” in the accompanying consolidated balance sheet as of January 31,
2016, in addition to $532.6 million of cash.
(2) Included in “prepaid expenses and other current assets” in the accompanying consolidated balance sheet as
of January 31, 2016.
(3) Included in “accounts payable, accrued expenses and other liabilities” in the consolidated balance sheet as
of January 31, 2016.
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The following table presents information about the Company’s assets and liabilities that are measured at fair
value as of January 31, 2015 and indicates the fair value hierarchy of the valuation (in thousands):
Description
Quoted Prices in
Active Markets
for Identical Assets
(Level 1)
Significant Other
Observable
Inputs
(Level 2)
Significant
Unobservable
Inputs
(Level 3)
Balances as of
January 31,
2015
Cash equivalents (1):
Time deposits . . . . . . . . . . . . . . . . . . . $ 0 $ 292,487 $ 0 $ 292,487
Money market mutual funds . . . . . . . . 13,983 0 0 13,983
Marketable securities:
Corporate notes and obligations . . . . . 0 608,274 0 608,274
U.S. treasury securities . . . . . . . . . . . . 0 73,482 0 73,482
Mortgage backed obligations . . . . . . . 0 43,925 0 43,925
Asset backed securities . . . . . . . . . . . . 0 120,137 0 120,137
Municipal securities . . . . . . . . . . . . . . 0 36,537 0 36,537
Foreign government obligations . . . . . 0 12,301 0 12,301
U.S. agency obligations . . . . . . . . . . . . 0 19,510 0 19,510
Covered bonds . . . . . . . . . . . . . . . . . . . 0 68,001 0 68,001
Foreign currency derivative
contracts (2) . . . . . . . . . . . . . . . . . . . . . . . 0 10,611 0 10,611
Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . $13,983 $1,285,265 $ 0 $1,299,248
Liabilities
Foreign currency derivative
contracts (3) . . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 5,694 $ 0 $ 5,694
Total Liabilities . . . . . . . . . . . . . . . . . . . . . . $ 0 $ 5,694 $ 0 $ 5,694
(1) Included in “cash and cash equivalents” in the accompanying consolidated balance sheet as of January 31,
2015, in addition to $601.6 million of cash.
(2) Included in “prepaid expenses and other current assets” in the accompanying consolidated balance sheet as
of January 31, 2015.
(3) Included in “accounts payable, accrued expenses and other liabilities” in the accompanying consolidated
balance sheet as of January 31, 2015.
Derivative Financial Instruments
The Company enters into foreign currency derivative contracts with financial institutions to reduce the risk
that its cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. The
Company uses forward currency derivative contracts to minimize the Company’s exposure to balances primarily
denominated in Euros, Japanese yen, Canadian dollars, Australian dollars and British pounds. The Company’s
foreign currency derivative contracts, which are not designated as hedging instruments, are used to reduce the
exchange rate risk associated primarily with intercompany receivables and payables. The Company’s derivative
financial instruments program is not designated for trading or speculative purposes. As of January 31, 2016 and
2015, the foreign currency derivative contracts that were not settled were recorded at fair value on the
consolidated balance sheets.
Foreign currency derivative contracts are marked-to-market at the end of each reporting period with gains
and losses recognized as other expense to offset the gains or losses resulting from the settlement or
remeasurement of the underlying foreign currency denominated receivables and payables. While the contract or
notional amount is often used to express the volume of foreign currency derivative contracts, the amounts
potentially subject to credit risk are generally limited to the amounts, if any, by which the counterparties’
obligations under the agreements exceed the obligations of the Company to the counterparties.
92
Details on outstanding foreign currency derivative contracts related primarily to intercompany receivables
and payables are presented below (in thousands):
As of January 31,
2016 2015
Notional amount of foreign currency derivative contracts . . . . . . . . . . . . $1,274,515 $942,086
Fair value of foreign currency derivative contracts . . . . . . . . . . . . . . . . . $ (9,294) $ 4,917
The fair value of the Company’s outstanding derivative instruments are summarized below (in thousands):
Fair Value of Derivative Instruments
As of January 31,
Balance Sheet Location 2016 2015
Derivative Assets
Derivatives not designated as hedging
instruments:
Foreign currency derivative
contracts . . . . . . . . . . . . . . . . . . . . .
Prepaid expenses and
other current assets $ 4,731 $10,611
Derivative Liabilities
Derivatives not designated as hedging
instruments:
Foreign currency derivative
contracts . . . . . . . . . . . . . . . . . . . . .
Accounts payable,
accrued expenses
and other liabilities $14,025 $ 5,694
The effect of the derivative instruments not designated as hedging instruments on the consolidated
statements of operations during fiscal 2016, 2015 and 2014, respectively, are summarized below (in thousands):
Derivatives Not Designated as Hedging
Instruments
Gains (losses) on Derivative Instruments
Recognized in Income
Fiscal Year Ended January 31,
Location 2016 2015 2014
Foreign currency derivative contracts . . . . . . . . . . . . Other expense $(25,786) $(1,186) $108
Strategic Investments
The Company’s strategic investments are comprised of marketable equity securities and non-marketable
debt and equity securities. Marketable equity securities are measured using quoted prices in their respective
active markets and the non-marketable equity and debt securities are recorded at cost. These investments are
presented on the consolidated balance sheets within strategic investments.
As of January 31, 2016, the Company had six investments in marketable equity securities with a fair value
of $16.2 million, which includes an unrealized gain of $8.5 million. As of January 31, 2015, the Company had four
investments in marketable equity securities with a fair value of $17.8 million, which included an unrealized gain
of $13.1 million. The change in the fair value of the investments in publicly held companies is recorded in the
consolidated balance sheets within strategic investments and accumulated other comprehensive loss.
The Company’s interest in non-marketable debt and equity securities consists of noncontrolling debt and
equity investments in privately held companies. The Company’s investments in these privately held companies are
reported at cost or marked down to fair value when an event or circumstance indicates an other-than-temporary
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decline in value has occurred. These investments are valued using significant unobservable inputs or data in an
inactive market and the valuation requires the Company’s judgment due to the absence of market prices and
inherent lack of liquidity.
As of January 31, 2016 and 2015, the carrying value of the Company’s non-marketable debt and equity
securities was $504.5 million and $158.0 million, respectively. The estimated fair value of the non-marketable
debt and equity securities was approximately $714.1 million and $280.0 million as of January 31, 2016
and January 31, 2015, respectively. These investments are measured using the cost method of accounting,
therefore the unrealized gains of $209.6 million and $122.0 million as of January 31, 2016 and January 31, 2015,
respectively, are not recorded in the consolidated financial statements.
Strategic investments consisted of the following (in thousands):
Description
Balance at
Beginning of
Year Additions
Sales,
Dispositions
and Fair
Market Value
Adjustments (1)
Balance at
End of Year
Fiscal year ended January 31, 2016
Strategic investments . . . . . . . . . . . . . . . $175,774 386,219 (41,272) $520,721
Fiscal year ended January 31, 2015
Strategic investments . . . . . . . . . . . . . . . $ 92,489 101,774 (18,489) $175,774
(1) Amounts include the release of the cost-basis and the current unrealized gain or loss balance recorded in
accumulated other comprehensive loss when shares of a publicly-held investment are sold, disposition-
related reductions of a cost-basis investment if a privately-held company within the portfolio is acquired by
another company, fair market value adjustments such as cost basis reductions related to impairments that are
other-than-temporary and unrealized gains or losses related to investments held in publicly traded
companies.
Investment Income
Investment income consists of interest income, realized gains, and realized losses on the Company’s cash,
cash equivalents and marketable securities. The components of investment income are presented below (in
thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,146 $10,129 $ 9,512
Realized gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,287 517 5,952
Realized losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,092) (608) (5,246)
Total investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,341 $10,038 $10,218
Reclassification adjustments out of accumulated other comprehensive loss into net loss were immaterial for
fiscal 2016, 2015 and 2014, respectively.
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3. Property and Equipment
Property and equipment, net consisted of the following (in thousands):
As of January 31,
2016 2015
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 183,888 $ 0
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614,081 125,289
Computers, equipment and software . . . . . . . . . . . . . . . . . . . . . . 1,281,766 1,171,762
Furniture and fixtures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,242 71,881
Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473,688 376,761
2,635,665 1,745,693
Less accumulated depreciation and amortization . . . . . . . . . . . . (919,837) (619,827)
$1,715,828 $1,125,866
Depreciation and amortization expense totaled $302.0 million, $246.6 million and $185.9 million during
fiscal 2016, 2015 and 2014, respectively.
Computers, equipment and software at January 31, 2016 and 2015 included a total of $747.1 million and
$734.7 million acquired under capital lease agreements, respectively. Accumulated amortization relating to
computers, equipment and software under capital leases totaled $310.3 million and $206.7 million, respectively,
at January 31, 2016 and 2015. Amortization of assets under capital leases is included in depreciation and
amortization expense.
Land
In August 2014, the Company sold approximately 3.7 net acres of its undeveloped real estate, which had
been classified as held for sale, for a total of $72.5 million. The Company recognized a gain of $7.8 million, net
of closing costs, on the sale of this portion of the Company’s land and building improvements.
Separately, in September 2014, the Company sold approximately 1.5 net acres of its remaining undeveloped
real estate, which had been classified as held for sale, and the remaining portion of the perpetual parking rights,
for a total of $125.0 million. The Company recognized a gain of $7.8 million, net of closing costs, on the sale of
this portion of the Company’s land, building improvements and perpetual parking rights.
In October 2015, the Company sold approximately 8.8 net acres of undeveloped real estate and the
associated perpetual parking rights in San Francisco, California, which were classified as held for sale. The total
proceeds from the sale were $157.1 million, of which the Company received $127.1 million in October 2015 and
previously received a nonrefundable deposit in the amount of $30.0 million during April 2014. The Company
recognized a gain of $21.8 million, net of closing costs, on the sale of this portion of the Company’s land and
building improvements and perpetual parking rights.
Building
In December 2013, the Company entered into a lease agreement for approximately 445,000 rentable square
feet of office space at 350 Mission Street in San Francisco, California. The space rented is for the total office space
available in the building, which is in the process of being constructed. As a result of the Company’s involvement
during the construction period, the Company is considered for accounting purposes to be the owner of the
construction project. As of January 31, 2016, the Company had capitalized $174.6 million of construction costs,
based on the construction costs incurred to date by the landlord, and recorded a corresponding current and
noncurrent financing obligation liability of $15.4 million and $196.7 million, respectively. As of January 31, 2015,
95
the Company had capitalized $125.3 million of construction costs, based on the construction costs incurred to date
by the landlord, and recorded a corresponding noncurrent financing obligation liability of $125.3 million. The total
expected financing obligation associated with this lease upon completion of the construction of the building,
inclusive of the amounts currently recorded, is $334.0 million, including interest (see Note 10 “Commitments” for
future commitment details). The obligation will be settled through monthly lease payments to the landlord once the
office space is ready for occupancy. To the extent that operating expenses for 350 Mission are material, the
Company, as the deemed accounting owner, will record the operating expenses. In April 2015, the building was
placed into service and depreciation commenced.
4. Business Combinations
50 Fremont
In February 2015, the Company acquired 50 Fremont Street, a 41 -story building totaling approximately
817,000 rentable square feet located in San Francisco, California (“50 Fremont”). At the time of the acquisition,
the Company was leasing approximately 500,000 square feet of the available space in 50 Fremont. As of
January 31, 2016, the Company occupied approximately 567,000 square feet. The Company acquired 50 Fremont
for the purpose of expanding its global headquarters in San Francisco. Pursuant to the acquisition agreement, the
Company also acquired existing third-party leases and other intangible property, terminated the Company’s
existing office leases with the seller and assumed the seller’s outstanding loan on 50 Fremont. In accordance with
Accounting Standards Codification 805 (“ASC 805”), Business Combinations, the Company accounted for the
building purchase as a business combination.
The purchase consideration for the corporate headquarters building was as follows (in thousands):
Fair Value
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $435,189
Loan assumed on 50 Fremont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Prorations due to ownership transfer midmonth . . . . . . . . . . . . . . . . . . 2,411
Total purchase consideration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $637,600
The following table summarizes the fair values of net tangible and intangible assets acquired (in thousands):
Fair Value
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $435,390
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183,888
Termination of salesforce operating lease . . . . . . . . . . . . . . . . . . . . . . . 9,483
Acquired lease intangibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,590
Loan assumed on 50 Fremont fair market value adjustment . . . . . . . . . 1,249
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $637,600
To fund the purchase of 50 Fremont, the Company used $115.0 million of restricted cash that the Company
had on the balance sheet as of January 31, 2015.
In connection with the purchase, the Company recognized a net non-cash gain totaling approximately
$36.6 million on the termination of the lease signed in January 2012. This amount reflects a gain of $46.1 million
for the reversal of tenant incentives provided from the previous landlord at the inception of the lease and a loss of
$9.5 million related to the termination of the Company’s operating lease. The tax impact as a result of the
difference between tax and book basis of the building is insignificant after considering the impact of the
Company’s valuation allowance. The amounts above have been included in the Company’s consolidated
statements of operations and consolidated balance sheet. The Company has included the rental income from third
96
party leases with other tenants in the building, and the proportionate share of building expenses for those leases
in other expense in the Company’s consolidated results of operations from the date of acquisition. These amounts
are recorded in other expense as this net rental income is not part of our core operations. These amounts were not
material for the periods presented.
Business Combinations Fiscal 2016
During fiscal 2016, the Company acquired several companies for an aggregate of $60.1 million in cash, net
of cash acquired, and has included the financial results of these companies in its consolidated financial
statements from the respective dates of acquisition. These transactions, individually and in aggregate, are not
material to the Company. The Company accounted for these transactions as business combinations. In allocating
the purchase consideration for each company based on estimated fair values, the Company recorded $68.7
million of goodwill. Some of the goodwill balance associated with these transactions is deductible for U.S.
income tax purposes.
Fiscal Year 2015
RelateIQ, Inc.
On August 1, 2014, the Company acquired the outstanding stock of RelateIQ, Inc. (“RelateIQ”), a
relationship intelligence platform company that uses data science and machine learning to automatically capture
data from email, calendars and smartphone calls and provide data science-driven insights in real time. The
Company acquired RelateIQ for the assembled workforce and expected synergies with the Company’s current
offerings. The Company has included the financial results of RelateIQ in the consolidated financial statements
from the date of acquisition, which have not been material to date. The acquisition date fair value of the
consideration transferred for RelateIQ was approximately $340.2 million, which consisted of the following (in
thousands, except share data):
Fair Value
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,123
Common stock (6,320,735 shares) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338,033
Fair value of stock options and restricted stock awards assumed . . . . . 1,050
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $340,206
The fair value of the stock options assumed by the Company was determined using the Black-Scholes
option pricing model. The share conversion ratio of 0.12 was applied to convert RelateIQ’s outstanding equity
awards for RelateIQ’s common stock into equity awards for shares of the Company’s common stock.
The following table summarizes the estimated fair values of assets acquired and liabilities assumed as of the
date of acquisition (in thousands):
Fair Value
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,194
Intangible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,200
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289,857
Current and noncurrent liabilities . . . . . . . . . . . . . . . . . . . . . . (4,700)
Deferred tax liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (345)
Net assets acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $340,206
The excess of purchase consideration over the fair value of net tangible and identifiable intangible assets
acquired was recorded as goodwill. The fair values assigned to tangible assets acquired, liabilities assumed and
identifiable intangible assets are based on management’s estimates and assumptions.
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The following table sets forth the components of identifiable intangible assets acquired (in thousands) and
their estimated useful lives as of the date of acquisition:
Fair
Value Useful Life
Developed technology . . . . . . . . . . . . . . . . . . . . . $14,470 7 years
Customer relationships and other purchased
intangible assets . . . . . . . . . . . . . . . . . . . . . . . . 1,730 1-3 years
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,200
The amount recorded for developed technology represents the estimated fair value of RelateIQ’s
relationship intelligence technology. The amount recorded for customer relationships represent the fair values of
the underlying relationships with RelateIQ customers. The goodwill balance is primarily attributed to the
assembled workforce and expanded market opportunities when integrating RelateIQ’s relationship intelligence
technology with the Company’s other offerings. The goodwill balance is not deductible for U.S. income tax
purposes.
The Company assumed unvested equity awards for shares of RelateIQ’s common stock with a fair value of
$33.9 million. Of the total consideration, $1.1 million was allocated to the purchase consideration and
$32.8 million was allocated to future services and will be expensed over the remaining service periods on a
straight-line basis.
Goodwill
Goodwill represents the excess of the purchase price in a business combination over the fair value of net
tangible and intangible assets acquired. Goodwill amounts are not amortized, but rather tested for impairment at
least annually during the fourth quarter.
Goodwill consisted of the following (in thousands):
Balance as of January 31, 2014 . . . . . . . . . . . . . . . . . . . . . . $3,500,823
RelateIQ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289,857
Finalization of acquisition date fair values . . . . . . . . . (8,020)
Balance as of January 31, 2015 . . . . . . . . . . . . . . . . . . . . . . 3,782,660
Other acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,655
Finalization of acquisition date fair values . . . . . . . . . (1,378)
Balance as of January 31, 2016 . . . . . . . . . . . . . . . . . . . . . . $3,849,937
There was no impairment of goodwill during fiscal 2016, 2015 or 2014.
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Intangible Assets
Intangible assets acquired resulting from business combinations are as follows as of January 31, 2016
(in thousands):
Gross
Fair Value
Accumulated
Amortization
Net Book
Value
Weighted
Average
Remaining
Useful Life
Acquired developed technology . . . . . . . . . . . . $ 684,260 $(451,889) $232,371 3.4
Customer relationships . . . . . . . . . . . . . . . . . . . 410,763 (160,866) 249,897 5.2
Trade name and trademark . . . . . . . . . . . . . . . . 38,980 (38,980) 0 0.0
Territory rights and other . . . . . . . . . . . . . . . . . 12,372 (8,585) 3,787 2.6
50 Fremont lease intangibles . . . . . . . . . . . . . . 7,713 (3,762) 3,951 2.3
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,154,088 $(664,082) $490,006 4.3
Intangible assets acquired resulting from business combinations were as follows as of January 31, 2015
(in thousands):
Gross
Fair Value
Accumulated
Amortization
Net Book
Value
Weighted
Average
Remaining
Useful Life
Acquired developed technology . . . . . . . . . . . . $ 674,160 $(371,997) $302,163 4.3
Customer relationships . . . . . . . . . . . . . . . . . . . 409,603 (107,245) 302,358 6.1
Trade name and trademark . . . . . . . . . . . . . . . . 38,980 (17,142) 21,838 1.0
Territory rights . . . . . . . . . . . . . . . . . . . . . . . . . 12,355 (6,522) 5,833 3.1
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,135,098 $(502,906) $632,192 5.0
The expected future amortization expense for purchased intangible assets as of January 31, 2016 is as
follows (in thousands):
Fiscal Period:
Fiscal 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $131,491
Fiscal 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,762
Fiscal 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101,425
Fiscal 2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73,268
Fiscal 2021 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,859
Thereafter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,201
Total amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . $490,006
5. Debt
Convertible Senior Notes
(in thousands)
Par Value
Outstanding
Equity
Component
Recorded
at Issuance
Liability Component of Par
Value as of January 31,
2016 2015
0.25% Convertible Senior Notes due April 1,
2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,150,000 $122,421(1) $1,095,059 $1,070,692
(1) This amount represents the equity component recorded at the initial issuance of the 0.25% convertible senior
notes.
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In March 2013, the Company issued at par value $1.15 billion of 0.25% convertible senior notes (the
“0.25% Senior Notes”) due April 1, 2018, unless earlier purchased by the Company or converted. Interest is
payable semi-annually, in arrears on April 1 and October 1 of each year.
The 0.25% Senior Notes are governed by an indenture between the Company, as issuer, and U.S. Bank
National Association, as trustee. The 0.25% Senior Notes are unsecured and do not contain any financial
covenants or any restrictions on the payment of dividends, the incurrence of senior debt or other indebtedness, or
the issuance or repurchase of securities by the Company.
If converted, holders of the 0.25% Senior Notes will receive cash equal to the principal amount, and at the
Company’s election, cash, shares of the Company’s common stock, or a combination of cash and shares, for any
amounts in excess of the principal amounts.
Certain terms of the conversion features of the 0.25% Senior Notes are as follows:
Conversion
Rate per $1,000
Par Value
Initial
Conversion
Price per
Share Convertible Date
0.25% Senior Notes . . . . . . . . . . . . . . . . . . 15.0512 $66.44 January 1, 2018
Throughout the term of the 0.25% Senior Notes, the conversion rate may be adjusted upon the occurrence of
certain events, including any cash dividends. Holders of the 0.25% Senior Notes will not receive any cash
payment representing accrued and unpaid interest upon conversion of a Note. Accrued but unpaid interest will be
deemed to be paid in full upon conversion rather than canceled, extinguished or forfeited.
Holders may convert the 0.25% Senior Notes under the following circumstances:
• during any fiscal quarter, if, for at least 20 trading days during the 30 consecutive trading day period
ending on the last trading day of the immediately preceding fiscal quarter, the last reported sales price
of the Company’s common stock for such trading day is greater than or equal to 130% of the applicable
conversion price on such trading day share of common stock on such last trading day;
• in certain situations, when the trading price of the 0.25% Senior Notes is less than 98% of the product
of the sale price of the Company’s common stock and the conversion rate;
• upon the occurrence of specified corporate transactions described under the 0.25% Senior Notes
indenture, such as a consolidation, merger or binding share exchange; or
• at any time on or after the convertible date noted above.
Holders of the 0.25% Senior Notes have the right to require the Company to purchase with cash all or a
portion of the Notes upon the occurrence of a fundamental change, such as a change of control, at a purchase
price equal to 100% of the principal amount of the 0.25% Senior Notes plus accrued and unpaid interest.
Following certain corporate transactions that constitute a change of control, the Company will increase the
conversion rate for a holder who elects to convert the 0.25% Senior Notes in connection with such change of
control.
In accounting for the issuances of the 0.25% Senior Notes, the Company separated the 0.25% Senior Notes
into liability and equity components. The carrying amount of the liability component was calculated by
measuring the fair value of a similar liability that does not have an associated convertible feature. The carrying
amount of the equity component representing the conversion option was determined by deducting the fair value
of the liability component from the par value of the 0.25% Senior Notes as a whole. The excess of the principal
amount of the liability component over its carrying amount (“debt discount”) is amortized to interest expense
over the term of the 0.25% Senior Notes. The equity component is not remeasured as long as it continues to meet
the conditions for equity classification.
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In accounting for the transaction costs related to the 0.25% Senior Notes issuance, the Company allocated
the total amount incurred to the liability and equity components based on its relative values. Transaction costs
attributable to the liability component are being amortized to expense over the terms of the 0.25% Senior Notes,
and transaction costs attributable to the equity component were netted with the equity component in temporary
stockholders’ equity and stockholders’ equity.
The 0.25% Senior Notes consisted of the following (in thousands):
As of
January 31,
2016
January 31,
2015
Liability component :
Principal:
0.25% Senior Notes (1) . . . . . . . . . . . . . . . . $1,150,000 $1,150,000
Less: debt discount, net
0.25% Senior Notes (2) . . . . . . . . . . . . . . . . (54,941) (79,308)
Net carrying amount . . . . . . . . . . . . . . . . . . . . . . . . . . $1,095,059 $1,070,692
(1) The effective interest rates of the 0.25% Senior Notes is 2.53%. These interest rates were based on the
interest rates of a similar liability at the time of issuance that did not have an associated convertible feature.
(2) Included in the consolidated balance sheets within Convertible 0.25% Senior Notes (which is classified as a
noncurrent liability) and is amortized over the life of the 0.25% Senior Notes using the effective interest rate
method.
The total estimated fair values of the Company’s 0.25% Senior Notes at January 31, 2016 was $1.4 billion.
The fair value was determined based on the closing trading price per $100 of the 0.25% Senior Notes as of the
last day of trading for fiscal 2016.
Based on the closing price of the Company’s common stock of $68.06 on January 29, 2016, the if-converted
value of the 0.25% Senior Notes exceeded their principal amount by approximately $28.0 million. Based on the
terms of the 0.25% Senior Notes, the Senior Notes were not convertible at any time during the fiscal year ended
January 31, 2016.
Note Hedges
To minimize the impact of potential economic dilution upon conversion of the Notes, the Company entered
into convertible note hedge transactions with respect to its common stock (the “Note Hedges”).
(in thousands, except for shares) Date Purchase Shares
0.25% Note Hedges . . . . . . . . . . . . . . . . . . . . . . . March 2013 $153,800 17,308,880
The Note Hedges cover shares of the Company’s common stock at a strike price that corresponds to the
initial conversion price of the respective Notes, also subject to adjustment, and are exercisable upon conversion
of the Notes. The Note Hedges will expire upon the maturity of the Notes. The Note Hedges are intended to
reduce the potential economic dilution upon conversion of the Notes in the event that the market value per share
of the Company’s common stock, as measured under the Notes, at the time of exercise is greater than the
conversion price of the Notes. The Note Hedges are separate transactions and are not part of the terms of the
Notes. Holders of the Notes will not have any rights with respect to the Note Hedges. The Note Hedges do not
impact earnings per share.
101
Warrants
Date
Proceeds
(in thousands) Shares
Strike
Price
0.25% Warrants . . . . . . . . . . . . . . . . . . . . . . . March 2013 $84,800 17,308,880 $90.40
In March 2013, the Company also entered into a warrants transaction (the “ 0.25% Warrants”), whereby the
Company sold warrants to acquire, subject to anti-dilution adjustments, shares of the Company’s common stock.
The 0.25% Warrants were anti-dilutive for the periods presented. The 0.25% Warrants are separate transactions
entered into by the Company and are not part of the terms of the 0.25% Senior Notes or the 0.25% Note Hedges.
Holders of the 0.25% Senior Notes and 0.25% Note Hedges will not have any rights with respect to the 0.25%
Warrants.
Term Loan
On July 11, 2013, the Company entered into a credit agreement (the “Prior Credit Agreement”) with Bank
of America, N.A. and certain other lenders. The Prior Credit Agreement provided for a $300.0 million term loan
(the “Term Loan”) maturing on July 11, 2016 (the “Term Loan Maturity Date”), which was entered into in
conjunction with and for purposes of funding the acquisition of ExactTarget in fiscal 2014. The Term Loan bore
interest at the Company’s option at either a base rate plus a spread of 0.50% to 1.00% or an adjusted LIBOR rate
as defined in the Prior Credit Agreement plus a spread of 1.50% to 2.00%.
In October 2014, the Company repaid the Term Loan in full and the Prior Credit Agreement was terminated.
Revolving Credit Facility
In October 2014, the Company entered into an agreement (the “Credit Agreement”) with Wells Fargo, N.A.
and certain other institutional lenders that provides for a $650.0 million unsecured revolving credit facility that
matures on October 6, 2019 (the “Credit Facility”). Immediately upon closing, the Company borrowed $300.0
million under the Credit Facility, approximately $262.5 million of which was used to repay in full the
indebtedness under the Company’s Term Loan, as described above. Borrowings under the Credit Facility bear
interest, at the Company’s option at either a base rate, as defined in the Credit Agreement, plus a margin of
0.00% to 0.75% or LIBOR plus a margin of 1.00% to 1.75%. The Company is obligated to pay ongoing
commitment fees at a rate between 0.125% and 0.25%. Such interest rate margins and commitment fees are
based on the Company’s consolidated leverage ratio for the preceding four fiscal quarter periods. Interest and the
commitment fees are payable in arrears quarterly. The Company may use amounts borrowed under the Credit
Facility for working capital, capital expenditures and other general corporate purposes, including permitted
acquisitions. Subject to certain conditions stated in the Credit Agreement, the Company may borrow amounts
under the Credit Facility at any time during the term of the Credit Agreement. The Company may also prepay
borrowings under the Credit Agreement, in whole or in part, at any time without premium or penalty, subject to
certain conditions, and amounts repaid or prepaid may be reborrowed.
The Credit Agreement contains certain customary affirmative and negative covenants, including a
consolidated leverage ratio covenant, a consolidated interest coverage ratio covenant, a limit on the Company’s
ability to incur additional indebtedness, dispose of assets, make certain acquisition transactions, pay dividends or
distributions, and certain other restrictions on the Company’s activities each defined specifically in the Credit
Agreement. The Company was in compliance with the Credit Agreement’s covenants as of January 31, 2016.
In March 2015, the Company paid down $300.0 million of outstanding borrowings under the Credit Facility.
There are currently no outstanding borrowings held under the Credit Facility as of January 31, 2016.
The weighted average interest rate on borrowings under the Credit Facility was 1.6% for the period
beginning October 6, 2014 and ended March 2015. The Company continues to pay a fee on the undrawn amount
of the Credit Facility.
102
Loan Assumed on 50 Fremont
The Company assumed a $200.0 million loan with the acquisition of 50 Fremont (the “Loan”). The Loan
bears an interest rate of 3.75% per annum and is due in June 2023. The Loan initially requires interest only
payments. Beginning in fiscal year 2019, principal and interest payments are required, with the remaining
principal due at maturity. For the fiscal year 2016, total interest expense recognized was $7.3 million. The Loan
can be prepaid at any time subject to a yield maintenance fee. The agreement governing the Loan contains certain
customary affirmative and negative covenants that the Company was in compliance with as of January 31, 2016.
Interest Expense on Convertible Senior Notes, Revolving Credit Facility and Loan Secured by 50 Fremont
The following table sets forth total interest expense recognized related to the Notes, the Term Loan and the
Credit Facility prior to capitalization of interest (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Contractual interest expense . . . . . . . . . . . . . . . . . . . $11,879 $10,224 $10,195
Amortization of debt issuance costs . . . . . . . . . . . . . . 4,105 4,622 4,470
Amortization of debt discount . . . . . . . . . . . . . . . . . . 24,504 36,575 46,942
$40,488 $51,421 $61,607
6. Other Balance Sheet Accounts
Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consisted of the following (in thousands):
As of
January 31,
2016
January 31,
2015
Prepaid income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,044 $ 21,514
Customer contract asset . . . . . . . . . . . . . . . . . . . . . . . . . 1,423 16,620
Other taxes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,341 27,540
Prepaid expenses and other current assets . . . . . . . . . . . 199,786 179,352
$250,594 $245,026
Customer contract asset reflects future billings of amounts that are contractually committed by
ExactTarget’s existing customers as of the acquisition date that will be billed in the next 12 months. As the
Company bills these customers this balance will reduce and accounts receivable will increase.
Included in prepaid expenses and other current assets are value-added tax and sales tax receivables
associated with the sale of the Company’s services to third parties. Value-added tax and sales tax receivables
totaled $27.3 million and $27.5 million at January 31, 2016 and 2015, respectively.
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Capitalized Software, net
Capitalized software consisted of the following (in thousands):
As of
January 31,
2016
January 31,
2015
Capitalized internal-use software development costs,
net of accumulated amortization of $186,251 and
$136,314, respectively . . . . . . . . . . . . . . . . . . . . . . . . $123,065 $ 96,617
Acquired developed technology, net of accumulated
amortization of $481,118 and $392,736,
respectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261,193 336,781
$384,258 $433,398
Capitalized internal-use software amortization expense totaled $49.9 million, $35.7 million, $29.2 million
for fiscal 2016, 2015 and 2014, respectively. Acquired developed technology amortization expense totaled $88.4
million, $98.4 million and $114.7 million for fiscal 2016, 2015 and 2014, respectively.
The Company capitalized $6.1 million, $5.3 million and $3.5 million of stock-based expenses related to
capitalized internal-use software development and deferred professional services during fiscal 2016, 2015 and
2014, respectively.
Other Assets, net
Other assets consisted of the following (in thousands):
As of
January 31,
2016
January 31,
2015
Deferred income taxes, noncurrent, net . . . . . . . . . . . . . $ 15,986 $ 16,948
Long-term deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,469 19,715
Purchased intangible assets, net of accumulated
amortization of $212,248 and $130,968,
respectively . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258,580 329,971
Acquired intellectual property, net of accumulated
amortization of $22,439 and $15,695, respectively . . 10,565 15,879
Customer contract asset . . . . . . . . . . . . . . . . . . . . . . . . . 93 1,447
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74,069 76,259
$378,762 $460,219
Purchased intangible assets amortization expense for fiscal 2016, 2015 and 2014 was $81.3 million,
$64.6 million, $37.6 million respectively. Acquired intellectual property amortization expense for fiscal 2016,
2015 and 2014 was $6.7 million, $5.0 million and $4.2 million respectively.
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Accounts Payable, Accrued Expenses and Other Liabilities
Accounts payable, accrued expenses and other liabilities consisted of the following (in thousands):
As of
January 31,
2016
January 31,
2015
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 71,481 $ 95,537
Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . 554,502 457,102
Accrued other liabilities . . . . . . . . . . . . . . . . . . . . . . . 447,729 321,032
Accrued income and other taxes payable . . . . . . . . . . 205,781 184,844
Accrued professional costs . . . . . . . . . . . . . . . . . . . . . 33,814 16,889
Customer liability, current (1) . . . . . . . . . . . . . . . . . . . 6,558 13,084
Accrued rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,071 14,847
Financing obligation, building in progress-leased
facility, current . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,402 0
$1,349,338 $1,103,335
(1) Customer liability reflects the legal obligation to provide future services that are contractually committed to
ExactTarget’s existing customers but unbilled as of the acquisition date in July 2013. As these services are
invoiced, this balance will decrease and deferred revenue will increase.
Other Noncurrent Liabilities
Other noncurrent liabilities consisted of the following (in thousands):
As of
January 31,
2016
January 31,
2015
Deferred income taxes and income taxes payable . . . . . $ 85,996 $ 66,541
Customer liability, noncurrent . . . . . . . . . . . . . . . . . . . . 66 1,026
Financing obligation, building in progress-leased
facility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196,711 125,289
Long-term lease liabilities and other . . . . . . . . . . . . . . . 550,292 701,612
$833,065 $894,468
7. Stockholders’ Equity
The Company maintains the following stock plans: the ESPP, the 2013 Equity Incentive Plan and the 2014
Inducement Equity Incentive Plan (the “2014 Inducement Plan”). The expiration of the 1999 Stock Option Plan
(“1999 Plan”) in fiscal 2010 did not affect awards outstanding, which continue to be governed by the terms and
conditions of the 1999 Plan.
On July 10, 2014, the Company adopted the 2014 Inducement Plan with a reserve of 335,000 shares of
common stock for future issuance solely for the granting of inducement stock options and equity awards to new
employees, including employees of acquired companies. In addition, approximately 319,000 shares of common
stock that remained available for grant under the 2006 Inducement Equity Incentive Plan (the “Prior Inducement
Plan”) as of July 9, 2014 were added to the 2014 Inducement Plan share reserve and the Prior Inducement Plan was
terminated. Further, any shares of common stock subject to outstanding awards under the Prior Inducement Plan
that expire, are forfeited, or are repurchased by the Company will also become available for future grant under the
2014 Inducement Plan. Termination of the Prior Inducement Plan did not affect the outstanding awards previously
issued thereunder. The 2014 Inducement Plan was adopted without stockholder approval in reliance on the
“employment inducement exemption” provided under the New York Stock Exchange Listed Company Manual.
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In September 2011, the Company’s Board of Directors amended and restated the ESPP. In conjunction with
the amendment of the ESPP, the Company’s Board of Directors determined that the offerings under the ESPP
would commence, beginning with a twelve month offering period starting in December 2011. As of January 31,
2016, $37.5 million has been withheld on behalf of employees for future purchases under the ESPP and is
recorded in accounts payable, accrued expenses and other liabilities. Employees purchased 3.0 million shares for
$155.0 million and 3.3 million shares for $127.8 million, in fiscal 2016 and 2015, respectively, under the ESPP.
Prior to February 1, 2006, options issued under the Company’s stock option plans generally had a term of
10 years. From February 1, 2006 through July 3, 2013, options issued had a term of five years. After July 3,
2013, options issued have a term of seven years.
During fiscal 2016, the Company granted a performance-based restricted stock unit award to the Chairman
of the Board and Chief Executive Officer subject to vesting based on a performance-based condition and a
service-based condition. These performance-based restricted stock units will vest simultaneously if the
performance condition is achieved.
Stock activity excluding the ESPP is as follows:
Options Outstanding
Shares
Available
for Grant
Outstanding
Stock
Options
Weighted-
Average
Exercise Price
Aggregate
Intrinsic Value
Balance as of January 31, 2015 . . . . . . 30,789,538 29,458,361 $44.36
Increase in shares authorized:
2013 Equity Incentive
Plan . . . . . . . . . . . . . . . . . 39,148,364 0 0.00
2014 Inducement Equity
Incentive Plan . . . . . . . . . 231,871 0 0.00
Options granted under all
plans . . . . . . . . . . . . . . . . . . . . . (7,119,327) 7,119,327 78.85
Restricted stock activity . . . . . . . (15,905,661) 0 0.00
Performance restricted stock
units . . . . . . . . . . . . . . . . . . . . . (411,471) 0 0.00
Stock grants to board and
advisory board members . . . . . (192,298) 0 0.00
Exercised . . . . . . . . . . . . . . . . . . . 0 (8,188,987) 35.53
Plan shares expired . . . . . . . . . . . (1,791,011) 0 0.00
Canceled . . . . . . . . . . . . . . . . . . . 2,129,903 (2,129,903) 46.87
Balance as of January 31, 2016 . . . . . . 46,879,908 26,258,798 $56.26 $386,893,769
Vested or expected to vest . . . . . . . . . . 23,956,184 $54.97 $375,375,548
Exercisable as of January 31, 2016 . . . 9,763,563 $41.99 $254,557,559
The total intrinsic value of the options exercised during fiscal 2016, 2015 and 2014 was $291.3 million,
$250.3 million and $292.3 million respectively. The intrinsic value is the difference between the current market
value of the stock and the exercise price of the stock option.
The weighted-average remaining contractual life of vested and expected to vest options is approximately
4.75 years.
As of January 31, 2016, options to purchase 9,763,563 shares were vested at a weighted average exercise
price of $41.99 per share and had a remaining weighted-average contractual life of approximately 3.3 years. The
total intrinsic value of these vested options as of January 31, 2016 was $254.6 million.
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The following table summarizes information about stock options outstanding as of January 31, 2016 :
Options Outstanding Options Exercisable
Range of Exercise
Prices
Number
Outstanding
Weighted-Average
Remaining
Contractual Life
(Years)
Weighted-Average
Exercise Price
Number of
Shares
Weighted-Average
Exercise Price
$0.86 to $37.95 . . . . . . . . 4,555,639 2.0 $29.18 3,838,627 $28.42
$38.03 to $52.14 . . . . . . . 2,556,681 2.3 39.94 1,826,462 39.62
$52.30 . . . . . . . . . . . . . . . 3,800,524 4.8 52.30 1,852,072 52.30
$53.60 to $57.79 . . . . . . . 1,466,601 5.4 55.29 459,196 55.31
$59.34 . . . . . . . . . . . . . . . 6,313,261 5.8 59.34 1,739,344 59.34
$59.37 to $77.86 . . . . . . . 1,925,609 6.2 68.04 47,862 63.07
$80.99 . . . . . . . . . . . . . . . 5,640,483 6.8 80.99 0 0.00
26,258,798 4.9 $56.26 9,763,563 $41.99
Restricted stock activity is as follows:
Restricted Stock Outstanding
Outstanding
Weighted-
Average
Exercise Price
Aggregate
Intrinsic
Value
Balance as of January 31, 2014 . . . . . . . . . 24,653,578 $0.001
Granted- restricted stock units and
awards . . . . . . . . . . . . . . . . . . . . . . . 11,170,913 0.001
Canceled . . . . . . . . . . . . . . . . . . . . . . . (3,174,976) 0.001
Vested and converted to shares . . . . . . (9,505,507) 0.001
Balance as of January 31, 2015 . . . . . . . . . 23,144,008 $0.001
Granted- restricted stock units and
awards . . . . . . . . . . . . . . . . . . . . . . . 9,736,623 0.001
Granted- performance stock units . . . . 191,382 0.001
Canceled . . . . . . . . . . . . . . . . . . . . . . . (2,715,332) 0.001
Vested and converted to shares . . . . . . (9,062,096) 0.001
Balance as of January 31, 2016 . . . . . . . . . 21,294,585 $0.001 $1,449,309,455
Expected to vest . . . . . . . . . . . . . . . . . . . . . 17,846,945 $1,214,663,077
The restricted stock, which upon vesting entitles the holder to one share of common stock for each share of
restricted stock, has an exercise price of $0.001 per share, which is equal to the par value of the Company’s
common stock, and generally vests over 4 years.
The weighted-average grant date fair value of the restricted stock issued for fiscal 2016, 2015 and 2014 was
$73.61, $58.89 and $46.99, respectively.
107
Common Stock
The following number of shares of common stock were reserved and available for future issuance at
January 31, 2016:
Options outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,258,798
Restricted stock awards and units and performance stock
units outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,294,585
Stock available for future grant:
2013 Equity Incentive Plan . . . . . . . . . . . . . . . . . . . . 46,233,360
2014 Inducement Equity Incentive Plan . . . . . . . . . . 646,548
2004 Employee Stock Purchase Plan . . . . . . . . . . . . 6,844,796
Convertible senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . 17,308,880
Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,308,880
135,895,847
During fiscal years 2016, 2015 and 2014, certain board members received stock grants totaling 67,041
shares of common stock, 83,127 shares of common stock and 108,800 shares of common stock, respectively for
board services pursuant to the terms described in the 2013 Plan and previously, the 2004 Outside Directors Stock
Plan. The expense related to these awards, which was expensed immediately at the time of the issuance, totaled
$4.8 million, $5.0 million and $4.5 million for fiscal 2016, 2015 and 2014, respectively.
Preferred Stock
The Company’s board of directors has the authority, without further action by stockholders, to issue up to
5,000,000 shares of preferred stock in one or more series. The Company’s board of directors may designate the
rights, preferences, privileges and restrictions of the preferred stock, including dividend rights, conversion rights,
voting rights, terms of redemption, liquidation preference, sinking fund terms, and number of shares constituting
any series or the designation of any series. The issuance of preferred stock could have the effect of restricting
dividends on the Company’s common stock, diluting the voting power of its common stock, impairing the
liquidation rights of its common stock, or delaying or preventing a change in control. The ability to issue
preferred stock could delay or impede a change in control. As of January 31, 2016 and 2015, no shares of
preferred stock were outstanding.
8. Income Taxes
Effective Tax Rate
The domestic and foreign components of income (loss) before provision for (benefit from) income taxes
consisted of the following (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Domestic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (49,558) $(211,253) $(326,392)
Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113,837 (1,832) (31,543)
$ 64,279 $(213,085) $(357,935)
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The provision for (benefit from) income taxes consisted of the following (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Current:
Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,723 $ 893 $ (10,431)
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,023 1,388 (245)
Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,347 50,493 39,784
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,093 52,774 29,108
Deferred:
Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,453 8,771 (128,798)
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (426) (10,830) (22,012)
Foreign . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (415) (1,112) (4,058)
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 612 (3,171) (154,868)
Provision for (benefit from) income taxes . . . . . . $111,705 $ 49,603 $(125,760)
During fiscal 2016, 2015 and 2014, the Company recorded net tax benefits that resulted from allocating
certain tax effects related to exercises of stock options and vesting of restricted stock directly to stockholders’
equity in the amount of $59.5 million, $7.7 million and $8.1 million, respectively.
In fiscal 2016, the Company recorded income taxes in profitable jurisdictions outside the United States and
current tax expense in the United States. The Company had U.S. current tax expense as a result of taxable income
before considering certain excess tax benefits from stock options and vesting of restricted stock. In fiscal 2015,
the Company recorded income taxes in profitable jurisdictions outside the United States, which was partially
offset by tax benefits from current year losses incurred by ExactTarget in certain state jurisdictions. In fiscal
2014, the Company recorded a partial release of its valuation allowance primarily in connection with the
acquisition of ExactTarget. Due to the ExactTarget acquisition, a deferred tax liability was recorded for the book-
tax basis difference related to purchased intangibles. The net deferred tax liability from acquisitions provided an
additional source of income to support the realizability of the Company’s pre-existing deferred tax assets and as a
result, the Company released a portion of its valuation allowance and recorded a tax benefit of $143.1 million.
A reconciliation of income taxes at the statutory federal income tax rate to the provision for (benefit from)
income taxes included in the accompanying consolidated statements of operations is as follows (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
U.S. federal taxes at statutory rate . . . . . . . . . . . . . . . $ 22,498 $ (74,580) $(125,277)
State, net of the federal benefit . . . . . . . . . . . . . . . . . . (5,260) (5,332) (10,780)
Foreign taxes in excess of the U.S. statutory rate . . . . (25,780) 29,880 33,412
Change in valuation allowance . . . . . . . . . . . . . . . . . . 139,565 100,143 (25,048)
Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (48,943) (28,056) (22,293)
Non-deductible expenses . . . . . . . . . . . . . . . . . . . . . . 26,841 26,224 21,407
Tax expense/(benefit) from acquisitions . . . . . . . . . . . 1,584 2,341 1,811
Other, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200 (1,017) 1,008
Provision for (benefit from) income taxes . . . . . . . . . $111,705 $ 49,603 $(125,760)
In December 2015, the U.S Tax Court (“Tax Court”) formally entered its decision in Altera Corporation’s
(“Altera”) litigation with the Internal Revenue Service (“IRS”). The litigation relates to the treatment of stock-
based compensation expense in an inter-company cost-sharing arrangement with Altera’s foreign subsidiary. In
its opinion, the Tax Court accepted Altera’s position of excluding stock-based compensation from its inter-
company cost-sharing arrangement. However, the IRS appealed the Tax Court’s decision on February 19, 2016.
109
The Company will continue to monitor this matter and the related potential impacts to its financial statements.
During the third quarter of fiscal 2016, the Company amended its inter-company cost-sharing arrangement to
exclude stock-based compensation expense beginning in fiscal 2016 and accordingly, the Company recognized
the related tax benefit through its tax provision. The Company also recorded a tax benefit of $30.4 million related
to the Company’s historical tax filing position, which was offset by the valuation allowance. In the above
reconciliation, most of the Altera related tax benefit was reflected in the foreign taxes in excess of the U.S.
statutory rate, which was partially offset by the change in valuation allowance.
In December 2015, the Protecting Americans from Tax Hikes (PATH) Act of 2015 was signed into law,
which made permanent several business-related provisions such as the research tax credit for qualifying amounts
paid or incurred after December 31, 2014, and extended other expired provisions including bonus depreciation.
While the retroactive benefit of the research tax credits was fully offset by an increase of the Company’s
valuation allowance in fiscal 2016 tax provision, the bonus depreciation election reduced the Company’s taxable
income before considering certain excess tax benefits from stock options and vesting of restricted stock, which
correspondingly reduced U.S current tax expense by $18.9 million.
In December 2014, the Tax Increase Prevention Act of 2014 was signed into law, which retroactively
renewed expired provisions including research and development tax credits through the end of calendar year
2014. The enacted law change did not impact the Company’s fiscal 2015 tax provision as the retroactive benefit
of the research tax credits was fully offset by an increase in valuation allowance.
The Company receives certain tax incentives in Switzerland and Singapore in the form of reduced tax rates. The
tax reduction program in Switzerland expired in fiscal 2015, and the program in Singapore expired in fiscal 2016.
Deferred Income Taxes
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of
assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant
components of the Company’s deferred tax assets and liabilities were as follows (in thousands):
As of January 31,
2016 2015
Deferred tax assets:
Net operating loss carryforwards . . . . . . . . . . . . . . $ 260,015 $ 252,858
Deferred stock-based expense . . . . . . . . . . . . . . . . 89,532 96,753
Tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211,997 152,715
Deferred rent expense . . . . . . . . . . . . . . . . . . . . . . . 49,790 58,849
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 122,950 92,506
Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 14,261 15,664
Basis difference on strategic and other
investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,202 24,637
Financing obligation . . . . . . . . . . . . . . . . . . . . . . . . 127,198 84,095
Deferred cost sharing adjustment . . . . . . . . . . . . . . 30,351 0
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,845 20,017
Total deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . 955,141 798,094
Less valuation allowance . . . . . . . . . . . . . . . . . . . . . . . . (439,971) (293,097)
Deferred tax assets, net of valuation allowance . . . . . . . 515,170 504,997
Deferred tax liabilities:
Deferred commissions . . . . . . . . . . . . . . . . . . . . . . (121,071) (107,197)
Purchased intangibles . . . . . . . . . . . . . . . . . . . . . . . (160,200) (213,920)
Unrealized gains on investments . . . . . . . . . . . . . . (2,858) (1,793)
Depreciation and amortization . . . . . . . . . . . . . . . . (224,435) (171,908)
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,207) (3,157)
Total deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . (510,771) (497,975)
Net deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,399 $ 7,022
110
At January 31, 2016, for federal income tax purposes, the Company had net operating loss carryforwards of
approximately $2.3 billion, which expire in fiscal 2021 through fiscal 2036, federal research and development tax
credits of approximately $146.3 million, which expire in fiscal 2020 through fiscal 2036, foreign tax credits of
approximately $26.8 million, which expire in fiscal 2019 through fiscal 2026, and minimum tax credits of
$0.7 million, which have no expiration date. For California income tax purposes, the Company had net operating
loss carryforwards of approximately $845.0 million which expire beginning in fiscal 2017 through fiscal 2036,
California research and development tax credits of approximately $124.2 million, which do not expire, and
$9.5 million of enterprise zone tax credits, which expire in fiscal 2025. For other states income tax purposes, the
Company had net operating loss carryforwards of approximately $1.1 billion which expire beginning in fiscal
2017 through fiscal 2036 and tax credits of approximately $11.1 million, which expire beginning in fiscal 2021
through fiscal 2026. Utilization of the Company’s net operating loss carryforwards may be subject to substantial
annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar
state provisions. Such an annual limitation could result in the expiration of the net operating loss and tax credit
carryforwards before utilization.
The Company regularly assesses the realizability of its deferred tax assets and establishes a valuation
allowance if it is more-likely-than-not that some or all of its deferred tax assets will not be realized. The
Company evaluates and weighs all available positive and negative evidence such as historic results, future
reversals of existing deferred tax liabilities, projected future taxable income, as well as prudent and feasible tax-
planning strategies. Generally, more weight is given to objectively verifiable evidence, such as the cumulative
loss in recent years. The Company recorded a valuation allowance as it considered its cumulative loss in recent
years as a significant piece of negative evidence that is difficult to overcome. During fiscal 2016, the valuation
allowance increased by $146.9 million, primarily due to federal and state research tax credits and other U.S
deferred tax assets. The Company will continue to assess the realizability of the deferred tax assets in each of the
applicable jurisdictions going forward.
The excess tax benefits associated with stock option exercises are recorded directly to stockholders’ equity
only when such benefits are realized following the tax law ordering approach. As a result, the excess tax benefits
included in net operating loss carryforwards but are not reflected in deferred tax assets for fiscal 2016 and 2015
are $623.2 million and $527.2 million, respectively.
Tax Benefits Related to Stock-Based Expense
The total income tax benefit related to stock-based awards was $180.2 million, $170.8 million and
$147.8 million for fiscal 2016, 2015 and 2014, respectively, the majority of which was not recognized as a result
of the valuation allowance.
Unrecognized Tax Benefits and Other Considerations
The Company records liabilities related to its uncertain tax positions. Tax positions for the Company and its
subsidiaries are subject to income tax audits by multiple tax jurisdictions throughout the world. Certain prior year
tax returns are currently being examined by various taxing authorities in countries including the United States,
Switzerland and the United Kingdom. The Company recognizes the tax benefit of an uncertain tax position only
if it is more likely than not that the position is sustainable upon examination by the taxing authority, based on the
technical merits. The tax benefit recognized is measured as the largest amount of benefit which is greater than
50 percent likely to be realized upon settlement with the taxing authority. The Company had gross unrecognized
tax benefits of $ 172.7 million, $ 146.2 million, and $102.3 million as of January 31, 2016, 2015 and 2014
respectively.
111
A reconciliation of the beginning and ending balance of total unrecognized tax benefits for fiscal years
2016, 2015 and 2014 is as follows (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Balance as of February 1, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $146,188 $102,275 $ 75,144
Tax positions taken in prior period:
Gross increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,456 17,938 8,420
Gross decreases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,264) (1,967) (4,466)
Tax positions taken in current period:
Gross increases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,978 34,226 27,952
Settlements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (8,684) 0 0
Lapse of statute of limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . (781) (1,224) (5,205)
Currency translation effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,152) (5,060) 430
Balance as of January 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $172,741 $146,188 $102,275
For fiscal 2016, 2015 and 2014 total unrecognized tax benefits in an amount of $56.2 million, $44.6 million
and $34.9 million, respectively, if recognized, would reduce income tax expense and the Company’s effective tax
rate after considering the impact of the change in valuation allowance in the U.S.
The Company recognizes accrued interest and penalties related to unrecognized tax benefits in the income
tax provision. The Company accrued penalties and interest in the amount of $1.3 million, $1.3 million and
$0.6 million in income tax expense during fiscal 2016, 2015 and 2014, respectively. The balance in the non-
current income tax payable related to penalties and interest was $6.3 million, $4.6 million and $3.3 million as of
January 31, 2016, 2015 and 2014, respectively.
The Company has operations and taxable presence in multiple jurisdictions in the U.S. and outside of the
U.S. Tax positions for the Company and its subsidiaries are subject to income tax audits by multiple tax
jurisdictions around the world. The Company currently considers U.S. federal and state, Canada, Japan,
Australia, Germany, France and the United Kingdom to be major tax jurisdictions. The Company’s U.S. federal
and state tax returns since February 1999, which was the inception of the Company, remain open to examination.
With some exceptions, tax years prior to fiscal 2008 in jurisdictions outside of U.S. are generally closed.
However, in Japan and United Kingdom, the Company is no longer subject to examinations for years prior to
fiscal 2014 and fiscal 2011, respectively.
The Company is currently under audit by the U.S. Internal Revenue Service and California Franchise Tax
Board for fiscal 2011 to 2012 and fiscal 2009 to 2010, respectively. Additionally, examinations are conducted in
other international jurisdictions, including Switzerland and the United Kingdom. During fiscal 2016, the
Company completed examinations or effectively settled on tax positions with various taxing authorities and
accordingly, decreased unrecognized tax benefits by $8.7 million resulting from settlements. The Company
regularly evaluates its uncertain tax positions and the likelihood of outcomes from these tax examinations.
Significant judgment and estimates are necessary in the determination of income tax reserves. The Company
believes that it has provided adequate reserves for its income tax uncertainties. However, the outcome of the tax
audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a
manner inconsistent with management’s expectations, the Company could adjust its provision for income taxes
in the future. In the next twelve months, as some of these ongoing examinations are completed and tax positions
in these tax years meet the conditions of being effectively settled, the Company anticipates it is reasonably
possible that a decrease of unrecognized tax benefits up to approximately $15 million may occur.
112
9. Earnings/Loss Per Share
Basic earnings/loss per share is computed by dividing net income (loss) by the weighted-average number of
common shares outstanding for the fiscal period. Diluted earnings/loss per share is computed by giving effect to
all potential weighted average dilutive common stock, including options, restricted stock units, warrants and the
convertible senior notes. The dilutive effect of outstanding awards and convertible securities is reflected in
diluted earnings per share by application of the treasury stock method. Diluted loss per share for fiscal 2016,
2015 and 2014 are the same as basic loss per share as there is a net loss in these periods and inclusion of
potentially issuable shares is anti-dilutive.
A reconciliation of the denominator used in the calculation of basic and diluted loss per share is as follows
(in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Numerator:
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (47,426) $(262,688) $(232,175)
Denominator:
Weighted-average shares outstanding for basic loss
per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 661,647 624,148 597,613
Effect of dilutive securities:
Convertible senior notes . . . . . . . . . . . . . . . . . . 0 0 0
Employee stock awards . . . . . . . . . . . . . . . . . . . 0 0 0
Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 0
Adjusted weighted-average shares outstanding and
assumed conversions for diluted loss per share . . . 661,647 624,148 597,613
The weighted-average number of shares outstanding used in the computation of basic and diluted
earnings/loss per share does not include the effect of the following potential outstanding common stock. The
effects of these potentially outstanding shares were not included in the calculation of diluted earnings/loss per
share because the effect would have been anti-dilutive (in thousands):
Fiscal Year Ended January 31,
2016 2015 2014
Employee Stock awards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,615 22,157 19,664
Convertible senior notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,309 25,953 43,965
Warrants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,309 37,517 44,253
10. Commitments
Letters of Credit
As of January 31, 2016, the Company had a total of $81.9 million in letters of credit outstanding
substantially in favor of certain landlords for office space. These letters of credit renew annually and expire at
various dates through December 2030.
Leases
The Company leases facilities space and certain fixed assets under non-cancelable operating and capital
leases with various expiration dates.
113
As of January 31, 2016, the future minimum lease payments under non-cancelable operating and capital
leases are as follows (in thousands):
Capital
Leases
Operating
Leases
Financing
Obligation,
Building in
Progress-Leased
Facility(1)
Fiscal Period:
Fiscal 2017 . . . . . . . . . . . . . . . . . . . . . $118,820 $ 356,527 $ 16,877
Fiscal 2018 . . . . . . . . . . . . . . . . . . . . . 122,467 319,878 21,107
Fiscal 2019 . . . . . . . . . . . . . . . . . . . . . 115,581 251,649 21,551
Fiscal 2020 . . . . . . . . . . . . . . . . . . . . . 201,543 202,514 21,995
Fiscal 2021 . . . . . . . . . . . . . . . . . . . . . 0 189,430 22,440
Thereafter . . . . . . . . . . . . . . . . . . . . . . 0 998,849 230,077
Total minimum lease payments . . . . . 558,411 $2,318,847 $334,047
Less: amount representing interest . . (60,207)
Present value of capital lease
obligations . . . . . . . . . . . . . . . . . . . $498,204
(1) Total Financing Obligation, Building in Progress-Leased Facility noted above represents the total obligation
on the lease agreement noted in Note 3 “Property and Equipment” and includes $196.7 million that was
recorded to Financing obligation, building in progress-leased facility, which is included in Other noncurrent
liabilities on the balance sheet.
The Company’s agreements for the facilities and certain services provide the Company with the option to
renew. The Company’s future contractual obligations would change if the Company exercised these options.
The terms of the lease agreements provide for rental payments on a graduated basis. The Company
recognizes rent expense on a straight-line basis over the lease period and has accrued for rent expense incurred
but not paid. Of the total operating lease commitment balance of $2.3 billion, approximately $2.0 billion is
related to facilities space. The remaining commitment amount is related to computer equipment and furniture and
fixtures.
Rent expense for fiscal 2016, 2015 and 2014 was $174.6 million, $162.8 million and $123.6 million,
respectively.
11. Employee Benefit Plan
The Company has a 401(k) plan covering all eligible employees in the United States and Canada. Since
January 1, 2006, the Company has been contributing to the plan. Total Company contributions during fiscal
2016, 2015 and 2014, were $45.6 million, $38.1 million and $27.9 million, respectively.
12. Legal Proceedings and Claims
In the ordinary course of business, the Company is or may be involved in various legal proceedings and
claims related to alleged infringement of third-party patents and other intellectual property rights, commercial,
corporate and securities, labor and employment, class actions, wage and hour, and other claims. The Company
has been, and may in the future be, put on notice and/or sued by third parties for alleged infringement of their
proprietary rights, including patent infringement.
114
In July 2015, the Company and certain of its current and former directors were named as defendants in a
purported shareholder derivative action in the Superior Court for the State of California, County of San
Francisco. The plaintiff filed an amended version of this derivative complaint in November 2015. The derivative
complaint alleged that excessive compensation was paid to such directors for their service and
included allegations of breach of fiduciary duty and unjust enrichment, and sought restitution and disgorgement
of a portion of the directors’ compensation as well as reform of a Company equity plan. Because the
complaint was derivative in nature, it did not seek monetary damages from the Company. In February 2016, the
parties agreed to dismiss the complaint with prejudice as to the plaintiff and submitted a stipulation to that effect
to the Court. In March 2016, the Court entered the order of dismissal. Neither the Company nor the individual
defendants paid any consideration to the plaintiff.
During fiscal 2015, the Company received a communication from a large technology company alleging that
the Company infringed certain of its patents. The Company continues to analyze this claim and no litigation has
been filed to date. There can be no assurance that this claim will not lead to litigation in the future. The resolution
of this claim is not expected to have a material adverse effect on the Company’s financial condition, but it could
be material to operating results or cash flows or both of a particular quarter.
In general, the resolution of a legal matter could prevent the Company from offering its service to others,
could be material to the Company’s financial condition or cash flows, or both, or could otherwise adversely
affect the Company’s operating results.
The Company makes a provision for a liability relating to legal matters when it is both probable that a
liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed
at least quarterly and adjusted to reflect the impacts of negotiations, estimated settlements, legal rulings, advice
of legal counsel and other information and events pertaining to a particular matter. In management’s opinion,
resolution of all current matters is not expected to have a material adverse impact on the Company’s consolidated
results of operations, cash flows or financial position. However, depending on the nature and timing of any such
dispute, an unfavorable resolution of a matter could materially affect the Company’s future results of operations
or cash flows, or both, of a particular quarter.
13. Related-Party Transactions
In January 1999, the Salesforce.com Foundation, also referred to as the Foundation, was chartered on an
idea of leveraging the Company’s people, technology, and resources to help improve communities around the
world. The Company calls this integrated philanthropic approach the 1-1-1 model. Beginning in 2008,
Salesforce.org, which is a non-profit public benefit corporation, was established to resell the Company’s services
to nonprofit organizations and certain higher education organizations.
The Company’s chairman is the chairman of both the Foundation and Salesforce.org. The Company’s
chairman holds one of the three Foundation board seats. The Company’s chairman, one of the Company’s
employees and one of the Company’s board members hold three of Salesforce.org’s nine board seats. The
Company does not control the Foundation’s or Salesforce.org’s activities, and accordingly, the Company does
not consolidate either of the related entities’ statement of activities with its financial results.
Since the Foundation’s and Salesforce.org’s inception, the Company has provided at no charge certain
resources to those entities’ employees such as office space, furniture, equipment, facilities, services, and other
resources. The value of these items was approximately $1.2 million for the fiscal year 2016.
The resource sharing agreement was amended in August 2015 to include resources outside of the United
States and is more explicit about the types of resources that the Company will provide.
115
Additionally, the Company has donated subscriptions of the Company’s services to other qualified non-
profit organizations. The Company also allows Salesforce.org to resell the Company’s service to non-profit
organizations and certain higher education entities. The Company does not charge Salesforce.org for these
subscriptions, therefore revenue from subscriptions provided to non-profit organizations is donated back to the
community through charitable grants made by the Foundation and Salesforce.org. The reseller agreement was
amended in August 2015 to include additional customer segments and certain customers outside the U.S. and was
amended in October 2015 to add an addendum with model clauses for the processing of personal data transferred
from the European Economic Area. The value of the subscriptions pursuant to reseller agreements was
approximately $69.9 million for the fiscal year 2016. The Company plans to continue these programs.
14. Subsequent Events
In February 2016, the Company acquired the outstanding stock of SteelBrick, Inc. (“SteelBrick”), a next
generation quote-to-cash platform, delivered 100 percent natively on the Salesforce platform, that offers apps for
automating the entire deal close process-from generating quotes and configuring orders to collecting cash. The
Company acquired SteelBrick for its employees and product offerings. Beginning with fiscal quarter ended
April 30, 2016, the Company will include the financial results of SteelBrick in its condensed consolidated
financial statements from the date of the acquisition. The total estimated consideration for SteelBrick was over
$300.0 million and primarily in shares.
In February 2016, the Company entered into an agreement to sublease additional office space. The amounts
associated with the agreement will be approximately $311.0 million over the approximately 12 year term of the
agreement, beginning in the Company’s first quarter of fiscal 2018.
15. Selected Quarterly Financial Data (Unaudited)
Selected summarized quarterly financial information for fiscal 2016 and 2015 is as follows:
1st
Quarter
2nd
Quarter
3rd
Quarter
4th
Quarter Fiscal Year
(in thousands, except per share data)
Fiscal 2016
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,511,167 $1,634,684 $1,711,967 $1,809,398 $6,667,216
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . 1,129,365 1,229,300 1,288,284 1,365,719 5,012,668
Income from operations . . . . . . . . . . . . . . . . 31,105 19,824 43,434 20,560 114,923
Net income (loss) . . . . . . . . . . . . . . . . . . . . . $ 4,092 $ (852) $ (25,157) $ (25,509) $ (47,426)
Basic net income (loss) per share . . . . . . . . . $ 0.01 $ 0.00 $ (0.04) $ (0.04) $ (0.07)
Diluted net income (loss) per share . . . . . . . . $ 0.01 $ 0.00 $ (0.04) $ (0.04) $ (0.07)
Fiscal 2015
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,226,772 $1,318,551 $1,383,655 $1,444,608 $5,373,586
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . 934,467 1,010,720 1,050,444 1,088,685 4,084,316
Loss from operations . . . . . . . . . . . . . . . . . . . (55,341) (33,434) (22,042) (34,816) (145,633)
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (96,911) $ (61,088) $ (38,924) $ (65,765) $ (262,688)
Basic net loss per share . . . . . . . . . . . . . . . . . $ (0.16) $ (0.10) $ (0.06) $ (0.10) $ (0.42)
Diluted net loss per share . . . . . . . . . . . . . . . $ (0.16) $ (0.10) $ (0.06) $ (0.10) $ (0.42)
116
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our chief executive officer
and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our
disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange
Act of 1934, as amended (the “Exchange Act”), as of the end of the period covered by this Annual Report on
Form 10-K.
In designing and evaluating our disclosure controls and procedures, management recognizes that any
disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives. In addition, the design of disclosure controls and
procedures must reflect the fact that there are resource constraints and that management is required to apply its
judgment in evaluating the benefits of possible controls and procedures relative to their costs.
Based on management’s evaluation, our chief executive officer and chief financial officer concluded that
our disclosure controls and procedures are designed to, and are effective to, provide assurance at a reasonable
level that the information we are required to disclose in reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified in Securities and Exchange
Commission rules and forms, and that such information is accumulated and communicated to our management,
including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions
regarding required disclosures.
(b) Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial
reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and
with the participation of our management, including our chief executive officer and chief financial officer, we
conducted an evaluation of the effectiveness of our internal control over financial reporting as of January 31,
2016 based on the guidelines established in the Internal Control—Integrated Framework (2013 framework)
issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our internal
control over financial reporting includes policies and procedures that provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external reporting purposes in
accordance with U.S. generally accepted accounting principles.
Based on the results of our evaluation, our management concluded that our internal control over financial
reporting was effective as of January 31, 2016. We reviewed the results of management’s assessment with our
Audit Committee.
The effectiveness of our internal control over financial reporting as of January 31, 2016 has been audited by
Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in
Item 8 of this Annual Report on Form 10-K.
(c) Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting that occurred during the quarter ended
January 31, 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.
117
(d) Inherent Limitations on Effectiveness of Controls
Our management, including our chief executive officer and chief financial officer, do not expect that our
disclosure controls or our internal control over financial reporting will prevent all errors and all fraud. A control
system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Further, the design of a control system must reflect the fact that there
are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the
inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations
include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a
simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by
collusion of two or more people or by management override of the controls. The design of any system of controls
is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls
may become inadequate because of changes in conditions, or the degree of compliance with policies or
procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements
due to error or fraud may occur and not be detected.
ITEM 9B. OTHER INFORMATION
None.
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PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information concerning our directors, compliance with Section 16(a) of the Exchange Act, our Audit
Committee and any changes to the process by which stockholders may recommend nominees to the Board
required by this Item are incorporated herein by reference to information contained in the Proxy Statement,
including “Directors and Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting
Compliance.”
The information concerning our executive officers required by this Item is incorporated by reference herein
to the section of this Annual Report on Form 10-K in Part I, entitled “Executive Officers of the Registrant.”
We have adopted a code of ethics, our Code of Conduct, which applies to all employees, including our
principal executive officer, Marc Benioff, principal financial officer, Mark Hawkins, principal accounting
officer, Joe Allanson, and all other executive officers. The Code of Conduct is available on our website at
http://www.salesforce.com/company/investor/governance/. A copy may also be obtained without charge by
contacting Investor Relations, salesforce.com, inc., The Landmark @ One Market, Suite 300, San Francisco,
California 94105 or by calling (415) 901-7000.
We plan to post on our website at the address described above future amendments and waivers of our Code
of Conduct as permitted under applicable NYSE and SEC rules.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated herein by reference to information contained in the
Proxy Statement, including “Compensation Discussion and Analysis,” “Committee Reports,” “Directors and
Corporate Governance” and “Executive Compensation and Other Matters.”
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS
The information required by this Item is incorporated herein by reference to information contained in the
Proxy Statement, including “Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters” and “Equity Compensation Plan Information.”
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE
The information required by this Item is incorporated herein by reference to information contained in the
Proxy Statement, including “Directors and Corporate Governance” and “Employment Contracts and Certain
Transactions.”
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item is incorporated herein by reference to information contained in the
Proxy Statement, including “Ratification of Appointment of Independent Auditors.”
119
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as a part of this Annual Report on Form 10-K:
1. Financial Statements: The information concerning our financial statements, and Report of
Independent Registered Public Accounting Firm required by this Item is incorporated by reference herein to
the section of this Annual Report on Form 10-K in Item 8, entitled “Consolidated Financial Statements and
Supplementary Data.”
2. Financial Statement Schedules: Schedule II Valuation and Qualifying Accounts is filed as part of
this Annual Report on Form 10-K and should be read in conjunction with the Consolidated Financial
Statements and Notes thereto.
The Financial Statement Schedules not listed have been omitted because they are not applicable or are
not required or the information required to be set forth herein is included in the Consolidated Financial
Statements or Notes thereto.
3. Exhibits: See “Index to Exhibits.”
(b) Exhibits. The exhibits listed below in the accompanying “Index to Exhibits” are filed or incorporated by
reference as part of this Annual Report on Form 10-K.
(c) Financial Statement Schedules.
120
salesforce.com, inc.
Schedule II Valuation and Qualifying Accounts
Description
Balance at
Beginning of
Year Additions
Deductions
Write-offs
Balance at
End of Year
Fiscal year ended January 31, 2016
Allowance for doubtful accounts . . . $8,146,000 $14,738,000 $(12,396,000) $10,488,000
Fiscal year ended January 31, 2015
Allowance for doubtful accounts . . . $4,769,000 $ 6,867,000 $ (3,490,000) $ 8,146,000
Fiscal year ended January 31, 2014
Allowance for doubtful accounts . . . $1,853,000 $ 7,963,000 $ (5,047,000) $ 4,769,000
121
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: March 4, 2016
salesforce.com, inc.
By: /S/ MARK J. HAWKINS
Mark J. Hawkins
Executive Vice President and
Chief Financial Officer
(Principal Financial Officer)
Dated: March 4, 2016
salesforce.com, inc.
By: /S/ JOE ALLANSON
Joe Allanson
Executive Vice President, Chief Accounting
Officer and Corporate Controller
(Principal Accounting Officer)
POWER OF ATTORNEY AND SIGNATURES
KNOW ALL PERSONS BY THESE PRESENT, that each person whose signature appears below
constitutes and appoints Marc Benioff, Mark J. Hawkins, Joe Allanson, Burke Norton and Amy Weaver, his or
her attorney-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any
amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other
documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that said attorney-in-fact, or his substitute or substitutes, may do or cause to be done by virtue
hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has
been signed below by the following persons on behalf of the registrant and in the capacities and on the dates
indicated.
Signature Title Date
/s/ MARC BENIOFF
Marc Benioff
Chairman of the Board of Directors
and Chief Executive Officer
(Principal Executive Officer)
March 4, 2016
/s/ MARK J. HAWKINS
Mark J. Hawkins
Executive Vice President and Chief
Financial Officer (Principal
Financial Officer)
March 4, 2016
/s/ JOE ALLANSON
Joe Allanson
Executive Vice President, Chief
Accounting Officer and
Corporate Controller (Principal
Accounting Officer)
March 4, 2016
122
Signature Title Date
/s/ KEITH BLOCK
Keith Block
Director, Vice Chairman, President
and Chief Operating Officer
March 4, 2016
/s/ CRAIG CONWAY
Craig Conway
Director March 4, 2016
/s/ ALAN HASSENFELD
Alan Hassenfeld
Director March 4, 2016
/s/ COLIN POWELL
Colin Powell
Director March 4, 2016
/s/ SANFORD R. ROBERTSON
Sanford R. Robertson
Director March 4, 2016
/s/ JOHN V. ROOS
John V. Roos
Director March 4, 2016
/s/ LAWRENCE TOMLINSON
Lawrence Tomlinson
Director March 4, 2016
/s/ ROBIN WASHINGTON
Robin Washington
Director March 4, 2016
/s/ MAYNARD WEBB
Maynard Webb
Director March 4, 2016
/s/ SUSAN WOJCICKI
Susan Wojcicki
Director March 4, 2016
123
Index to Exhibits
Exhibit
No.
Provided
Herewith
Incorporated by Reference
Exhibit Description Form SEC File No. Exhibit Filing Date
3.1 Amended and Restated Certificate of
Incorporation of salesforce.com, inc.
8-K 001-32224 3.1 6/11/2013
3.2 Amended and Restated Bylaws of
salesforce.com, inc.
8-K 001-32224 3.2 2/2/2016
4.1 Specimen Common Stock Certificate S-1/A 333-111289 4.2 4/20/2004
4.2 Indenture dated March 18, 2013 between
salesforce.com, inc. and U.S. Bank National
Association including the form of 0.25%
Convertible Senior Notes due 2018 therein
8-K 001-32224 4.1 3/18/2013
10.1* Form of Indemnification Agreement between
salesforce.com, inc. and its officers and
directors
S-1/A 333-111289 10.1 4/20/2004
10.2* 1999 Stock Option Plan, as amended 10-K 001-32224 10.2 3/15/2006
10.3* 2004 Equity Incentive Plan, as amended 10-Q 001-32224 10.1 8/22/2008
10.4* 2013 Equity Incentive Plan and related forms
of equity award agreements, as amended
8-K 001-32224 10.1 6/9/2015
10.5* 2004 Employee Stock Purchase Plan, as
amended
8-K 001-32224 10.1 6/9/2015
10.6* 2004 Outside Directors Stock Plan, as
amended
10-K 001-32224 10.5 3/23/2011
10.7* 2006 Inducement Equity Incentive Plan, as
amended
8-K 001-32224 10.1 6/8/2012
10.8* 2014 Inducement Equity Incentive Plan and
related forms of equity award agreements
8-K 001-32224 10.1 7/11/2014
10.9* Kokua Bonus Plan, as amended and restated
December 5, 2014, effective February 1, 2015
10-K 001-32224 10.7 3/6/2015
10.10* RelateIQ, Inc. 2011 Stock Plan and related
forms of equity award agreements
S-8 333-198361 4.1 8/26/2014
10.11 Resource Sharing Agreement, dated
August 1, 2015, by and between
salesforce.com, inc., the salesforce.com
foundation, and Salesforce.org
10-Q 001-32224 10.5 8/25/2015
10.12 Reseller Agreement, dated August 1, 2015,
between salesforce.com, inc. and
Salesforce.org
10-Q 001-32224 10.4 8/25/2015
10.13 Amendment to Reseller Agreement, dated
October 13, 2015, between salesforce.com,
inc. and Salesforce.org
10-Q 001-32224 10.1 11/20/2015
10.14* Form of Offer Letter for Executive Officers
and schedule of omitted details thereto
10-K 001-32224 10.1 3/9/2012
Exhibit
No.
Provided
Herewith
Incorporated by Reference
Exhibit Description Form SEC File No. Exhibit Filing Date
10.15* Employment Offer Letter, dated May 2, 2013
between salesforce.com, inc. and Keith Block
8-K 001-32224 10.1 6/11/2013
10.16* Employment Offer Letter, dated June 11, 2014,
between salesforce.com, inc. and Mark
Hawkins
8-K 001-32224 10.2 6/30/2014
10.17* Form of Change of Control and Retention
Agreement as entered into with Marc Benioff
10-K 001-32224 10.13 3/9/2009
10.18* Form of Change of Control and Retention
Agreement as entered into with non-CEO
Executive Officers
10-K 001-32224 10.14 3/9/2009
10.19* Performance-Based Restricted Stock Unit
Agreement
8-K 001-32224 10.1 11/24/2015
10.20 Form of Convertible Bond Hedge Confirmation 8-K 001-32224 10.2 3/18/2013
10.21 Form of Warrant Confirmation 8-K 001-32224 10.3 3/18/2013
10.22 Credit Agreement, dated as of October 6, 2014,
by and among salesforce.com, inc., the
guarantors from time to time party thereto, the
lenders from time to time party thereto and
Wells Fargo Bank, N.A., as Administrative
Agent.
8-K 001-32224 10.10 10/6/2014
10.23 Amendment No. 1 to Credit Agreement, dated
as of June 17, 2015, by and among
salesforce.com, inc., the guarantors from time
to time party thereto, the lenders from time to
time party thereto and Wells Fargo Bank, N.A.,
as Administrative Agent.
10-Q 001-32224 10.3 8/25/2015
10.24 Office Lease dated as of April 10, 2014 by and
between salesforce.com, inc. and Transbay
Tower LLC
10-Q 001-32224 10.2 5/30/2014
10.25 Purchase and Sale Agreement, dated
November 10, 2014, between salesforce.com,
inc. and 50 Fremont Tower, LLC
10-Q 001-32224 10.2 11/26/2014
21.1 List of Subsidiaries X
23.1 Consent of Independent Registered Public
Accounting Firm
X
24.1 Power of Attorney (incorporated by reference
to the signature page of this Annual Report on
Form 10-K)
X
31.1 Certification of Chief Executive Officer
pursuant to Exchange Act Rule 13a-14(a) or
15(d)-14(a), as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
X
Exhibit
No.
Provided
Herewith
Incorporated by Reference
Exhibit Description Form SEC File No. Exhibit Filing Date
31.2 Certification of Chief Financial Officer
pursuant to Exchange Act Rule 13a-14(a) or
15(d)-14(a), as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 2002
X
32.1 Certification of Chief Executive Officer and
Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
X
101.INS XBRL Instance Document
101.SCH XBRL Taxonomy Extension Schema
Document
101.CAL XBRL Taxonomy Extension Calculation
Linkbase Document
101.DEF XBRL Extension Definition
101.LAB XBRL Taxonomy Extension Label Linkbase
Document
101.PRE XBRL Taxonomy Extension Presentation
Linkbase Document
* Indicates a management contract or compensatory plan or arrangement.
Marc Benioff Chairman of the Board of Directors and Chief Executive Officer
Keith Block Vice Chairman, President, and Chief Operating Officer
Craig Conway Former Chief Executive Officer, PeopleSoft Inc.
Alan Hassenfeld Director, Hasbro Inc.
Colin Powell General, Former U.S. Secretary of State, Former Chairman,
Joint Chiefs of Staff
Sanford Robertson Principal, Francisco Partners
John V. Roos Former U.S. Ambassador to Japan
Larry Tomlinson Former Senior Vice President & Treasurer, Hewlett-Packard Co.
Robin Washington Executive Vice President and Chief Financial Officer, Gilead Sciences Inc.
Maynard Webb Chairman, Yahoo Inc.
Susan Wojcicki Chief Executive Officer, YouTube
Neelie Kroes Former Vice President of the European Commission
(appointment effective May 1, 2016)
Marc Benioff Chairman of the Board of Directors and Chief Executive Officer
Joe Allanson Chief Accounting Officer and Corporate Controller
Keith Block Vice Chairman, President, and Chief Operating Officer
Alexandre Dayon President and Chief Product Officer
Parker Harris Co-Founder
Mark Hawkins Chief Financial Officer
Maria Martinez President, Sales & Customer Success
Burke Norton Chief Legal Officer and Chief of Corporate and Government Affairs
Cindy Robbins Executive Vice President, Global Employee Success
Amy Weaver Executive Vice President, General Counsel
Note on Forward-Looking Statements
This annual report contains forward-looking statements within the meaning of the federal securities laws.
Results could differ materially. Further information on factors that could affect results is included in the fiscal
2016 Form 10-K, included in this annual report.
Investor Relations investor@salesforce.com, +1-415-536-6250
Stock Listing Salesforce.com trades on the New York Stock Exchange under
the ticker symbol “CRM.”
8121Insert_BackC6.indd 28121Insert_BackC6.indd 2 4/15/16 9:01 AM4/15/16 9:01 AM
WORLDWIDE CORPORATE HEADQUARTERS
salesforce.com, inc.
The Landmark @ One Market
Suite 300
San Francisco, CA 94105
USA
hero
1.3MILLIONHOURS
contributed to the community
since inception
do better
be better
and live better.
(We are in a renaissance of giving.)
Our newly connected
world is your chance to
LAURA ESSERMAN, MD, MBA
DIRECTOR, UCSF BREAST CARE CENTER
AND ATHENA BREAST HEALTH NETWORK
Salesforce helps us
deliver personalized
medicine to our
patients.
“
RACHEL THOMAS
PRESIDENT & CO-FOUNDER
LEAN IN
With Salesforce,
we cultivate
smarter, stronger
partnerships to help
women succeed.
“
MARC BENIOFF
“I stand for equality.”
As a CEO, you have a
responsibility to say
MARC BENIOFF
“The business of business is to improve the state of the world.”
CORPORATE HEADQUARTERS
The Landmark @ One Market | Suite 300
San Francisco, CA 94105
United States
1-800-NO-SOFTWARE
Copyright © 2016, salesforce.com, inc. All rights reserved. Salesforce and salesforce.com are registered trademarks of salesforce.com, inc.
Salesforce.com owns other registered and unregistered trademarks. Other names used herein may be trademarks of their respective owners.
www.salesforce.com | /salesforce | @salesforce
166961_009_BMK
INDEX
PART I
Item 1. Business
Item 1A. Risk Factors
Item 1B. Unresolved Staff Comments
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Mine Safety Disclosures
Item 4A. Executive Officers of the Registrant
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6. Selected Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Consolidated Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
PART III
Item 10. Directors, Executive Officers and Corporate Governance
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13. Certain Relationships and Related Transactions and Director Independence
Item 14. Principal Accountant Fees and Services
PART IV
Item 15. Exhibits and Financial Statement Schedules
Signatures
Index to Exhibits
?
May the Force Be With You: Wide-Moat Salesforce.com Is the
Newest Software Empire
The market is discounting growth opportunities and operating
leverage for this software leader
.
Executive Summary
Salesforce.com has evolved from a salesforce automation point vendor to a full-fledged cloud-based
customer relationship management, or CRM, software behemoth. The company has been the key
forerunner for software as a service, or SaaS, and we believe the firm is among the most advantageously
positioned companies in software to capitalize on the ongoing secular migration to the cloud. We think
the market is underappreciating the opportunities Salesforce has to not only grow its business via its
existing products, but also through greenfield opportunities. Salesforce has generated consistent,
annual share gains across each of its product buckets, yielding leadership positions in salesforce
automation (45% share), customer service (18%), marketing (12%), and overall CRM spending (20%).
We believe enterprises will increasingly look to consolidate application spending around full-featured
suites, leaving Salesforce as the most likely beneficiary in the CRM market, propping up significant top-
and bottom-line growth for several years. Beyond growth opportunities, we revisit the economics of
software as a service (introduced in our 2015 Observer The SaaS Is Greener on the Other Side: The
Economics of Cloud Application Software Companies) and Salesforce.com’s path to operating leverage.
Key Takeaways
× Despite Salesforce.com’s abundance of success in the cloud-based customer relationship management
market, we believe the market underappreciates and underestimates the remaining CRM opportunity.
Salesforce has the most complete cloud-based customer relationship management suite to date,
including a network of applications around salesforce automation, customer service, digital marketing,
and e-commerce (via the recent $2.8 billion Demandware acquisition). This breadth should only
propagate the firm’s ability to land large, multiapplication deals.
× We are encouraged by the steps Salesforce has taken to add functionality to its applications. The firm is
also branching out into new verticals, and we see ample opportunity for the firm’s platform-as-a-service
offerings in addition to newer products around the “Internet of Things” and artificial intelligence,
including the firm’s recent announcement of the Einstein AI platform.
× Although many of Salesforce.com’s new initiatives contribute minimal revenue today, we believe the
connected device boom and the secular trend toward machine learning and intelligent applications
should yield ample opportunity for the firm’s Internet of Things and Einstein offerings.
Companies Mentioned
Name/Ticker
Economic
Moat
Moat
Trend
Currency
Fair Value
Estimate
Current
Price
Uncertainty
Rating
Morningstar
Rating
Market
Cap (Bil)
Salesforce.com CRM Wide Positive USD 98 75.06 High QQQQ 50.98
Morningstar Equity Research
25 October 2016
Contents
2 Overview of Salesforce’s Moat
3 Sizing Up the CRM Opportunity
9 Sales Cloud
14 Service Cloud
19 Marketing Cloud
24 Commerce Cloud
29 Summing the Parts
30 PaaS and Beyond
34 SaaS Economics and Valuation
Rodney Nelson
Equity Analyst
+1 312-244-7298
rodney.nelson@morningstar.com
http://select.morningstar.com/downloadarchive.aspx?year=2015&docid=699553&secid=&companyid=&title=Technology+Observer%3a+SaaS+Is+Greener+on+the+Other+Side%3a+The+Economics+of+Cloud+Application+Software+Companies
http://select.morningstar.com/downloadarchive.aspx?year=2015&docid=699553&secid=&companyid=&title=Technology+Observer%3a+SaaS+Is+Greener+on+the+Other+Side%3a+The+Economics+of+Cloud+Application+Software+Companies
mailto:rodney.nelson@morningstar.com
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Wide-Moat Salesforce.com Dominates in CRM
Salesforce.com has evolved from a salesforce automation point vendor to a full-fledged cloud-based
CRM software behemoth. The company has been the key SaaS forerunner, and we believe it is among
the most advantageously positioned companies in software to capitalize on the ongoing secular
migration to the cloud. In our view, Salesforce.com has established a wide moat based on two sources:
customer switching costs and network effect. Given the proximity to revenue-generating activities and
the interconnectedness of its products, we believe CRM applications have a high degree of switching
costs, while the use of multiple applications from the same vendor can have network-effect-like benefits.
We believe the Sales Cloud for salesforce automation bears the greatest degree of switching costs, a
market in which Salesforce boasts upwards of 40% market share. Sales are the lifeblood of any
organization, and Salesforce.com’s best-in-breed solution allows representatives to manage and track
their activity within their deal pipeline, while the product helps automate activity while dictating the
best course of action with a given prospect.
We also believe the service (for multichannel customer service management), marketing (for
multichannel campaign management, targeting, and analytics), and commerce (for business-to-
consumer digital commerce platform build-outs) clouds each bear a meaningful degree of switching
costs, particularly as vendors look to take a unified approach across multiple channels to engage and
retain customers. To this end, 70% of Salesforce.com’s top 200 customers use four or more of its cloud
products, up from just 1
3%
of its top 40 customers four years ago (Salesforce also offers several
products geared toward application development and greenfield opportunities, housed under the App
Cloud). We believe this growth in attach rates also serves as evidence for our positive moat trend rating,
as we believe customers are increasingly locked in to the platform as they adopt additional products.
We are also heartened by Salesforce.com’s thought leadership, yielding constant upgrades to its CRM
solutions and innovative features such as intelligent lead scoring and predictive analytics, making it far
more difficult for customers to abandon its products. Further, as more users come into the Salesforce
network, both Salesforce and its users benefit. In the case of the former, Salesforce receives more
feedback and data to improve all of its products, while more application developers in Salesforce.com’s
App Cloud yields a greater number of useful business applications in the firm’s AppExchange, which we
believe is the largest online enterprise application software marketplace live today.
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Sizing Up Salesforce.com’s Core CRM Opportunity
Customer Relationship Management Market Overview
CRM software is vital to both revenue-generating and customer interaction activities for businesses of
all sizes. As enterprises look to become more tactical in their sales, marketing, and customer service
practices, firms are turning toward innovative software platforms to track and gather insight into not
only their customers, prospects, and deal pipelines, but to also understand best practices for providing
service, extracting maximum value out of its relationships by upselling and cross-selling to additional
products and services, and creating, targeting, and managing marketing campaigns. As a result, the
CRM software vertical received an overwhelming share of the $156 billion spent on application software
in 2015, excluding the highly fragmented vertical-specific software market.
Exhibit 1 CRM and ERP Dominated the $156 Billion Application Market in 2015
Source: Gartner, Morningstar research
While the market outlay exceeded $25 billion on customer relationship management software in 2015,
we think this market opportunity is still several years from reaching its peak spending levels. There are
three key waves propagating growth rates for CRM spending, including:
Business Intelligence
and Analytics
11%
Customer Relationship
Mgmt. (CRM
)
1
8%
Digital Content Creation
2%
Enterprise Content
Management
4%
Enterprise Resource
Planning (ERP)
19%
Office Suites
11%
Other Application
Software
23%
Project and Portfolio
Management
2%
Supply Chain
Management
7%
Web Conferencing,
Collaboration/Social
Software Suites
3%
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1. Enterprises moving away from internally developed CRM systems.
× The source code for proprietary, internally developed CRM systems can date back multiple
decades, and they generally lack crucial functionality including modern, intuitive user
interfaces, built-in analytics, and the ability to tap into CRM data from other applications via
APIs. We suspect this wave will fully play out over the next several years as enterprises
address points of weakness in the IT infrastructure.
2. Software as a way to improve business processes.
× Small businesses frequently retrofit generic business applications (such as Excel) for other
uses, including customer relationship management. These processes are generally
completed via manual data entry and updating, costing businesses valuable time that could
be spent engaging its customers. While this wave is a much more fragmented opportunity,
we expect small and midsize businesses to continually look to software for operational
improvements as growth materializes, while larger enterprises turn to software as a means
of improving the customer experience and capitalize on greenfield opportunities.
3. Software as a way to save costs via the cloud.
× Beyond improving business processes, cloud computing has allowed enterprises to eliminate
costly infrastructure (in the form of underutilized physical hardware, maintenance, and IT
management headcount). Despite torrid growth for many cloud vendors, this wave remains
in the early stages, particularly in international markets where cloud adoption has lagged
North American markets. We estimate that shifting to the cloud can save customers as much
as 30% on their total IT costs over the long run, largely derived from downsizing on-premises
data center hardware and IT staffing required to run and maintain legacy software
applications.
These three waves largely underpin our expectations for application software growth over the next
several years. Further, organizations are increasingly embracing the value of each step of the customer
relationship journey, which has yielded CRM growth well above the overall application market growth
rate for several years, a trend we expect to continue for several years. Research firm Gartner estimates
that the CRM market (which covers most of Salesforce.com’s core products, including salesforce
automation, customer service, marketing, and digital commerce) will grow at a compounded annual rate
of just over 14% through 2020, well ahead of the broader application market (8.6%), making CRM the
largest application spending category.
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Exhibit 2 Midteens Growth Will Make Customer Relationship Management the Largest Application Vertical by 2020
Source: Gartner, Morningstar research
At a midteens growth rate, Gartner estimates that spending on customer relationship management will
exceed $50 billion in 2020, or roughly one fourth of its global enterprise application spending estimate of
more than $215 billion. However, exhibits 1 and 2 do not delineate between cloud and legacy on-
premises applications. While organizations have been more hesitant to move some applications to the
cloud (such as financial management applications within the ERP suite, though this trepidation is
gradually abating), Salesforce has helped lead the migration to the cloud for CRM applications, making it
the most heavily deployed application vertical in cloud-based environments today. Of the nearly $31
billion spent on software as a service in 2015, 39% was allocated toward CRM applications, a number
Gartner expects to inflate to 43% by 2020.
Business Intelligence
and Analytics
11%
Customer Relationship
Mgmt. (CRM)
24%
Digital Content Creation
2%
Enterprise Content
Management
4%
Enterprise Resource
Planning (ERP)
17%
Office Suites
1
0%
Other Application
Software
21%
Project and Portfolio
Management
1%
Supply Chain
Management
7%
Web Conferencing,
Collaboration/Social
Software Suites
3%
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Exhibit 3 In 2020, the $75 Billion SaaS Market Will Still Be Dominated by CRM
Source: Gartner, Morningstar research
While enterprises are all at different stages of the cloud migration, we believe that the IT community is
generally in the early stages of moving legacy workloads into the cloud. Even with torrid growth through
2020, Gartner estimates that just 5% of total IT spending worldwide will be geared toward cloud-based
services. Admittedly, certain data stores and application workloads will need to stay out of multitenant,
public cloud infrastructure because of regulations around security and data sovereignty, but we believe
most core enterprise applications will eventually migrate to the cloud.
We think it is important to distinguish between SaaS and on-premises CRM spending growth for that
reason, at least as a point of reference, particularly since Salesforce.com offers its products only via the
SaaS delivery model, while legacy vendors such as Oracle and SAP scramble to reconfigure legacy
applications for the cloud. Over the next five years, we expect the mix between on-premises and SaaS
CRM spending to increasingly tilt toward the cloud, with the SaaS spending growth rate coming in well
above that of on-premises expenditures. Specifically, Gartner estimates that SaaS CRM spending will
grow at a compounded annual rate of 21% over the next five years. We believe that Salesforce.com’s
best-in-breed CRM portfolio will be the largest beneficiary of this growth, which could make our base-
case estimate of 19% compounded annual revenue growth over the next five years for the firm’s core
CRM applications (including Sales, Service, Marketing, and Commerce clouds) look conservative. Given
the mission-criticality and revenue-generating functions to which these applications are tied, along with
dollar attrition rates across the entire Salesforce.com portfolio of less than 9%, we believe these factors
in totality support our belief that Salesforce.com’s customers bear a large degree of switching costs,
underpinning our wide moat rating.
Business Intelligence
Applications
6%
Customer Relationship
Management
43%
Digital Content Creation
3%
Enterprise Content
Management
2%
Enterprise Resource
Planning
13%
Office Suites
4%
Other Application
Software
13%
Project and Portfolio
Management
2%
Supply Chain
Management
7%
Web Conferencing,
Teaming Platforms, and
Social Software Suites
7%
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Exhibit 4 Gartner: CRM SaaS Spending Will Grow at a 21% CAGR Over the Next Five Years Versus Just 7% for On-Premises Spending and 18% for Salesforce
Source: Gartner, Morningstar research
Note: “M* Salesforce Sales” includes our subscription revenue forecasts for the Salesforce.com’s sales, Service, Marketing, And Commerce clouds only; does not include App Cloud/other sales.
Leaders in this space include most of the usual suspects in the software industry, such as Microsoft,
Oracle, and SAP. However, many of the application vendors that once dominated the CRM vertical
largely rely on legacy on-premises applications. Vendors such as Oracle and SAP are racing against the
clock to retrofit these solutions and mash them together with acquired SaaS technologies to create a
complete cloud-based offering, but so far we believe those organizations are taking a back seat (from a
revenue and technological reliability and scalability perspective) in the SaaS wars versus cloud-native
firms such as Salesforce.com, particularly at the high end of the more than $25 billion market.
0%
5%
10%
15%
20%
25%
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
CY 2014
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Salesforce Sales* Cl oud-Based CRM Spendi ng On-Premises CRM Spending
Salesforce Grow th Cl oud-Based CRM Growth On-Premises CRM Growth
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Exhibit 5 Salesforce.com’s CRM Success Has Come at the Expense of Its Rivals
Source: Gartner, Morningstar research
Based on Gartner’s estimates, just 22% of application software expenditures were allocated toward
software-as-a-service solutions. While this number should surge in general across software, we suspect
that the migration of CRM suites could accelerate even beyond Gartner’s expectations, particularly as
application software vendors like Salesforce.com look to build new functionality into its products such as
embedded analytics, artificial intelligence, and use cases around the Internet of Things that could help
further consolidate IT spending. We believe this type of thought leadership can provide greenfield
opportunities for Salesforce.com’s products, ultimately creating the potential to expand its total available
market beyond Gartner’s estimates. Over the next several sections, we explore these themes, along with
the state of each of Salesforce.com’s existing CRM products and their respective opportunities and
challenges.
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
CY 2010 CY 2011
CY 2012 CY 2013 CY 2014 CY 201
5
Salesforce.com SAP Oracle Microsoft IBM Adobe
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Parting the Clouds
Sales Cloud
Sales Cloud is Salesforce.com’s flagship salesforce automation application, or SFA. Introduced in 1999,
the product is the firm’s most mature offering. Sales Cloud allows salespeople to track deal pipelines,
manage interactions, and gain access to contact information for customers and prospects alike. Over the
years, Salesforce.com has added increased functionality to the platform via both internally developed
and acquired technology. Among these improvements are the modernized Lightning user interface
(released in mid-2015 and creates a uniform experience across all devices and Salesforce products), the
introduction of an out-of-the-box automation solution for small businesses via the RelateIQ acquisition
(rebranded SalesforceIQ), and the development of the Data.com platform that allows users to mine
contact information from third-party sources such as Thomson Reuters.
Market Backdrop, Competition, and the Salesforce Approach
Salesforce automation was not a new concept when Salesforce.com launched its original product.
However, Salesforce.com pioneered the cloud-based delivery model for the software, allowing the firm
to rapidly gain share against the behemoths of the era, including Siebel CRM, which would ultimately be
acquired and marketed by Oracle. Over the years, Salesforce.com’s offering has been recognized as the
market leader thanks in large part to an aggressive upgrade cycle with three to four releases annually,
factors that are reflected in its dominant share of this vertical. More recently, the company has
sharpened its focus on fine-tuning its products for specific industries, highlighted by recent launches
including the Financial Services and Healthcare cloud products. In 2015, Gartner estimates that global
spending on salesforce automation applications totaled $6 billion, while Salesforce.com’s Sales Cloud
generated $2.7 billion in revenue for the fiscal year ended Jan. 31, 2016, implying the company owns
45% market share relative to Gartner estimates, more than the combined share of Microsoft, Oracle, and
SAP, with Microsoft serving as the only one of the three that has gained meaningful share over the last
few years. We believe Sales Cloud boasts the strongest competitive position (and widest moat) among
Salesforce.com’s core CRM products, evidenced by the firm’s dominant market share and dollar renewal
rates well above 90%.
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Exhibit 6 SFA Is Salesforce.com’s World, and We’re Just Living In It
Source: Gartner, Morningstar research
Salesforce has essentially taken a broad approach to the salesforce automation market, offering its fully
configurable Lightning Sales Cloud across three size and functionality buckets (Lightning Professional,
Lightning Enterprise, and Lightning Unlimited) while also marketing a standardized, out-of-the-box
solution in SalesforceIQ to smaller businesses. Although the firm offers flexible pricing in certain
competitive situations and high-volume deals, Salesforce has generally maintained premium pricing over
its peers based on deeper functionality and superior scalability and reliability. The firm follows the
traditional per user, per month pricing model for selling Sales Cloud subscriptions.
Exhibit 7 Salesforce.com’s Breadth and Depth of SFA Offering Allows for Premium Pricing
Source: Company data, Morningstar research
Although Oracle’s pricing is greater than three of Salesforce.com’s offerings, the firm’s limited success in
this market and falling market share over the past couple of years suggest Oracle is struggling to win
customers at a premium price point. American Express, Merck, and Vodafone are among
Salesforce.com’s premium customers in the Sales Cloud.
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
CY 2010 CY 2011 CY 2012 CY 2013 CY 2014 CY 2015
Salesforce.com Microsoft Oracle SAP Calli dus
Vendor Lightweight Middleweight Heavyweight Premium
Salesforce.com 25$ 75$ 150$ 300$
Microsoft* 50$ 65$ 85$
Oracle 65$ 100$ 200$ 300$
$/User/Month
*Microsoft’s premium salesforce automation product includes Office 365 Enterprise E5, pending eligibility.
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Salesforce.com has bolstered its Sales Cloud offering with several bolt-on acquisitions, including
SteelBrick for CPQ (configure, price, quote) that allows users to seamlessly integrate sales lead data and
quickly generate optimal price quotes based on various parameters such as number of users, levels of
product bundling, and payment terms. The firm has also begun introducing embedded analytics
dashboards to help salespeople understand best practices for when and how to reach out to customers
and prospects, gain visibility into the pipeline, and help set expectations for meeting quotas. Further,
Salesforce.com users can upgrade its Sales Cloud offering with the Data.com platform, which ties into
third-party data sources to update prospect and customer contact information automatically. We believe
this platform serves as a natural cross-selling opportunity for Salesforce, which can be consumed in two
ways. First, the company offers a data clean-up service that updates leads and customers entered into
the Sales Cloud by the user at $25 per month per user. Second, the Data.com Prospector application
(priced at $150/user/month) allows users to search for new leads by industry, company, or individual
contact, alongside robust company data for improving sales efficacy.
Looking Ahead
Today, we view the Sales Cloud as Salesforce.com’s most profitable product, but we believe there is
meaningful growth remaining. While Gartner estimates that salesforce automation will be a $12 billion
opportunity by 2020, we suspect this figure could prove conservative. If we assume an average
subscription price of $75 per user per month (or $900 per year, in line with a year of Lightning
Professional) for Sales Cloud, Salesforce ended its last fiscal year with roughly 2.96 million subscribers.
We estimate there are roughly 14.45 million employees in sales roles in the United States alone, using
May 2015 data from the U.S. Bureau of Labor Statistics. We conservatively estimate that 70% of Sales
Cloud revenue comes from the United States (for reference, 73% of Salesforce.com’s consolidated
revenue comes from the Americas), meaning Salesforce has reached U.S. user penetration of just 14%,
much lower than Gartner’s estimated 41% global market penetration for Sales Cloud.
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Exhibit 8 Sales Cloud May Be Maturing, but the Opportunity Remains Large
Source: U.S. Bureau of Labor Statistics, Salesforce.com filings, Morningstar research
While some may question our inclusion of retail salespeople and cashiers in our analysis, we believe the
increased usage of mobile devices as sales tools in brick-and-mortar stores allows opportunities for
Salesforce to penetrate this area with both its Sales Cloud and the recently launched
Commerce Cloud
(which we discuss in depth later on). Further, Salesforce.com’s platform can already be converted into a
point-of-sales solution utilizing add-on applications from Salesforce.com’s AppExchange, creating an
incremental revenue opportunity. For example, SuitePOS can be purchased via the AppExchange (on
which Salesforce receives a royalty) and used as a primary point-of-sales solution on Apple devices, and
the application fully integrates with the Sales Cloud. Further, as Salesforce becomes more focused on
addressing industry-specific applications, we believe the company will be better suited to address a
larger swath of this potential user base. For example, the recently launched Financial Services Cloud is
largely built on the core functionality of Sales Cloud, and many of the company’s first customers on this
product are net new customers to the Salesforce ecosystem.
CY 2015 CY 2020 (Est.)
Category Number of Jobs Annual Growth Est. Number of Jobs
Retail Salespersons 4,612,510 7% 6,469,284
Cashiers 3,478,420 2% 3,840,457
Wholesale /Manufacturing Sales Reps 1,800,900 7% 2,525,855
Retail Sales Supervisors 1,193,850 4% 1,452,501
Services-Related Sales Reps 886,580 8% 1,302,677
Counter and Rental Clerks 447,050 4% 543,905
Insurance Sales Reps 386,140 9% 594,124
Financial Services Sales Reps 319,280 10% 514,204
Non-Retail Sales Supervisors 247,850 5% 316,326
Parts Salespersons 238,470 3% 276,452
Telemarketers 226,730 -3% 194,701
Real Estate Agents/Brokers 421,300 3% 488,402
Advertising Sales Reps 149,770 -3% 128,613
Sales and Related Workers 84,240 11% 141,949
Demonstrators/Promoters 83,620 9% 128,660
Sales Engineers 72,200 7% 101,264
Travel Agents 66,560 -12% 35,126
Gaming Cashiers 22,790 -11% 12,726
Total US Salespeople 14,738,260 5% 19,067,226
Sales Cloud Revenue $2,669,000,000 11% $4,442,016,18
4
Estimated Annual ASP ÷ $900 2% ÷ $990
Implied Sales Cloud User Base 2,965,556 8% 4,430,117
Estimated Mix of US Sales x 70% x 65%
Implied SFDC US User Base 2,075,889 7% 2,879,576
Implied US User Penetration 14% 15%
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If we apply the same $900 average annual sales price to our estimate for the U.S. market opportunity,
we believe Salesforce.com’s addressable market for Sales Cloud totaled more than $13 billion in 2015, or
roughly double Gartner’s $6 billion estimate for 2015 global SFA spending. Using modest sales job
growth expectations of 5% annually (in line with the Bureau of Labor Statistics’ forecast) and modest
growth in average sales prices, we arrive at a U.S. addressable market north of $20 billion by 2020.
Internationally, the rate of cloud adoption has proved to be much slower than in the U.S., but we believe
the tide is beginning to turn. If we make the two-part assumption that the international market will
prove to be at least as large as the U.S. opportunity, but only one third of it is addressable with SaaS in
the next five years (which is likely a conservative estimate), we arrive at a global addressable market of
more than $25 billion by 2020. We compare these forecasts with our estimate for Sales Cloud revenue
growth over the next five years in Exhibit 9. We expect Sales Cloud to generate roughly $4.5 billion in
annual subscription revenue by 2020, or roughly 27% of total subscription sales.
Exhibit 9 Our 10% Five-Year Sales Cloud CAGR Could Prove Conservative Versus Our Total Addressable Market Expectations
Source: Gartner, Morningstar research, U.S. Bureau of Labor Statistics, company data
Key: Bars represent revenue/spending levels ($ thousands, left axis), lines represent annual growth rates (right axis)
.
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
–
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
30,000,000
35,000,000
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Sales Cloud Gartner SFA TAM M* SFA TAM Sales Cloud Growth Gartner Growth M* SFA TAM Growth
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Service Cloud
Salesforce.com launched its branded Service Cloud offering in 2009. The product is largely based on
technology acquired for a mere $31.5 million from Instranet in 2008 (along with other bolt-on
acquisitions), which Salesforce.com subsequently scaled up and repurposed for SaaS delivery. Service
Cloud gives users complete oversight of the omnichannel customer feedback platform, spanning social
media, email, web forms, call centers, and SMS messaging, allowing companies to offer a uniform,
personalized experience when engaging with its customers across multiple outlets.
Market Backdrop, Competition, and the Salesforce Approach
As customers engage with vendors and companies across multiple channels, firms must ensure that the
experience is not only standardized, but also intuitive and personalized to allow for higher levels of
customer satisfaction and, ultimately, repeat business. Since launching the Service Cloud,
Salesforce.com has improved the product with a series of new features, including adding support for live
chat and call centers via the Activa Live Chat and Informavores acquisitions, while the company has also
built out its offering for small businesses, Desk.com, which was born out of the 2011 Assistly acquisition.
Unlike Sales Cloud, the customer service engagement market is far more fragmented and lacks a
dominant vendor, but Salesforce.com has emerged as the overall leader. While the usual heavy hitters
such as Oracle and SAP compete in this market, the firm also faces pockets of competition from the likes
of native SaaS companies (including modest encroachment from companies like ServiceNow), and point
vendors including workforce optimization companies Verint and Nice Systems. Gartner estimates that
spending on customer service and support software totaled just over $10 billion in 2015. Despite
Salesforce.com’s relatively short presence in this market, the firm commanded 18% market share, up
from just 3.5% in 2010, with gains at least partially coming at the expense of rivals Oracle and SAP. As a
result, Service Cloud was Salesforce.com’s fastest-growing CRM product in its latest fiscal year at 38%
year-over-year growth.
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Exhibit 10 The $10 Billion Service Software Market Has Been Crowded, but Salesforce Is Pulling Away
Source: Gartner, Morningstar Research
Salesforce has taken a go-to-market approach with Service Cloud similar to that of Sales Cloud by
creating an out-of-the-box offering for small businesses in Desk.com and a fully configurable offering for
midsize, large, and enterprise-scale organizations. Once again, the company is a price and feature set
leader, while many of the services that Salesforce includes in its Service Cloud offering would require
additional SaaS purchases from rivals such as Oracle, or require proprietary development by the end
user.
Exhibit 11 Salesforce.com Maintains Pricing Power Despite Market Fragmentation
Source: Company data, Morningstar research
One of the key differentiators we see for Service Cloud is the Community functionality, which Salesforce
announced in 2015. Community is essentially a knowledge base and self-service hub that users can
purchase as a stand-alone product (pricing based on volume of usage) or receive as part of
Salesforce.com’s premium Service Cloud offering (Lightning Unlimited). Community can be used as an
internal, centralized resource that can host discussions and point to articles to help employees access
the proper information and receive critical company updates quickly. Applications can be integrated with
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
CY 2010 CY 2011 CY 2012 CY 2013 CY 2014 CY 2015
Salesforce.com Oracle SAP Ni ce Systems Verint
Vendor Lightweight Middleweight Heavyweight Premium
Salesforce.com Variable** 75$ 150$ 300$
Microsoft 50$ 85$ 200$
Oracle 90$ 110$ 140$ 250$
$/User/Month
*Market share figures based on Gartner Estimates for 2015.
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the Community as well, allowing for easy access if employees have inquiries regarding specific
processes, such as logging expense reports in Concur. Community customers can also create externally
facing knowledge stores with FAQs, discussion boards, and troubleshooting tips that can allow
customers to find answers without needing to contact a customer service rep. The product has built-in
analytics and dashboards that can help Community customers identify which issues are the most
pressing, which products are causing the greatest trouble, and isolate incidents that may require
escalation. We believe functionality such as this, combined with the increasing unification of the sales
and customer service effort, is allowing the Service Cloud to carve out a moaty position in this space,
even against the backdrop of a fragmented market. Service Cloud counts Activision, Coca-Cola, and
Wells Fargo among its customers.
Looking Ahead
Service Cloud is Salesforce.com’s fastest-growing and second-largest revenue driver, contributing $1.8
billion in sales in fiscal 2016. Given the level of fragmentation in the service and support market, we
believe Salesforce can continue to consolidate this market and gain incremental share, even in the face
of competition from large software vendors such as Microsoft, Oracle, and SAP. Gartner estimates that
customer service and support application spending will grow at a low-teens CAGR over the next five
years, yielding a total of just over $20 billion in spending in 2020. However, we believe Salesforce.com’s
customer service platform has the breadth and depth required for a large number of uses and continues
to generate above-market growth (for reference, the customer service and support market grew roughly
21% in 2015 compared with 38% growth for Service Cloud over the same period). We believe features
such as Community will help customers address both internal and external service and support issues,
ultimately yielding greater spending within the Salesforce Service Cloud and faster revenue growth than
the addressable market. Given the amount of fragmentation in this market, we believe Salesforce will
also have an opportunity to consolidate this market, which saw more than 40% of total spending
allocated toward vendors with negligible individual market share.
Similar to our forecast for Sales Cloud, we’ve looked at employment data from the U.S. Bureau of Labor
Statistics to get a sense for how many potential users there are for Salesforce.com’s Service Cloud. We
estimate that there are just over 5.6 million customer service jobs in the United States that represent
opportunities for Salesforce.com to sell its Service Cloud. By assuming an average annual sales price per
user of $1,200 (in line with the purchase of Salesforce.com’s lightweight Service Cloud and Community
Cloud subscriptions), we arrive at total customer service and support spending of just over $5 billion.
Finally, assuming the international market is at least as large as the United States opportunity, we
believe Gartner’s estimate for the current size of this market at $10 billion looks accurate. Looking at the
growth estimates for each of these employment buckets, coupled with modest price increases, we arrive
at a total U.S. market opportunity for customer service and support of nearly $10 billion by 2020, or $20
billion globally, roughly in line with Gartner’s expectations. However, we believe both Gartner’s and our
estimates ignore potential greenfield opportunities around the Internet of Things, a topic we’ll explore
later on, which could ultimately unlock new opportunities for Service Cloud. We outline our market
sizing rationale in Exhibit 11, and we compare our growth expectations for Service Cloud versus the
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market growth opportunity in Exhibit 12. By 2020, we believe Service Cloud will contribute $5 billion in
subscription revenue, challenging Sales Cloud for the firm’s largest CRM product.
Exhibit 12 Increased Focus on Customer Service Creates a Large Opportunity for Service Cloud
Source: U.S. Bureau of Labor Statistics, company data, Morningstar research
We believe our above-market growth for Service Cloud is a reflection of a few key trends. First, we
believe this vertical is ripe for consolidation and that Salesforce.com can capitalize on the more than
40% of this market spending (or more than $4 billion) that was allocated to a negligible share of vendors
in 2015. Second, we believe enterprises will continually look to consolidate application spending around
suites of products as they migrate to the cloud, as opposed to deploying solutions from disparate
vendors. Finally, we believe a large portion of customer service software spending is still being delivered
on-premises, as vendors such as Verint have only recently introduced SaaS solutions and Oracle and
SAP continue to work to migrate their legacy customers to the cloud. We believe these factors will allow
Salesforce.com to continue to make modest annual share gains over the next few years, driving our
expectations for revenue growth outperformance.
CY 2015 CY 2020 (Est.)
Category Number of Jobs Annual Growth Est. Number of Jobs
Customer Service Representatives 2,581,000 10% 4,156,726
Computer Support Specialist 766,900 12% 1,351,540
Network and Computer Systsem Admins 382,600 8% 562,165
Medical and Health Service Managers 333,000 17% 730,085
Food Service Managers 305,000 5% 389,266
Social and Community Service Managers 138,500 10% 223,056
Information Clerks 1,545,000 2% 1,705,805
Administrative Services Managers 287,300 8% 422,138
Operations Research Analysts 91,300 30% 338,991
Total US Customer Service Reps 6,430,600 9% 9,879,771
Service Cloud Revenue $1,817,700,000 22% $4,908,666,000
Estimated Annual ASP ÷ $1,200 3% ÷ $1,390
Implied Service Cloud User Base 1,514,750 18% 3,531,414
Estimated Mix of US Sales x 70% x 65%
Implied SFDC US User Base 1,060,325 17% 2,295,419
Implied US User Penetration 16% 23%
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Exhibit 13 As Customer Satisfaction Demand Grows, Service Cloud Should Continue to Take Share, Yielding Greater Than Market Growth
Source: Gartner, Morningstar research, U.S. Bureau of Labor Statistics, company data
Key: Bars represent revenue/spending levels ($ thousands, left axis), lines represent annual growth rates (right axis)
0%
5%
10%
15%
20%
25%
30%
35%
40%
–
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Service Cloud Gartner Service TAM M* Service TAM Service Cloud Growth Gartner Growth M* Service TAM Growth
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Marketing Cloud
Salesforce.com’s Marketing Cloud has essentially reached its present state via acquisition and
integration, with the 2013 purchase of Exact Target serving as the product’s backbone and core digital
marketing platform. Marketing Cloud allows customers to build, target, monitor, analyze, and automate
omnichannel marketing campaigns.
Market Backdrop, Competition, and the Salesforce Approach
Digital marketing is arguably the most competitive market Salesforce.com operates in, as several major
vendors boast growing share. Chief among these rivals is Adobe, which we believe has established itself
as a leader in digital marketing. While the company boasts top market share by revenue, we believe
Adobe’s value proposition will align much more closely with content creation given the synergies the
company creates with its Creative Cloud product. As a result, we believe there are digital marketing
deals that only Adobe can win, but we also believe that vendors with end-to-end CRM suites will be
able to serve certain enterprise customers more effectively than Adobe, which lacks native applications
for customer service and salesforce automation. This thesis has been playing out over the last few years
as Salesforce.com’s marketing platform grew into a leader in the $5.5 billion market in 2015.
Exhibit 14 Despite Large Competitors, Salesforce.com Continues to Take Marketing Share
Source: Gartner, Morningstar research
We think customers that are looking to leverage data from these applications to refine marketing
activities will gravitate toward the digital marketing offerings from the same vendor, which is
increasingly proving to be the case for Salesforce.com. Seventy-five percent of Salesforce.com’s top 200
customers use four or more its cloud products, up from just 20% of the top 100 customers in fiscal 2016
and 13% of the top 40 customers four years ago.
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
CY 2010 CY 2011 CY 2012 CY 2013 CY 2014 CY 2015
Salesforce.com Adobe IBM SAP SAS Oracle Marketo
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Exhibit 15 Salesforce.com’s Customers Are Increasingly Embracing the Platform Approach
Source: Salesforce.com investor presentation
In general, global advertising and marketing dollars are increasingly shifting toward digital, creating a
strong secular tailwind for multichannel campaign management software. According to media agency
Carat, advertising spending in the Americas, Asia-Pacific, and Europe, the Middle East, and Africa will
reach $538 billion in 2016, of which 27% will be driven to digital channels (versus 24% in 2015),
increasing to 29% of total spending in 2017. We believe Salesforce has been a beneficiary of this trend,
and the company has found success by continuing to build out its marketing platform functionality
natively for the cloud, while the efforts of rivals such as Oracle and SAP once again revolve around
reconfiguring on-premises applications and integrating cloud acquisitions for SaaS delivery. Although
email marketing automation remains the primary use for Salesforce.com’s marketing platform, the
company has consistently added features that allow customers to truly manage a multichannel
marketing campaign across email, mobile, web, and social media, thanks in part to the acquisitions of
firms such as Buddy Media and Radian6. As a result, Gartner notes that Salesforce.com’s marketing
offering is increasingly appearing on the short list in competitive situations (more than 80% in Gartner’s
estimation), and Salesforce.com continues to invest in the platform to increase functionality. Since
ramping up its investment in Marketing Cloud in 2013, the company has increased the analytics and
artificial intelligence capabilities of the platform to allow for greater automation, while also allowing for
customers to better manage the user experience across a brand’s entire campaign. For example, the
company has launched Advertising Studio, Content Builder, and Personalization Builder, which provide
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tools for customers to manage the look and feel of a campaign’s content across each channel, while the
firm allows for audience building and targeting with Audience Builder. Further, the company has built
out its digital advertising capabilities that allows customers to purchase and place ads across multiple
outlets, including Facebook, Twitter, Instagram, LinkedIn, and Google sites.
Finally, the company has stepped up its business-to-business marketing automation and data
management platforms with the acquisitions of Pardot and Krux, the latter of which was announced just
ahead of the firm’s 2016 Dreamforce conference in October. Krux is a longtime partner of
Salesforce.com, and having an integrated DMP will allow Salesforce to leverage Krux’s data processing
capabilities across not only Marketing, but Sales, Service, Commerce, and Internet of Things clouds, as
well as the Einstein AI platform, which we explore later on. While there is a great degree of competition
in the marketing category, we believe Marketing Cloud is beginning to show signs of stickiness that we
would associate with an economic moat. Mattel, Nestle Water, and Stanley Black and Decker are
among Salesforce.com’s Marketing Cloud customers.
While Salesforce.com does not break out explicit pricing, the company generally structures its Marketing
Cloud pricing based on usage in each channel. For example, email, mobile, and web carry monthly usage
fees that are calculated from data consumption and contacts made, while social media is based on the
number of accounts and engagement with those accounts. Pricing for the firm’s digital advertising
platform is generally a combination of a monthly fee plus a portion of the customer’s ad spending.
Finally, the B2B marketing automation is based on a fixed fee per number of leads.
Exhibit 16 Salesforce.com’s Marketing Cloud Pricing Structure
Source: Company data, Morningstar research
Looking Ahead
Although we believe the digital marketing vertical will remain hotly contested, we believe
Salesforce.com’s ability to innovate on its platform, coupled with data synergies from leveraging multiple
Salesforce.com cloud, will continue to attract users. When evaluating the addressable opportunity for
the Marketing Cloud, we contrast Gartner’s estimates with expected spending on digital advertising
globally. According to Gartner, category spending reached $5.7 billion in 2015 and will more than double
over the next five years to roughly $14 billion. We compare this with the $515 billion spent on global
advertising in 2015, according to Carat. Carat forecasts spending growth of 4.5% in 2016, yielding $538
billion globally. However, the digital mix is growing much faster than the overall market. Using these
themes, we make a series of assumptions to attempt to triangulate our market expectations:
Email/Mobile/Web Social Digital Advertising B2B Marketing Automation
*$1,000/$2,000/$3,000 per month based on configuration and functionality needs; 10,000 contacts per year
Data Usage and Contacts Salesforce Pricing Method
Accounts and
Engagement
Fixed Fee and Budget
Commission
Variable*
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× Advertising spending grows at a compounded annual rate of 3.6% over the next five years, yielding just
over $600 billion in total spending, which we believe represents a conservative estimate.
× Mix of digital advertising spending increases 200 to 300 basis points annually over the next five years, in
line with the last few years, yielding nearly 40% mix in the digital marketing bucket, or nearly $235
billion in 2020, up from $124 billion in 2015.
× Of the dollars spent on digital marketing, we allocate 25% toward technology platforms by 2020, which
we believe is conservative compared with Gartner’s CMO survey that stated 33% of digital marketing
spending was technology-related. Of that 25%, we assume roughly 40% is directed toward software by
2020. In other words, we suspect that roughly 10% of digital marketing spending will go toward
software, or less than 5% of total advertising spending.
These assumptions yield a potential market that is much larger than the one Gartner projects. We
believe this is possible as more employees within an organization turn to software products to gain
insights into their businesses and automate tasks. Exhibit 17 displays the output of our market
assumptions, while Exhibit 18 compares our growth estimates for Marketing Cloud with both Gartner’s
and our own addressable market expectations. By 2020, we believe Marketing Cloud will contribute
nearly $1.4 billion in subscription revenue.
Exhibit 17 Digital Advertising Spending is Likely to Explode Higher, and Marketing Software Will Be A Driving Force
Source: Carat, Morningstar research
($, Millions) CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Global Advertising Spending 514,833$ 538,000$ 559,520$ 579,103$ 596,476$ 614,371$
YoY Growth 4.5% 4.0% 3.5% 3.0% 3.0%
Digital Marketing Spending 123,560$ 145,260$ 167,856$ 191,104$ 211,749$ 233,461$
YoY Growth 17.6% 15.6% 13.9% 10.8% 10.3%
As % of Total Spending 24.0% 27.0% 30.0% 33.0% 35.5% 38.0%
Technology Platform Spending 24,712$ 33,410$ 41,964$ 47,776$ 52,937$ 58,365$
YoY Growth 35.2% 25.6% 13.9% 10.8% 10.3%
As % of Digital Spending 20.0% 23.0% 25.0% 25.0% 25.0% 25.0%
Software Opportunity 7,414$ 11,025$ 15,107$ 18,155$ 21,175$ 23,346$
YoY Growth 48.7% 37.0% 20.2% 16.6% 10.3%
As % of Tech Spending 30.0% 33.0% 36.0% 38.0% 40.0% 40.0%
As % of Total Ad Spending 1.4% 2.0% 2.7% 3.1% 3.6% 3.8%
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Exhibit 18 Multichannel Customer Experience and Need for Personalization Yield Ample Opportunity for Marketing Cloud
Source: Carat, Morningstar research
Key: Bars represent revenue/spending levels ($ thousands, left axis), lines represent annual growth rates (right axis)
0%
10%
20%
30%
40%
50%
60%
–
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Marketing Cloud Gartner Service TAM M* Marketing TAM Marketing Cloud Growth Gartner Growth M* TAM Growth
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Commerce Cloud
Commerce Cloud is a new offering from Salesforce.com, born out of the 2016 acquisition and rebranding
of Demandware, Salesforce.com’s largest acquisition to date at $2.8 billion. Demandware was a long-
time partner of Salesforce.com before the deal, and we believe the product filled a natural gap in
Salesforce’s offerings that will allow the firm to address the burgeoning business-to-consumer, or B2C,
e-commerce space. Commerce Cloud will allow customers to build a complete online shopping
experience for B2C businesses, including personalization of the shopping experience across all channels,
order management, and point-of-sale execution, while also allowing Commerce Cloud customers to
leverage insights from other Salesforce.com CRM products.
Market Backdrop, Competition, and the Salesforce Approach
Although B2C e-commerce is largely dominated by Amazon, individual brands and larger brick-and-
mortar retailers have embraced the idea of not only having a web presence, but also building out a fully
functioning online store tailored to customers’ interests. However, in many cases, retail outlets do not
have the IT know-how or manpower to build out a proprietary platform or managing it at scale, opening
the door for e-commerce software providers to solve the problem. Core among these problems is
delivering a personalized experience to the customer. According to Gartner, smart personalization
engines used to recognize customer intent will enable digital businesses to increase their profits by as
much as 15% by 2020. This requires a multifaceted approach that can engage the customer across
multiple channels with tailored buying experiences, including social, mobile, and on the web.
The digital commerce market is likely even more fragmented than the customer service market, in our
view, though we believe there are only a handful of vendors with the technological superiority to serve
the world’s largest B2C organizations, including the usual suspects: Salesforce.com, Oracle, SAP, and
IBM. While SAP is the far and away leader in this space, we think Salesforce.com has the ability to
differentiate itself with Demandware, as it is the only cloud-native digital commerce provider among the
vendors listed above. In fact, IBM did not offer a multitenant SaaS delivery model as of Gartner’s latest
Magic Quadrant for Digital Commerce, while the cloud migration roadmaps for Oracle and SAP remain
onerous. Although there are other cloud-native peers such as Shopify, they do not boast the scalability
or the breadth or depth in their product or customer base that Demandware has built, and Shopify
largely serves small to midsize businesses.
From a market share perspective, a number of disparate vendors compete in this space, as more than
half of spending in 2015 (which totaled just over $4 billion, according to Gartner) was directed toward
vendors with minimal market share, but we believe spending will consolidate about best-in-breed
solutions, including Salesforce.com’s Commerce Cloud. We think it is too early to award an economic
moat to Commerce Cloud because of the fragmentation in this market and the product’s relative youth,
but we believe it has inherent stickiness given how imperative it is to the B2C experience. Brands such
as Adidas, Callaway Golf, Panasonic, and Puma are all customers of Commerce Cloud.
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Exhibit 19 Salesforce Lags in Commerce, but Platform Consolidation Should Yield Continued Growth
Source: Gartner, Morningstar research
Note: Salesforce market share based on Demandware revenue as a stand-alone entity.
Salesforce has yet to publicly indicate how it will price the rebranded Demandware, but it (and other
digital commerce vendors) has historically been priced based on gross merchandise value that passes
through the platform, typically targeting only the smallest and largest businesses. We believe this rate
amounts to roughly 100 basis points collected on gross merchandise value. Other vendors have tied
pricing toward different metrics such as total number of orders that pass through the system, and
Salesforce.com may choose to tweak the model as it scales up Commerce Cloud.
Looking Ahead
While SAP’s lead is sizable today, we question the cloud-readiness of its platform, which is largely based
on legacy on-premises technology and the 2013 acquisition of SaaS vendor Hybris, which Gartner
estimates generated $36 million in revenue in its final year as an independent company in 2013. Given
the difference in architecture and code bases that supports SAP’s legacy applications and its acquired
cloud properties, combined with the firm’s decision to standardize its products on the HANA database,
we think the company will face stiff competition in terms of holding on to its customer base, which
should unlock opportunities for more nimble, scalable solutions like Salesforce.com’s Commerce Cloud
that can integrate smoothly with other products in the CRM suite. We also suspect that Commerce
Cloud will be a more open platform with Salesforce.com’s resources behind it, allowing for more heavy-
duty customizations (a previous sticking point between Demandware and some customers).
We suspect that Commerce Cloud will be a key point of contention as Salesforce increases its
investment in foreign markets, particularly as it attempts to gain on market leader SAP. SAP has been
aggressive in marketing its Hybris cloud-based commerce platform, which could help stymie
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
CY 2012 CY 2013 CY 2014 CY 2015
Salesforce SAP Digital River Oracle IBM eBay Shopify
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Salesforce.com’s efforts in this vertical in the EMEA region. EMEA represented 44% of SAP’s software
subscription and support revenue in 2015, a region where Salesforce has grown both its revenue and
headcount 30% annually over the last three years (the fastest rates of any theater) while the company
has opened data centers in the United Kingdom, France, and Germany since 2014. Presently,
Salesforce.com generates just 30% of its revenue internationally, and we expect the overall CRM
revenue mix to tilt more toward 50/50 as the company matures.
Generally, the mix of e-commerce sales as a percentage of overall retail sales continues to increase.
According to the U.S. Census Bureau, e-commerce sales mix has quadrupled since 2004, yet it still
represents just 8% of total retail sales as of June 2016 (or roughly $366 billion over the trailing 12
months). However, the pace of increase has remained consistent over that time frame, as e-commerce
sales have risen in mix by roughly 100 basis points every 2.5 years as year-over-year growth has hovered
in the midteens for years. By comparison, retail sales to the traditional channel has average just 1.7%
year-over-year growth over the last eight quarters.
Exhibit 20 U.S. E-Commerce Sales Reached $340 Billion in 2015 With Plenty of Room to Grow
Source: U.S. Census Bureau, Morningstar research
Key: Bars represent spending levels ($ millions, left axis), lines represent growth rates (right axis)
Again, we make a set of assumptions about the potential for a digital commerce platform:
× First, we assume that U.S. e-commerce retail sales continue to grow at a mid- to low-teens rate over the
next several years, in line to modestly below the growth rate in recent years.
× Second, we net out our estimate for Amazon retail sales from our U.S. e-commerce sales. Amazon
directly processed just over $79 billion in gross merchandise value in 2015. We do not include third-party
sales on Amazon, as Demandware’s products can be made available on Amazon.
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
$-
$200,000
$400,000
$600,000
$800,000
$1,000,000
$1,200,000
4
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(p
)
Total Retail S ales Ex-EC Total E-Commerce Sales YoY Retail Sales Growth Ex-EC YoY E-Commerce Sal es Growth
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× Third, we apply a pricing mechanism of 100 basis points collected on gross merchandise volume, in line
with Demandware’s prior model.
× Finally, we assume that the international opportunity is at least as large as the domestic opportunity,
though we acknowledge the presence of large, Amazon-like vendors with proprietary platforms such as
Alibaba in international theaters.
Using these assumptions, we outline what we believe a digital commerce market could look like for
Salesforce.com’s Commerce Cloud in Exhibit 21 and compare these forecasts with Gartner’s expectations
and our own revenue growth assumptions for Commerce Cloud in Exhibit 22. By 2020, we believe
Commerce Cloud will contribute roughly $725 million in annual subscription revenue, reaching $1 billion
shortly thereafter.
Exhibit 21 The Shift to E-Commerce Should Help Drive Demand for Scalable, Customizable Platforms in the Cloud
Source: U.S. Census Bureau, Morningstar research
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
US E-Commerce Sales (Ex-AMZN) 263,692$ 303,246$ 347,823$ 397,909$ 454,015$ 516,669$
YoY Growth 14.9% 15.0% 14.7% 14.4% 14.1% 13.8%
Digital Commerce Commission 100 bps 100 bps 100 bps 100 bps 100 bps 100 bps
US Digital Commerce TAM 2,636.92$ 3,032.46$ 3,478.23$ 3,979.09$ 4,540.15$ 5,166.69$
YoY Growth 15.0% 14.7% 14.4% 14.1% 13.8%
Global Digital Commerce TAM 5,273.84$ 6,064.92$ 6,956.46$ 7,958.19$ 9,080.29$ 10,333.37$
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Exhibit 22 Demandware Should Benefit as a Cog in Salesforce.com’s CRM Machine
Source: Carat, Morningstar research
Key: Bars represent revenue/spending levels ($ thousands, left axis), lines represent annual growth rates (right axis)
Note: Commerce Cloud revenue reflects consolidated Demandware revenue. Demandware’s first full-year contribution to Salesforce will occur in CY 2017.
0%
5%
10%
15%
20%
25%
30%
35%
40%
0
2000000
4000000
6000000
8000000
10000000
12000000
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
Commerce Cloud Gartner Digital Commerce TAM M* DC TAM Commerce Cloud Growth Gartner Growth M* TAM Growth
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Summing the CRM Parts
After evaluating each core product in the CRM suite, we believe we have not only laid a strong
foundation for our revenue forecasts for Salesforce.com, but also established evidence that the CRM
market is potentially much larger than the $52 billion Gartner forecasts from CRM spending in 2020. We
believe Salesforce.com’s path from $10 billion to $20 billion in revenue begins to come into focus even if
we ignore the remainder of the firm’s products (the firm’s App Cloud and professional services
contributed nearly $1.5 billion in revenue in fiscal 2016 while growing at 39% and 28%, respectively),
and we think our analysis has shown that there is ample room to capture the growth we expect for the
firm over the next decade. In fact, our forecasts could prove conservative, as we model only modest total
market share gains for Salesforce.com over the next several years. We display our total findings below,
including the revenue contributions of each of Salesforce.com’s CRM products and the company’s
standing against both our and Gartner’s CRM market forecasts in terms of share.
Exhibit 23 We Estimate That Salesforce.com’s CRM Subscriptions Alone Will Be a $10 Billion Business Soon
Source: Company filings, Morningstar research
Exhibit 24 Salesforce.com Can Hit Our Growth Targets With Only Minimal Market Share Gains
Source: Company filings, Gartner, U.S. Census Bureau, Bureau of Labor Statistics, Carat, Morningstar research
Note: Spending/revenue figures are in USD thousands
$-
$2,000,000
$4,000,000
$6,000,000
$8,000,000
$10,000,000
$12,000,000
$14,000,000
$16,000,000
$18,000,000
$20,000,000
CY 2015 CY 2016 CY 2017 CY 2018 CY 2019 CY 2020 CY 2021 CY 2022 CY 2023 CY 2024 CY 2025
Sales Cloud Service Cloud Marketing Cloud Commerce Cloud
CY 2015 CY 2016 CY 2017 CY 2018 CY 2019 CY 2020
Salesforce.com CRM Subscription Revenue 5,170,800$ 6,303,862$ 7,627,361$ 8,941,475$ 10,335,515$ 11,663,603$
Gartner CRM TAM 26,287,789$ 30,021,141$ 34,469,318$ 39,475,900$ 45,197,555$ 51,545,232$
Morningstar CRM TAM 36,679,854$ 43,202,137$ 50,897,976$ 57,967,965$ 65,464,578$ 72,618,414$
Gartner Implied Market Share 19.7% 21.0% 22.1% 22.7% 22.9% 22.6%
Morningstar Implied Market Share 14.1% 14.6% 15.0% 15.4% 15.8% 16.1%
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Pulling the Next Growth Lever: PaaS, AI, Internet of
Things, and Beyond
While we have made the argument that Salesforce.com’s core is strong and getting stronger, we are
encouraged that the company is not resting on its laurels in the face of the persistent threat of
disruption. We believe Salesforce is one of the leading players in the burgeoning platform-as-a-service
market, which allows users to build applications on Salesforce infrastructure and either use them
internally or market them externally or on the AppExchange. The company has also made a habit of
launching new products at its annual Dreamforce conference over the last several years, including
Community Cloud (part of Service Cloud), Internet of Things Cloud, and the recently announced Einstein
artificial intelligence Cloud. We will briefly touch on these products, their opportunities, and how they
differentiate Salesforce.com’s core business.
App Cloud, AppExchange, Lightning, Thunder, Analytics, and Einstein
App Cloud represents Salesforce.com’s PaaS offering and third-party application marketplace,
AppExchange, the largest enterprise application marketplace, boasting 3,000 apps and 4 million total
downloads. App Cloud allows users to build stand-alone applications that run on the Salesforce platform
while leveraging proprietary enterprise data, third-party data, and data generated within the Salesforce
ecosystem via its other main products. The uses for App Cloud are relatively limitless, as users have
developed applications as small as simple business process apps to automation and full-scale enterprise
resource planning applications that can integrate with the Salesforce platform. For example,
FinancialForce has built out accounting and HR software on the Salesforce platform, while Salesforce
customer Brown-Forman has built over 50 business applications for its employees, including vendor
onboarding and inventory management apps. Though this market is still in its relative infancy, we
believe Salesforce is carving out a leadership position, evidenced by its top placement in the Leaders
quadrant of Gartner’s Magic Quadrant for Application Platform as a Service. As enterprises move down
the stack and look for ways to cut costs, PaaS represents a unique opportunity for firms to eliminate
costly development and testing computer infrastructure, which frequently are woefully underutilized,
creating poor returns on investment for the enterprise.
Salesforce.com’s main development products on App Cloud include Force.com, Heroku, and the
Lightning user interface. Force.com allows users to build applications in multiple ways, including via
traditional code-writing and simple drag-and-drop tools, allowing business users of all types to build
useful applications to improve business processes and insights. Force.com runs on Salesforce
infrastructure (which is primarily driven by Oracle databases and middleware). Heroku, on the other
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hand, runs on Amazon Web Services, offering developers a much wider swath of tools and underlying
infrastructure configurations for building applications. This offering is targeted toward heavy-duty
programmers and software developers. App Cloud has become something of a SaaS proving ground for
many enterprise software vendors, including Veeva Systems, a CRM vendor that serves the life sciences
industry specifically. Veeva runs its software on App Cloud, and the firm is engaged in a lucrative,
multiyear contract with Salesforce to host its CRM product.
App Cloud has a highly variable pricing model based on needs such as number of users, types of users,
and the ultimate problem a given project is attempting to solve. We believe this level of flexibility will
allow Salesforce to approach a wide swath of potential business users, even those with little to no
coding experience. For example, users can start on App Cloud with point-and-click app development in
Force.com for as little as $25 per month while also gaining access to Community for employees. At the
higher end, the Heroku Starter package starts at $4,000 per user, while unlimited access is negotiable.
We think the broad application infrastructure and middleware market is a good starting point for
thinking about the size of this market, though we believe aspects of Salesforce.com’s offering could
unlock new opportunities. Most notably, the aforementioned point-and-click/drag-and-drop application
development tools can allow even the most rudimentary business user to build object-based
applications, while we view the Internet of Things Cloud, Analytics Cloud, and Einstein as services that
could create incremental upside for App Cloud. In the case of the former, we think the impending wave
of devices coming online over the next several years will drive not only a surge in data, but unlock new
uses for software development. Gartner estimates more than 20 billion devices will be connected to the
Internet worldwide by 2020, up from just 4.9 billion in 2015. We believe the software opportunities for
the Internet of Things are too difficult to quantify today with reasonable accuracy, but they are
opportunities for additional upside to Salesforce.com’s total addressable market.
With regards to Einstein, this intelligence engine is already being put to use in the Salesforce.com
platform, driving several new predictive capabilities within the core CRM portfolio. For example, Sales
Cloud will now perform analysis on sales leads by gathering data from multiple channels, resulting in a
lead score for targeting the highest-probability leads first. Einstein will also suggest the best next course
of action, pre-write e-mails for the sales rep, and route colder leads to people tasked with building the
foundation for that relationship. Salesforce is marketing Einstein as an AI engine for everyone, as the
product is a compilation of machine learning, deep learning, and data processing technologies. Longer
term, the Einstein engine will be made available to developers to build their own predictive, intelligent
applications, creating greenfield revenue opportunities for Einstein.
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Exhibit 25 Einstein Is Already Driving the CRM Platform, but Application Development Uses Create New Sales Opportunities
Source: Salesforce investor presentation
Using Gartner’s estimates for application development and middleware as a guide (a large portion of
which remains in the on-premises realm today), we believe Salesforce.com’s opportunity within App
Cloud and Salesforce.com’s more greenfield products could approach (if not surpass) the firm’s total
opportunity in customer relationship management. While we expect competition to be intense across all
major software vendors (including Oracle, which is rapidly looking for ways to migrate its middleware
customers to the cloud), we believe Salesforce has the inside track in the platform-as-a-service market
based on the breadth and depth of its offerings highlighted above. We believe there is potentially
further upside to these estimates, as they do not account for royalties Salesforce.com collects on
AppExchange sales.
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Exhibit 26 App Cloud Is a Massive, Untapped Opportunity for Salesforce.com
Source: Gartner, Morningstar research
0%
5%
10%
15%
20%
25%
30%
35%
40%
$0
$10,000,000
$20,000,000
$30,000,000
$40,000,000
$50,000,000
$60,000,000
$70,000,000
$80,000,000
CY 2015 CY 2016 (Est.) CY 2017 (Est.) CY 2018 (Est.) CY 2019 (Est.) CY 2020 (Est.)
App Cloud Gartner App Development/Anal ytics TAM App Cloud Growth Gartner Growth
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The Economics of SaaS and Salesforce.com’s Valuation
We frequently hear that Salesforce.com’s valuation always seems rich. While we acknowledge that the
firm has generally received a high valuation in the marketplace, we believe the strength in its core
business creates one of the most robust economic moats in software, justifying its premium valuation.
What’s more, we continue to think the market underappreciates not only the opportunity that lies ahead
of Salesforce.com, but also the economics of software as a service in general. Before addressing
Salesforce.com’s valuation, we revisit some of the themes we highlighted in our May 2015 Observer The
SaaS Is Greener on the Other Side: The Economics of Cloud Application Software Companies.
Total Cost of Ownership: SaaS Versus On-Premises
Customers will not migrate to a new technology solely for technology’s sake. Their primary goal is to
maximize the cash outlays it makes in its IT infrastructure to generate the highest levels of return on
investment. For SaaS companies to succeed, they must be able to deliver this value proposition: reliable,
user-friendly software at a manageable cost. In the traditional on-premises license/maintenance model,
software vendors collect a large license premium from the customer in the first year, then collect annual
maintenance payments every year thereafter, usually in the realm of 20% of the cost of the license.
Conversely, SaaS companies generally collect annual payments that are uniform over the life of the
contract. The difference in dollars collected over the first few years is largely trivial between the two
models. However, after four or five years, the on-premises company will come back to its customers with
Version 2.0, featuring some incremental upgrades at the cost of an upgrade license. The customer is
now in a bind: Ride out the aging software product or pay for the incremental upgrade at a large
expense (which may come with implementation and user retraining)? Further, the on-premises customer
is still on the hook for operating its internal application servers and paying its IT staff, adding further
costs on top of its already expensive software license. Conversely, the SaaS customer is continually
operating on the latest version of the product while receiving consistent support in exchange for
subscription payments. The result? Customers wind up paying far less to operate SaaS products versus
on-premises software. Exhibit 27 compares SaaS and on-premises costs that an enterprise may face.
http://select.morningstar.com/downloadarchive.aspx?year=2015&docid=699553&secid=&companyid=&title=Technology+Observer%3a+SaaS+Is+Greener+on+the+Other+Side%3a+The+Economics+of+Cloud+Application+Software+Companies
http://select.morningstar.com/downloadarchive.aspx?year=2015&docid=699553&secid=&companyid=&title=Technology+Observer%3a+SaaS+Is+Greener+on+the+Other+Side%3a+The+Economics+of+Cloud+Application+Software+Companies
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Exhibit 27 SaaS Total Cost of Ownership Is a Much Prettier Picture Than On-Premises, Which Includes Hardware and IT Staff
Source: Morningstar research
Note: Bars represent spending levels (left axis), lines represent cumulative spending (right axis)
There are certainly concerns beyond cost for migrating to SaaS, most notably data sovereignty and
security, but a SaaS provider at scale will have much more capital to spend on infrastructure than an
individual enterprise. For reference, Oracle’s management team outlined this dichotomy, as the company
has spent $7 billion on security across the IT stack (infrastructure, platform, applications, and
operations). By comparison, the SANS Institute estimates the average $1 billion enterprise spends just
$30 million on security.
SaaS Companies Are Playing the Long Game
Even though SaaS companies do not receive the benefit of a large up-front payment from its customers,
we believe SaaS companies at scale will ultimately be able to extract more dollars out of them than in
the traditional on-premises model. Customer satisfaction and renewal rates drive everything for SaaS
companies. Companies that can maintain consistent incremental improvements in the product and
reliability in delivery should be able to reap more revenue dollars from its customers over the long haul.
We believe this speaks to the stickiness and innovation that economic-moat-bearing software
companies are able to generate with their products, resulting in substantial customer switching costs.
The previous exhibit detailed all costs to the customer, including hardware and IT staff via the on-
premises model. If we strip out hardware costs and look exclusively at cash flowing from customers to
vendors for software, we believe SaaS companies are actually collecting a greater degree of software
revenue over the life of the customer relationship, with the inflection occurring sometime in the fifth
year. This is in line with what we have heard from many SaaS companies, with some saying that they
$-
$2,000,000
$4,000,000
$6,000,000
$8,000,000
$10,000,000
$12,000,000
$-
$500,000
$1,000,000
$1,500,000
$2,000,000
$2,500,000
$3,000,000
$3,500,000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Annual On-Premises Costs Annual SaaS Costs Cumul ative On-Premises Costs Cumul ative S aaS Costs
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catch up with the on-premises revenue model within three years. Exhibit 28 shows the potential
reduction in costs that an enterprise may face.
Exhibit 28 Moaty SaaS Companies at Scale Will Earn More Lifetime Value From Customers Looking to Downsize Hardware Costs
Source: Morningstar research
Note: Bars represent spending levels (left axis), lines represent cumulative spending (right axis)
As we look across the SaaS landscape today, there are few companies generating consistent GAAP
profitability. However, we believe this is purely a reflection of the cost versus revenue recognition
practices of SaaS companies. In general, the faster a company wins new customers (and subsequently
grows revenue), the worse profitability will look. To land a new customer, SaaS companies must
recognize all of the sales and marketing and product development costs associated with signing that
deal immediately. SaaS contracts are typically three to five years long, and revenue is recognized ratably
over the life of that contract. This results in a massive spread in profitability between new customer
billings and renewals billings, the latter of which require very little cost to book.
SaaS companies that can generate consistently high renewal rates (a trait we look for when evaluating
moats) as it matures will eventually realize meaningful operating leverage in its business model, as a
greater mix of its billings (and costs) will be derived from renewals business versus new customers. This
leverage will not only come from the sales and marketing line, but also through research and
development. As the product matures, incremental upgrades will become much more maintenance-
oriented, allowing firms to scale back research and development expenditures on those products (and
potentially shift some of those dollars to other projects to support growth in new verticals).
The SaaS business model obviously shifts several costs from the customer to the vendor, most notably
the infrastructure that is running and delivering the software itself. The result is a step-down in gross
$-
$1,000,000
$2,000,000
$3,000,000
$4,000,000
$5,000,000
$6,000,000
$7,000,000
$8,000,000
$9,000,000
$10,000,000
$-
$500,000
$1,000,000
$1,500,000
$2,000,000
$2,500,000
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Annual On-Premises Costs Annual SaaS Costs Cumul ative On-Premises Costs Cumul ative S aaS Costs
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margins from the mid-80s to the mid-90s that legacy on-premises software companies once generated
on licenses and maintenance revenue. However, we believe that customer satisfaction for SaaS
companies can be much higher, as customers are consistently on the latest version of the software, and
there is no natural upgrade cliff that SaaS companies have to engage in. This should result in high
renewal rates for top-flight SaaS firms, ultimately allowing them to make up most of these costs through
the operating line. We believe this is best exemplified through wide-moat Salesforce.com’s history and
our forecasts.
Exhibit 29 Salesforce.com Has Proven Profitability From 2008-11, and Operating Leverage Will Come With Maturity
Source: Company filings, Morningstar research
Note: Bars represent spending levels (left axis), lines represent growth (right axis)
Salesforce has followed the growth/profitability relationship we just alluded to, as the company saw
sales growth decline coming out of the financial crisis amid a maturing product set. However, the
company made the conscious decision to actively invest in its business by expanding into new cloud
verticals (such as service, marketing, and commerce), driving margins down and revenue growth up in
the process. Since then, the relationship is trending back toward greater profitability amid stable to
modestly decelerating revenue growth.
We think this point bears repeating. Salesforce would likely be a highly profitable software vendor today
if it were in a mature segment of the market with little greenfield opportunity and less of a need to
spend on sales and marketing because new customers are harder and harder to find. We are fully
comfortable with Salesforce’s limited profitability today given the natural operating leverage in renewals
billings (which we explore below), and we think the company should continue to put the pedal to the
metal in terms of reinvesting in the business in order to acquire new customers and expand on its core
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
(5,000,000)
–
5,000,000
10,000,000
15,000,000
20,000,000
25,000,000
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
(Est.)
2018
(Est.)
2019
(Est.)
2020
(Est.)
2021
(Est.)
2022
(Est.)
2023
(Est.)
2024
(Est.)
2025
(Est.)
2026
(Est.)
Subscription Revenue Operating Profit YoY Revenue Growth Operating Margin
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products. As these businesses mature, we foresee tremendous operating leverage entering the
Salesforce model.
To add further context to the relationship between growth and profitability, we examine the billings mix
of each of Salesforce.com’s individual products. As referenced earlier, new customer billings will yield
detrimental profit margins, while renewals billings carry substantially lower costs to book and
significantly greater profitability. Although Salesforce does not break out its billings mix by product,
management disclosed at its Dreamforce Conference in October 2016 that roughly 60% of sales are
being derived from the installed base, while 40% of sales are coming from new customers. Billings mix is
tilting more heavily toward renewals, so we assume that 64% of billings mix is renewal business. Using
the age of Salesforce.com’s core products and this ratio as a guide, we use our assumed renewals cost
to book of 15% from sales and marketing (which we outlined in our cost of customer acquisition
discussion in our May 2015 Observer The SaaS Is Greener On The Other Side), 10% from research and
development spending, 5% from general and administrative, and our subscription gross margin
assumptions to back into our Salesforce.com’s 2016 operating margin and our forecast margin
expansion.
Exhibit 30 Salesforce.com Has Proved Profitability Before, and We Estimate That Operating Leverage Will Come With Maturity
Source: Company filings, Morningstar research
That’s Great, but What Should I Pay for It?
Salesforce.com is certainly a unique case among software giants, as it is growing much faster than any
of its enterprise peers (though we acknowledge stronger sales growth for smaller SaaS vendors
ServiceNow and Workday). However, its profitability remains negligible, making multiples comparisons
(GAAP, $ billions) 2016 2021 2026 2016 2021 2026 2016 2021 2026 2016 2021 2026
2016 2021 2026
Renewals Billings Mix 80% 85% 90% 55% 70% 87% 54% 69% 87% – 68% 85% 50% 65% 80%
New Billings Mix 20% 15% 10% 45% 30% 13% 46% 31% 13% – 32% 15% 50% 35% 20%
Subscription Billings 2.9 4.3 6.3 2.0 4.8 7.2 0.9 1.6 2.3 – 0.8 1.5 1.3 3.7 5.6
Renewals Margin 51% 52% 55% 51% 52% 55% 51% 52% 55% – 52% 55% 51% 52% 55%
New Billings Margin -85% -85% -85% -85% -85% -85% -85% -85% -85% – -85% -85% -85% -85% -85%
Product Op. Profit 0.7 1.4 2.6 (0.2) 0.5 2.6 (0.1) 0.2 0.8 – 0.1 0.5 (0.2) 0.1 1.5
Product Op. Margin 23% 31% 41% -10% 11% 37% -12% 10% 37% – 8% 34% -17% 4% 27%
2016 2021 2026
Renewals Mix 64% 73% 86%
New Mix 36% 27% 14%
Renewals Billings 4.5 11.1 19.7
New Billings 2.6 4.1 3.2
Prof. Services Rev. 0.6 1.1 1.5
Prof. Services Op. Margin 0% 0% 0%
Salesforce Revenue 7.7 16.3 24.4
Salesforce Op. Profit 0.1 2.3 8.1
Implied Op. Margin 1.9% 13.9% 33.3%
Salesforce.com
Sales Cloud Service Cloud Marketing Cloud Commerce Cloud App Cloud/Other
http://select.morningstar.com/downloadarchive.aspx?year=2015&docid=699553&secid=&companyid=&title=Technology+Observer%3a+SaaS+Is+Greener+on+the+Other+Side%3a+The+Economics+of+Cloud+Application+Software+Companies
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much more challenging. When we speak to investors about Salesforce.com, we encourage them to look
at the long-term story, marrying the near-term revenue growth and medium- to long-term profitability as
a more accurate way of looking at the business than any near-term earnings multiple. However, we do
need to contextualize the value the market is placing on companies like this. We believe Salesforce.com
is one of the best long-term growth and operating leverage stories in software, but the growth aspect of
this business still has several years of runway.
With this in mind, we think Salesforce.com needs to be evaluated on what the business looks like now
and what it will look like as it inflects more toward profitability and away from high-speed growth.
We’ve pulled together our software estimates for companies in our coverage for calendar years 2016
and 2021 (Salesforce.com’s fiscal 2017 and 2022, respectively). Based on our earlier analysis, greater
sales growth will mask profitability in the near term, but operating leverage flows naturally to SaaS
companies over the long term. To that end, we first examine Salesforce.com on a price to sales basis
versus software companies growing revenue at 20% and up.
Exhibit 31 Salesforce.com’s Current P/S Multiple Does Not Reflect Its Performance
Source: Company filings, Morningstar Research
Note: Price data as of Oct. 21, 2016.
Only one other wide-moat software company appears on this list: Adobe. We think this is likely the most
appropriate comparison for Salesforce.com. Much like Salesforce, Adobe has dominant share in a single
product (salesforce automation for Salesforce.com, content creation for Adobe), and is generating strong
growth and increasing share in others. However, we think Salesforce.com’s growth runway is much
longer than Adobe’s, as the latter is limited to content creation and digital marketing. For reference, our
five-year revenue CAGRs for Adobe and Salesforce.com are 20% and 17%. We believe Salesforce.com
deserves to be on equal footing as Adobe and much closer to Workday, which faces much stronger
incumbents in the ERP market.
MBLYSPLK
NOW
WDAY
PANW
VEEVDATA
CRM
ADBE
ATHN
RHT
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
– 5 10 15 20 25 30
Revenue Growth (Y-Axis) vs. Price to 2016 Sales Multiple (X-Axi s)
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Exhibit 32 Our $98 Fair Value Estimate for Salesforce.com Implies a Fiscal 2017 P/S Multiple of 8.3 times
Source: Company filings, Morningstar Research
Note: Price data as of Oct. 21, 2016.
Still, we are cognizant that cash generation is king for deriving and contextualizing our fair value
estimate. We evaluate Salesforce.com on a free cash flow basis in calendar year 2021, a point where we
expect the firm’s business model to be generating midteens GAAP operating margins along with
midteens revenue growth. We have excluded Tableau, Splunk, and Workday from the following analysis,
as their operating profit growth rates are not meaningful in 2021, and we have included several large
software companies for further context.
MBLYSPLK
NOW
WDAYPANW
VEEVDATA
CRM
ADBE
ATHN RHT
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
– 5 10 15 20 25 30
Revenue Growth (Y-Axis) vs. Price to 2016 Sales Multiple (X-Axi s)
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Exhibit 33 The Market Is Not Rewarding Salesforce.com’s Operating Leverage Runway
Source: Company filings, Morningstar research
Note: Price data as of Oct. 21, 2016.
Today, the market is placing far greater free cash flow per share multiples on companies that boast
neither the revenue scale (such as Guidewire and Veeva) nor profitability potential (such as Blackbaud)
as Salesforce.com. Despite boasting the fourth-fastest rate of operating profit growth among the cohort
in 2021, the market is valuing Salesforce below other wide-moat names Adobe, Blackbaud, Guidewire,
Intuit, and Veeva Systems (many of which trade near our fair value estimates today). We believe a
company with the competitive strength of Salesforce deserves to be valued at similar multiples to these
firms, again reflected in our $98 fair value estimate.
ADBE
ADSK
ATHN
BLKB
CA
CRM
CTXS
GWRE
INTU
MBLY
MSFT
NOW
ORCL
PANW
RHT
SAP
SYMC
VEEV
VMW
VRNT
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
0 5 10 15 20 25 30 35 40
2021Operating Profit Growth vs. Price to 2021 FCF/Share Multiple
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Exhibit 34 Our $98 Fair Value Estimate for Salesforce.com Implies a Fiscal 2022 P/FCF Multiple of 19
Source: Company filings, Morningstar research
Note: Price/FCF data as of Oct. 21, 2016.
We believe a 19 times multiple on Salesforce.com’s fiscal 2022 free cash flow is appropriate (versus the
14 multiple the stock receives today), placing the company still well within the realm of other wide-moat
vendors Adobe, Blackbaud, Microsoft, Guidewire, Intuit, and Veeva Systems.
What If We’re Wrong?
Although we view Salesforce.com’s competitive position and addressable market as robust, we are
certainly aware that the software market is filled with rivals attempting to innovate and take a large
piece of the CRM pie.
In our upside scenario, we believe SaaS adoption accelerates in the near term, allowing Salesforce.com
to capitalize on growth opportunities much faster and pull forward its timeline for generating operating
leverage. In this case, we think Salesforce would act as the consolidator in the CRM market while also
continuing to win deals at the top end of the market against rivals such as Microsoft, Oracle, and SAP.
Further, we believe Salesforce would serve as the go-to platform-as-a-service vendor in this scenario,
pilfering middleware customers away from the likes of Oracle and IBM. As a result, we believe
Salesforce.com can sustain a five-year revenue CAGR in excess of 20%, allowing the firm to cross the
$20 billion sales threshold in fiscal 2022 (versus fiscal 2024 in our base case). We believe this would
allow operating margins to accelerate beyond the mid-30s by the end of our 10-year explicit forecast,
ultimately yielding a fair value estimate of $131 per share.
In our downside scenario, we believe competition will ultimately slow Salesforce.com’s growth much
more quickly. We think this would most likely occur in a world where Oracle and SAP are able to convert
an overwhelming number of their existing customers to their own SaaS solutions, while also making
ADBE
ADSK
ATHN
BLKB
CA
CRM
CTXS
GWRE
INTU
MBLY
MSFT
NOW
ORCL
PANW
RHT
SAP
SYMC
VEEV
VMW
VRNT
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
0 5 10 15 20 25 30 35 40
2021Operating Profit Growth vs. Price to 2021 FCF/Share Multiple
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progress with new customers as well. Further, we think the firm’s PaaS solution faces increased
competition from these firms as well, while infrastructure-as-a-service firms such as Microsoft and
Amazon pose potential long-term threats for the PaaS opportunity. As a result, Salesforce.com’s five-year
compounded annual revenue growth rate falls to just 14%, while operating margins top out in the mid-
20s, ultimately yielding a fair value estimate of $52 per share. K
Exhibit 35 Salesforce.com’s Execution Will Determine the Magnitude of Profitability
Source: Company filings, Morningstar research
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
$0
$5,000,000
$10,000,000
$15,000,000
$20,000,000
$25,000,000
$30,000,000
FY 2016 FY 2017 (Est.) FY 2018 (Est.) FY 2019 (Est.) FY 2020 (Est.) FY 2021 (Est.) FY 2022 (Est.) FY 2023 (Est.) FY 2024 (Est.) FY 2025 (Est.) FY 2026 (Est.)
Bul l Case Revenue Base Case Revenue Bear Case Revenue
Bul l Case Op. Margin Base Case Op. Margin Bear Case Op Margin
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Appendix
Morningstar Equity Research |
Last Price Fair Value Uncertainty Stewardship Econom ic Moat Moat Trend Morningstar Credit Rating
74 USD 98 USD High Standard Wide Positiv e N/A
Analy st Rodney Nelson Fiv e-Star Price 58.80 Estimated COE 9.0% Adjusted P / E 79.7 105.5
Phone & Email 312-244-7298 Fair Value Estimate 98.00 Pre-Tax Cost of Debt 5.5% EV / Adjusted EBITDA 42.9 56.9
rodney.nelson@morningstar.com One-Star Price 151.90 Estimated WACC 8.9% EV / Sales 6.2 8.3
Sector Technology Market Price 74.00 ROIC * 15.4% Price / Book 7.3 9.7
Industry P / FVE 0.76 Adjusted ROIC * 41.8% FCF Yield 3.5% 2.6%
* 5-Yr Projected Average Div idend Yield 0.0% 0.0%
(2017 Estimates) (Price) (Fair Value)
3-Yr Forecast 5-Yr
Historical
CAGR/AV 2016 2017 2018 2019 2020 2021
Projected
CAGR/AVG
Incom e Statem ent
Rev enue 6,667,216 8,336,604 10,252,207 12,207,544 14,261,239 16,311,464
Gross Profit 5,012,668 6,270,560 7,732,914 9,245,713 10,857,586 12,486,877
Operating Income 114,923 143,155 371,830 773,678 1,359,601 2,243,278
Net Income (47,426) 128,891 211,634 491,392 944,203 1,564,212
Adjusted Income 506,783 653,016 906,180 1,253,005 1,760,631 2,391,129
Adjusted EPS 0.77 0.93 1.27 1.75 2.44 3.28
Adjusted EBITDA 1,205,438 1,210,075 1,685,648 2,147,759 2,894,094 3,928,339
Growth (% YoY)
Rev enue 29.8% 24.1% 25.0% 23.0% 19.1% 16.8% 14.4% 19.6%
Gross Profit 28.4% 22.7% 25.1% 23.3% 19.6% 17.4% 15.0% 20.0%
Operating Income NM -178.9% 24.6% 159.7% 108.1% 75.7% 65.0% 81.2%
Net Income NM -81.9% -371.8% 64.2% 132.2% 92.1% 65.7% NM
Adjusted EPS 21.3% 40.0% 21.3% 36.8% 37.3% 39.5% 34.9% 33.8%
Adjusted EBITDA 53.2% 49.6% 0.4% 39.3% 27.4% 34.7% 35.7% 26.7%
Profitability (%)
Gross Margin 75.8% 75.2% 75.2% 75.4% 75.7% 76.1% 76.6% 75.8%
Operating Margin -2.7% 1.7% 1.7% 3.6% 6.3% 9.5% 13.8% 7.0%
Net Margin -3.8% -0.7% 1.5% 2.1% 4.0% 6.6% 9.6% 4.8%
Adjusted EBITDA Margin 14.8% 18.1% 14.5% 16.4% 17.6% 20.3% 24.1% 18.6%
Return on Equity -5.7% -1.1% 2.1% 2.8% 6.0% 10.1% 14.3% 7.1%
Adjusted ROIC 26.3% 26.4% 25.1% 34.7% 42.1% 49.7% 57.7% 41.8%
Adjusted RONIC 26.3% 29.5% -2.1% 245.5% 693.0% 64.8% 258.0% 251.8%
Leverage
Debt / Capital 28.0% 20.5% 20.1% 18.8% 17.2% 11.5% 9.8% 15.5%
Debt / EBITDA 9.7 2.0 2.9 2.1 1.4 0.7 0.5 1.5
EBITDA / Interest Ex pense 4.7 8.8 5.1 9.7 14.2 76.1 113.1 43.6
FCFE / Total Debt 0.66 1.03 1.00 1.08 1.34 2.26 2.66 1.67
Cash Flow
Div idends per Share 0.00 0.00 0.00 0.00 0.00 0.00
Free Cash Flow to the Firm 461,424 (2,903,672) 947,510 1,288,514 1,655,629 2,097,174
FCFE (CFO-Capex ) 1,328,109 1,799,677 1,935,250 2,398,507 2,927,239 3,448,232
Div idend Franking 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Div idend Pay out Ratio 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
2,699,000.0 3,006,686.0 3,337,421.5 3,687,850.7 4,056,635.8 4,442,016.2
1,817,700.0 2,363,010.0 2,953,762.5 3,618,359.1 4,305,847.3 4,994,782.8
654,100.0 824,166.0 1,001,361.7 1,186,613.6 1,394,271.0 1,589,468.9
110,000.0 334,815.0 448,652.1 578,761.2 723,451.5
1,034,800.0 1,428,024.0 1,874,995.5 2,381,244.3 2,917,024.3 3,442,088.6
Serv ice Cloud Rev enue
Marketing Cloud Rev enue
21 October 2016
Salesforce.com (CRM)
Softw are –
Application
All values (except per share
amounts) in: USD Thousands
Com pany-Specific Metrics
Sales Cloud Rev enue
Commerce Cloud Rev enue
App Cloud/Other Rev enue
May the Force Be With You: Salesforce.com Is the Newest Software Empire | 25 October 2016
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www.hbr.org
B
EST
OF
HBR 1997
Value Innovation
The Strategic Logic of High Growth
by W. Chan Kim and
Renée Mauborgn
e
•
What separates high-growth
companies from the pack is
the way managers make sense
of how they do business
.
Reprint R0407P
This document is authorized for use only by Familia Herring in Financial Management II at Strayer University, 2018.
http://www.hbr.org
http://harvardbusinessonline.hbsp.harvard.edu/relay.jhtml?name=itemdetail&referral=4320&id=R0407P
B
EST
OF
HBR 1997
Value Innovation
The Strategic Logic of High Growth
by W. Chan Kim and Renée Mauborgne
harvard business review • top-line growth • july–august 2004 page 1
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.
What separates high-growth companies from the pack is the way
managers make sense of how they do business.
Most companies focus on matching and beating
their rivals. As a result, their strategies tend to
take on similar dimensions. What ensues is head-
to-head competition based largely on incremen-
tal improvements in cost, quality, or both. W.
Chan Kim and Renée Mauborgne from Insead
study how innovative companies break free from
the pack by staking out fundamentally new mar-
ket space—that is, by creating products or ser-
vices for which there are no direct competitors.
This path to value innovation requires a different
competitive mind-set and a systematic way of
looking for opportunities. Instead of searching
within the conventional boundaries of industry
competition, managers can look methodically
across those boundaries to find unoccupied terri-
tory that represents real value innovation. The
French hotel chain Accor, for example, discarded
conventional notions of what a budget hotel
should be and offered what most value-conscious
customers really wanted: a good night’s sleep at
a low price.
During the past decade, the authors have de-
veloped the idea of value innovation, often in the
pages of HBR. This article presents the notion in
its original, most fundamental form.
After a decade of downsizing and increasingly
intense competition, profitable growth is a tre-
mendous challenge many companies face.
Why do some companies achieve sustained
high growth in both revenues and profits? In a
five-year study of high-growth companies and
their less successful competitors, we found
that the answer lay in the way each group ap-
proached strategy. The difference in approach
was not a matter of managers choosing one
analytical tool or planning model over an-
other. The difference was in the companies’
fundamental, implicit assumptions about
strategy. The less successful companies took a
conventional approach: Their strategic think-
ing was dominated by the idea of staying
ahead of the competition. In stark contrast,
the high-growth companies paid little atten-
tion to matching or beating their rivals. In-
stead, they sought to make their competitors
irrelevant through a strategic logic we call
This document is authorized for use only by Familia Herring in Financial Management II at Strayer University, 2018.
Value Innovation
•
•
•
B
EST
OF
HBR 1997
harvard business review • top-line growth • july–august 2004 page 2
W. Chan Kim
is the Boston Consulting
Group Bruce D. Henderson Chair Pro-
fessor of International Management at
Insead in Fountainebleau, France.
Renée Mauborgne
is the Insead Dis-
tinguished Fellow and a professor of
strategy and management. She is also
the president of ITM, a strategy re-
search group in Fountainebleau.
value innovation.
Consider Bert Claeys, a Belgian company
that operates movie theaters. From the 1960s
to the 1980s, the movie theater industry in Bel-
gium was declining steadily. With the spread of
videocassette recorders and satellite and cable
television, the average Belgian’s moviegoing
dropped from eight to two times per year. By
the 1980s, many cinema operators (COs) were
forced to shut down.
The COs that remained in business found
themselves competing head-to-head for a
shrinking market. All took similar actions.
They turned cinemas into multiplexes with as
many as ten screens, broadened their film of-
ferings to attract all customer segments, ex-
panded their food and drink services, and in-
creased showing times.
Those attempts to leverage existing assets
became irrelevant in 1988, when Bert Claeys
created Kinepolis. Neither an ordinary cinema
nor a multiplex, Kinepolis is the world’s first
megaplex, with 25 screens and 7,600 seats. By
offering moviegoers a radically superior experi-
ence, Kinepolis won 50% of the market in
Brussels in its first year and expanded the mar-
ket by about 40%. Today, many Belgians refer
not to a night at the movies but to an evening
at Kinepolis.
Consider the differences between
Kinepolis
and other Belgian movie theaters. The typical
Belgian multiplex has small viewing rooms
that often have no more than 100 seats, screens
that measure seven meters by five meters, and
35-millimeter projection equipment. Viewing
rooms at Kinepolis have up to 700 seats, and
there is so much legroom that viewers do not
have to move when someone passes by. Bert
Claeys installed oversized seats with individual
armrests and designed a steep slope in the
floor to ensure everyone an unobstructed view.
At Kinepolis, screens measure up to 29 meters
by ten meters and rest on their own founda-
tions so that sound vibrations are not transmit-
ted among screens. Many viewing rooms have
70-millimeter projection equipment and state-
of-the-art sound equipment. And Bert Claeys
challenged the industry’s conventional wisdom
about the importance of prime, city-center real
estate by locating Kinepolis off the ring road
circling Brussels, 15 minutes from downtown.
Patrons park for free in large, well-lit lots. (The
company was prepared to lose out on foot traf-
fic in order to solve a major problem for the
majority of moviegoers in Brussels: the scarcity
and high cost of parking.)
Bert Claeys can offer this radically superior
cinema experience without increasing ticket
prices because the concept of the megaplex re-
sults in one of the lowest cost structures in the
industry. The average cost to build a seat at Ki-
nepolis is about 70,000 Belgian francs, less
than half the industry’s average in Brussels.
Why? The megaplex’s location outside the city
is cheaper; its size gives it economies in pur-
chasing, more leverage with film distributors,
and better overall margins; and with 25 screens
served by a central ticketing and lobby area,
Kinepolis achieves economies in personnel and
overhead. Furthermore, the company spends
very little on advertising because its value in-
novation generates a lot of word-of-mouth
praise.
Within its supposedly unattractive industry,
Kinepolis has achieved spectacular growth and
profits. Belgian moviegoers now attend the cin-
ema more frequently because of Kinepolis, and
people who never went to the movies have
been drawn into the market. Instead of bat-
tling competitors over targeted segments of
the market, Bert Claeys made the competition
irrelevant. (See the exhibit “How Kinepolis
Achieves Profitable Growth.”)
Why did other Belgian COs fail to seize that
opportunity? Like the others, Bert Claeys was
an incumbent with sunk investments: a net-
work of cinemas across Belgium. In fact, Kine-
polis would have represented a smaller invest-
ment for some COs than it did for Bert Claeys.
Most COs were thinking—implicitly or explic-
itly—along these lines: The industry is shrink-
ing, so we should not make major invest-
ments—especially in fixed assets. But we can
improve our performance by outdoing our ri-
vals on each of the key dimensions of competi-
tion. We must have better films, better ser-
vices, and better marketing.
Bert Claeys followed a different strategic
logic. The company set out to make its cinema
experience not better than that at competitors’
theaters but completely different—and irresist-
ible. The company thought as if it were a new
entrant into the market. It sought to reach the
mass of moviegoers by focusing on widely
shared needs. In order to give most moviegoers
a package they would value highly, the com-
pany put aside conventional thinking about
what a theater is supposed to look like. And it
This document is authorized for use only by Familia Herring in Financial Management II at Strayer University, 2018.
Value Innovation
•
•
•
B
EST
OF
HBR 1997
harvard business review • top-line growth • july–august 2004 page 3
did that while reducing its costs. That’s the
logic behind value innovation.
Conventional Logic Versus Value
Innovation
Conventional strategic logic and the logic of
value innovation differ along the five basic di-
mensions of strategy. Those differences deter-
mine which questions managers ask, what op-
portunities they see and pursue, and how they
understand risk. (See the exhibit “Two Strate-
gic Logics.”)
Industry Assumptions.
Many companies
take their industries’ conditions as given and
set strategy accordingly. Value innovators
don’t. No matter how the rest of the industry
is faring, value innovators look for blockbuster
ideas and quantum leaps in value. Had Bert
Claeys, for example, taken its industry’s condi-
tions as given, it would never have created a
megaplex. The company would have followed
the endgame strategy of milking its business
or the zero-sum strategy of competing for
share in a shrinking market. Instead, through
Kinepolis, the company transcended the in-
dustry’s conditions.
Strategic Focus.
Many organizations let
competitors set the parameters of their strate-
gic thinking. They compare their strengths
and weaknesses with those of their rivals and
focus on building advantages. Consider this ex-
ample. For years, the major U.S. television net-
works used the same format for news pro-
gramming. All aired shows in the same time
slot and competed on their analysis of events,
the professionalism with which they delivered
the news, and the popularity of their anchors.
In 1980, CNN came on the scene with a focus
on creating a quantum leap in value, not on
competing with the networks. CNN replaced
the networks’ format with real-time news
from around the world, 24 hours a day.
CNN not only emerged as the leader in global
news broadcasting—and created new demand
around the globe—but also was able to pro-
duce 24 hours of real-time news for one-fifth
the cost of one hour of network news.
Conventional logic leads companies to com-
pete at the margin for incremental share. The
logic of value innovation starts with an ambi-
tion to dominate the market by offering a tre-
mendous leap in value. Value innovators never
say, Here’s what competitors are doing; let’s do
this in response. They monitor competitors but
do not use them as benchmarks. Hasso Platt-
ner, vice chairman of SAP, the global leader in
Researching the Roots of High Growth
During the past five years, we have studied
more than 30 companies around the world in
approximately 30 industries. We looked at
companies with high growth in both reve-
nues and profits and companies with less suc-
cessful performance records. In an effort to
explain the difference in performance be-
tween the two groups of companies, we inter-
viewed hundreds of managers, analysts, and
researchers. We built strategic, organiza-
tional, and performance profiles. We looked
for industry or organizational patterns. And
we compared the two groups of companies
along dimensions that are often thought to
be related to a company’s potential for
growth. Did private companies grow more
quickly than public ones? What was the im-
pact on companies of the overall growth of
their industry? Did entrepreneurial start-ups
have an edge over established incumbents?
Were companies led by creative, young radi-
cals likely to grow faster than those run by
older managers?
We found that none of those factors mat-
tered in a systematic way. High growth was
achieved by both small and large organiza-
tions, by companies in high-tech and low-
tech industries, by new entrants and incum-
bents, by private and public companies, and
by companies from various countries.
What did matter—consistently—was the
way managers in the two groups of compa-
nies thought about strategy. In interviewing
the managers, we asked them to describe
their strategic moves and the thinking be-
hind them. Thus we came to understand
their views on each of the five textbook di-
mensions of strategy: industry assumptions,
strategic focus, customers, assets and capa-
bilities, and product and service offerings.
We were struck by what emerged from our
content analysis of those interviews. The
managers of the high-growth companies—
irrespective of their industry—all described
what we have come to call the logic of value
innovation. The managers of the less success-
ful companies all thought along conventional
strategic lines.
Intrigued by that finding, we went on to
test whether the managers of the high-
growth companies applied their strategic
thinking to business initiatives in the market-
place. We found that they did.
Furthermore, in studying the business
launches of about 100 companies, we were
able to quantify the impact of value innova-
tion on a company’s growth in both revenues
and profits. Although 86% of the launches
were line extensions—that is, incremental
improvements—they accounted for 62% of
total revenues and only 39% of total profits.
The remaining 14% of the launches—the true
value innovations—generated 38% of total
revenues and a whopping 61% of total profits.
This document is authorized for use only by Familia Herring in Financial Management II at Strayer University, 2018.
Value Innovation
•
•
•
B
EST
OF
HBR 1997
harvard business review • top-line growth • july–august 2004 page 4
business application software, puts it this way:
“I’m not interested in whether we are better
than the competition. The real test is, will most
buyers still seek out our products even if we
don’t market them?”
Because value innovators don’t focus on
competing, they can distinguish the factors
that deliver superior value from all the factors
the industry competes on. They do not expend
their resources to offer certain product and ser-
vice features just because that is what their ri-
vals are doing. CNN, for example, decided not
to compete with the networks in the race to
get big-name anchors. Companies that follow
the logic of value innovation free up their re-
sources to identify and deliver completely new
sources of value. Ironically, even though value
innovators do not set out to build advantages
over the competition, they often end up
achieving the greatest competitive
advantages.
Customers.
Many companies seek growth
through retaining and expanding their cus-
tomer bases. This often leads to finer segmen-
tation and greater customization of offerings
to meet specialized needs. Value innovation
follows a different logic. Instead of focusing on
the differences between customers, value in-
novators build on the powerful commonalities
in the features that customers value. In the
words of a senior executive at the French hote-
lier Accor, “We focus on what unites custom-
ers. Customers’ differences often prevent you
from seeing what’s most important.” Value in-
novators believe that most people will put
their differences aside if they are offered a con-
siderable increase in value. Those companies
shoot for the core of the market, even if it
means losing some of their customers.
Assets and Capabilities.
Many companies
view business opportunities through the lens
of their existing assets and capabilities. They
ask, Given what we have, what is the best we
can do? In contrast, value innovators ask,
What if we start anew? That is the question
the British company Virgin Group put to itself
in the late 1980s. The company had a sizable
chain of small music stores across the United
Kingdom when it came up with the idea of
music and entertainment megastores, which
would offer customers a tremendous leap in
value. Seeing that its small stores could not be
leveraged to seize that opportunity, the com-
pany decided to sell off the entire chain. As
one of Virgin’s executives puts it, “We don’t let
what we can do today condition our view of
what it takes to win tomorrow. We take a clean
slate approach.”
This is not to say that value innovators
never leverage their existing assets and capabil-
ities; they often do. But, more important, they
assess business opportunities without being bi-
ased or constrained by where they are at a
given moment. For that reason, value innova-
tors not only have more insight into where
value for buyers resides—and how it is chang-
ing—but also are much more likely to act on
that insight.
Product and Service Offerings.
Conven-
tional competition takes place within clearly
established boundaries defined by the prod-
ucts and services the industry traditionally of-
fers. Value innovators often cross those bound-
aries. They think in terms of the total solution
buyers seek, and they try to overcome the
chief compromises their industry forces cus-
tomers to make—as Bert Claeys did by provid-
ing free parking. A senior executive at Com-
paq Computer describes the approach: “We
continually ask where our products and ser-
vices fit in the total chain of buyers’ solutions.
We seek to solve buyers’ major problems
Kinepolis
Company’s Perspective Customers’ Perspective
Industry’s conditions
can be transcended.
Economies
of personnel
and overhead
Cost
savings
Cost
additions
Low
marketing
costs
Low cost
position
High
volume
Expanded
market
High growth in revenues and profits
Quantum leap
in value
Competitive
price
Radically superior
cinema experience
Low
land
costs
Better
overall
margins
Free and easy
parking
Superior screens,
sound, and seats
Best pick of
blockbusters
Go for a quantum leap
in value; competition
is not the benchmark.
Go for the mass of
moviegoers; let some
customers go.
Think beyond
existing assets
and capabilities.
Think in terms of the total
solution buyers seek.
How Kinepolis Achieves Profitable Growth
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across the entire chain, even if that takes us
into a new business. We are not limited by the
industry’s definition of what we should and
should not do.”
Creating a New Value Curve
How does the logic of value innovation trans-
late into a company’s offerings in the market-
place? Consider the case of Accor. In the mid-
1980s, the budget hotel industry in France was
suffering from stagnation and overcapacity.
Accor’s cochairmen, Paul Dubrule and Gérard
Pélisson, challenged the company’s managers
to create a major leap in value for customers.
The managers were urged to forget everything
they knew about the existing rules, practices,
and traditions of the industry. They were
asked what they would do if Accor were start-
ing fresh.
In 1985, when Accor launched Formule 1, a
line of budget hotels, there were two distinct
market segments in the industry. One segment
consisted of no-star and one-star hotels, whose
average price per room was between 60 and 90
French francs. Customers came to those hotels
just for the low price. The other segment was
two-star hotels, with an average price of 200 Fr
per room. Those more expensive hotels at-
tracted customers by offering a better sleeping
environment than the no-star and one-star ho-
tels. People had come to expect that they
would get what they paid for: Either they
would pay more and get a decent night’s sleep,
or they would pay less and put up with poor
beds and noise.
Accor’s managers began by identifying what
customers of all budget hotels—no star, one
star, and two star—wanted: a good night’s
sleep for a low price. Focusing on those widely
shared needs, Accor’s managers saw an oppor-
tunity to overcome the chief compromise that
the industry forced customers to make. They
asked themselves the following four questions:
Which of the factors that our industry takes for
granted should be eliminated? Which factors
should be reduced well below the industry’s
standard? Which factors should be raised well
above the industry’s standard? Which factors
should be created that the industry has never
offered?
The first question forces managers to con-
sider whether the factors that companies
compete on actually deliver value to consum-
ers. Often those factors are taken for granted,
even though they have no value or even de-
tract from value. Sometimes what buyers
value changes fundamentally, but companies
that are focused on benchmarking one an-
other do not act on—or even perceive—the
change. The second question forces managers
to determine whether products and services
have been overdesigned in the race to match
and beat the competition. The third question
pushes managers to uncover and eliminate
the compromises their industry forces cus-
tomers to make. The fourth question helps
managers break out of the industry’s estab-
lished boundaries to discover entirely new
sources of value for consumers.
In answering the questions, Accor came up
with a new concept for a hotel, which led to
the launch of Formule 1. First, the company
eliminated such standard hotel features as
costly restaurants and appealing lounges.
Accor reckoned that even though it might lose
some customers, most people would do with-
out those features.
Accor’s managers believed that budget ho-
tels were overserving customers along other
dimensions as well. On those, Formule 1 offers
less than many no-star hotels do. For exam-
ple, receptionists are on hand only during
peak check-in and checkout hours. At all
other times, customers use an automated
teller. Rooms at a Formule 1 hotel are small
Two Strategic Logics
The Five
Dimensions Conventional Value Innovation
of Strategy Logic Logic
Industry Industry’s conditions are given. Industry’s conditions can be shaped.
assumptions
Strategic A company should build competitive Competition is not the benchmark.
focus advantages. The aim is to beat A company should pursue a quantum
the competition. leap in value to dominate the market.
Customers A company should retain and A value innovator targets the mass of
expand its customer base through buyers and willingly lets some existing
further segmentation and custom- customers go. It focuses on the key
ization. It should focus on the commonalities in what customers value.
differences in what customers value.
Assets and A company should leverage its A company must not be constrained by
capabilities existing assets and capabilities. what it already has. It must ask, What
would we do if we were starting anew?
Product and An industry’s traditional boundaries A value innovator thinks in terms of
service determine the products and services the total solution customers seek, even
offerings a company offers. The goal is to if that takes the company beyond its
maximize the value of those offerings. industry’s traditional offerings. Co
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and equipped only with a bed and the bare
necessities—no stationery, desks, or decora-
tions. Instead of closets and dressers, there are
a few shelves and a pole for clothing in one
corner of the room. The rooms themselves
are modular blocks manufactured in a fac-
tory, a method that results in economies of
scale in production, high quality control, and
good sound insulation.
Formule 1 gives Accor considerable cost ad-
vantages. The company cut in half the average
cost of building a room, and its staff costs
dropped from between 25% and 35% of sales—
the industry average—to between 20% and
23%. Those cost savings have allowed Accor to
improve the features customers value most to
levels beyond those of the average French two-
star hotel, but the price is only marginally
above that of one-star hotels.
Customers have rewarded Accor for its
value innovation. The company has not only
captured the mass of French budget hotel cus-
tomers but also expanded the market. From
truck drivers who previously slept in their vehi-
cles to businesspeople needing a few hours of
rest, new customers have been drawn to the
budget category. Formule 1 made the competi-
tion irrelevant. At last count, Formule 1’s mar-
ket share in France was greater than the sum
of the five next largest players.
The extent of Accor’s departure from the
standard thinking of its industry can be seen in
what we call a value curve—a graphic depic-
tion of a company’s relative performance
across its industry’s key success factors. (See
the exhibit “Formule 1’s Value Curve.”) Accord-
ing to the conventional logic of competition,
an industry’s value curve follows one basic
shape. Rivals try to improve value by offering a
little more for a little less, but most don’t chal-
lenge the shape of the curve.
Like Accor, all the high-performing compa-
nies we studied created fundamentally new
and superior value curves. They achieved that
through a combination of eliminating features,
creating features, and reducing and raising fea-
tures to levels unprecedented in their indus-
tries. Take, for example, SAP, which was started
in the early 1970s by five former IBM employ-
ees in Walldorf, Germany, and became the
worldwide industry leader. Until the 1980s,
business application software makers focused
on subsegmenting the market and customizing
their offerings to meet buyers’ functional
needs, such as production management, logis-
tics, human resources, and payroll.
While most software companies were focus-
ing on improving the performance of particu-
lar application products, SAP took aim at the
mass of buyers. Instead of competing on cus-
tomers’ differences, SAP sought out common-
alities in what customers value. The company
correctly hypothesized that for most custom-
ers, the performance advantages of highly cus-
tomized, individual software modules had
been overestimated. Such modules forfeited
the efficiency and information advantages of
an integrated system, which allows real-time
data exchange across a company.
In 1979, SAP launched R/2, a line of real-
time, integrated business application software
for mainframe computers. R/2 has no restric-
tion on the platform of the host hardware; buy-
ers can capitalize on the best hardware avail-
able and reduce their maintenance costs
dramatically. Most important, R/2 leads to
Ele
m
en
ts
of
pr
od
uc
t o
r s
er
vic
e
Relative level
Eating facilities
Architectural
aesthetics
Lounges
Room size
Availability
of receptionist
Furniture and
amenities in rooms
Bed quality
Hygiene
Room quietness
Price
average
two-star
hotel’s
value
curve
average
one-star
hotel’s
value
curve
Formule 1’s
value
curve
Low High
Formule 1’s Value Curve
Formule 1 offers unprecedented value to the mass of budget hotel cus-
tomers in France by giving them much more of what they need most
and much less of what they are willing to do without.
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huge gains in accuracy and efficiency because
a company needs to enter its data only once.
And R/2 improves the flow of information. A
sales manager, for example, can find out when
a product will be delivered and why it is late by
cross-referencing the production database.
SAP’s growth and profits have exceeded its in-
dustry’s. In 1992, SAP achieved a new value in-
novation with R/3, a line of software for the cli-
ent-server market.
The Trap of Competing, the
Necessity of Repeating
What happens once a company has created a
new value curve? Sooner or later, the competi-
tion tries to imitate it. In many industries,
value innovators do not face a credible chal-
lenge for many years, but in others, rivals ap-
pear more quickly. Eventually, however, a
value innovator will find its growth and profits
under attack. Too often, in an attempt to de-
fend its hard-earned customer base, the com-
pany launches offenses. But the imitators
often persist, and the value innovator—de-
spite its best intentions—may end up in a race
to beat the competition. Obsessed with hang-
ing on to market share, the company may fall
into the trap of conventional strategic logic. If
the company doesn’t find its way out of the
trap, the basic shape of its value curve will
begin to look just like those of its rivals.
Consider this example. When Compaq Com-
puter launched its first personal computer in
1983, most PC buyers were sophisticated corpo-
rate users and technology enthusiasts. IBM
had defined the industry’s value curve. Com-
paq’s first offering—the first IBM-compatible
PC—represented a completely new value
curve. Compaq’s product not only was techno-
logically superb but also was priced roughly
15% below IBM’s. Within three years of its
launch, Compaq joined the
Fortune
500. No
other company had ever achieved that status
as quickly.
How did IBM respond? It tried to match
and beat Compaq’s value curve. And Compaq,
determined to defend itself, became focused
on beating IBM. But while IBM and Compaq
were battling over feature enhancements,
most buyers were becoming more sensitive to
price. User-friendliness was becoming more
important to customers than the latest tech-
nology. Compaq’s focus on competing with
IBM led the company to produce a line of PCs
that were overengineered and overpriced for
most buyers. When IBM walked off the cliff in
the late 1980s, Compaq was following close
behind.
Could Compaq have foreseen the need to
create another value innovation rather than go
head-to-head against IBM? If Compaq had
monitored the industry’s value curves, it would
have realized that by the mid- to late 1980s,
IBM’s and other PC makers’ value curves were
converging with its own. And by the late 1980s,
the curves were nearly identical. That should
have been the signal to Compaq that it was
time for another quantum leap.
Monitoring value curves may also keep a
company from pursuing innovation when
there is still a huge profit stream to be col-
lected from its current offering. In some rap-
idly emerging industries, companies must in-
novate frequently. In many other industries,
companies can harvest their successes for a
long time; a radically different value curve is
difficult for incumbents to imitate, and the vol-
ume advantages that come with value innova-
tion make imitation costly. Kinepolis, Formule
1, and CNN, for example, have enjoyed uncon-
tested dominance for a long time. CNN’s value
innovation was not challenged for almost ten
years. Yet we have seen companies pursue nov-
elty for novelty’s sake, driven by internal pres-
sures to leverage unique competencies or to
apply the latest technology. Value innovation
is about offering unprecedented value, not
technology or competencies. It is not the same
as being first to market.
When a company’s value curve is funda-
mentally different from that of the rest of the
industry—and the difference is valued by most
customers—managers should resist innova-
tion. Instead, companies should embark on
geographic expansion and operational im-
provements to achieve maximum economies
of scale and market coverage. That approach
discourages imitation and allows companies to
tap the potential of their current value innova-
tion. Bert Claeys, for example, has been rapidly
rolling out and improving its Kinepolis concept
with Metropolis, a megaplex in Antwerp, and
with megaplexes in many countries in Europe
and Asia. And Accor has already built more
than 300 Formule 1 hotels across Europe, Af-
rica, and Australia. The company is now target-
ing Asia.
Ironically, even though
value innovators do not
set out to build
advantages over the
competition, they often
end up achieving the
greatest competitive
advantages.
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The Three Platforms
The companies we studied that were most suc-
cessful at repeating value innovation were
those that took advantage of all three platforms
on which value innovation can take place: prod-
uct, service, and delivery. The precise meaning
of the three platforms varies across industries
and companies, but in general, the product
platform is the physical product; the service
platform is support such as maintenance, cus-
tomer service, warranties, and training for dis-
tributors and retailers; and the delivery plat-
form includes logistics and the channel used to
deliver the product to customers.
Too often, managers trying to create a value
innovation focus on the product platform and
ignore the other two elements. Over time, that
approach is not likely to yield many opportuni-
ties for repeated value innovation. As custom-
ers and technologies change, each platform
presents new possibilities. Just as good farmers
rotate their crops, good value innovators rotate
their value platforms. (See the sidebar “Virgin
Atlantic: Flying in the Face of Conventional
Logic.”)
The story of Compaq’s server business,
which was part of the company’s successful
comeback, illustrates how the three platforms
can be used alternately over time to create
new value curves. (See the exhibit “How Has
Compaq Stayed on Top of the Server Indus-
try?”) In late 1989, Compaq introduced its first
server, the SystemPro, which was designed to
run five network operating systems—SCO
UNIX, OS/2, Vines, NetWare, and DOS—and
many application programs. Like the System-
Pro, most servers could handle many operating
systems and application programs. Compaq ob-
served, however, that the majority of custom-
ers used only a small fraction of a server’s ca-
pacity. After identifying the needs that cut
across the mass of users, Compaq decided to
build a radically simplified server that would
be optimized to run NetWare and file and
print only. Launched in 1992, the ProSignia
was a value innovation on the product plat-
form. The new server gave buyers twice the
SystemPro’s file-and-print performance at one-
third the price. Compaq achieved that value in-
novation mainly by reducing general applica-
tion compatibility—a reduction that translated
into much lower manufacturing costs.
As competitors tried to imitate the Pro-
Signia and value curves in the industry began
Virgin Atlantic: Flying in the Face of Conventional Logic
When Virgin Atlantic Airways challenged its
industry’s conventional logic by eliminating
first-class service in 1984, the airline was sim-
ply following the logic of value innovation.
Most of the industry’s profitable revenue
came from business class, not first class. And
first class was a big cost generator. Virgin
spotted an opportunity. The airline decided
to channel the cost it would save by cutting
first-class service into value innovation for
business-class passengers.
First, Virgin introduced large, reclining
sleeper seats, raising seat comfort in business
class well above the industry’s standard. Sec-
ond, Virgin offered free transportation to and
from the airport—initially in chauffeured
limousines and later in specially designed
motorcycles called LimoBikes—to speed busi-
ness-class passengers through snarled city
traffic.
With those innovations, which were on the
product and service platforms, Virgin at-
tracted not only a large share of the indus-
try’s business-class customers but also some
full economy fare and first-class passengers of
other airlines. Virgin’s value innovation sepa-
rated the company from the pack for many
years, but the competition did not stand still.
As the value curves of some other airlines
began converging with Virgin’s value curve,
the company went for another leap in value,
this time from the service platform.
Virgin observed that most business-class
passengers want to use their time produc-
tively before and between flights and that,
after long-haul flights, they want to freshen
up and change their wrinkled clothes before
going to meetings. The airline designed
lounges where passengers can take showers,
have their clothes pressed, enjoy massages,
and use state-of-the-art office equipment.
The service allows busy executives to make
good use of their time and go directly to
meetings without first stopping at their ho-
tels—a tremendous value for customers that
generates high volume for Virgin. The air-
line has one of the highest sales per em-
ployee in the industry, and its costs per pas-
senger mile are among the lowest. The
economics of value innovation create a posi-
tive and reinforcing cycle.
When Virgin first challenged the industry’s
assumptions, its ideas were met with a great
deal of skepticism. After all, conventional wis-
dom says that in order to grow, a company
must embrace more, not fewer, market seg-
ments. But Virgin deliberately walked away
from the revenue generated by first-class pas-
sengers. And it further rejected conventional
wisdom by conceiving of its business in
terms of customer solutions, even if that took
the company well beyond an airline’s tradi-
tional offerings. Virgin has applied the logic
of value innovation not just to the airline in-
dustry but also to insurance, music, and en-
tertainment retailing. The company has al-
ways done more than leverage its existing
assets and capabilities. It has been a consis-
tent value innovator.
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to converge, Compaq took another leap, this
time from the service platform. Viewing its
servers not as stand-alone products but as ele-
ments of its customers’ total computing needs,
Compaq saw that 90% of customers’ costs were
in servicing networks and only 10% were in the
server hardware itself. Yet Compaq, like other
companies in the industry, had been focusing
on maximizing the price/performance ratio of
the server hardware, the least costly element
for buyers.
Compaq redeployed its resources to bring
out the ProLiant 1000, a server that incorpo-
rates two innovative pieces of software. The
first, SmartStart, configures server hardware
and network information to suit a company’s
operating system and application programs. It
slashes the time it takes a customer to config-
ure a server network and makes installation
virtually error free so that servers perform reli-
ably from day one. The second piece of soft-
ware, Insight Manager, helps customers man-
age their server networks by, for example,
spotting overheating boards or troubled disk
drives before they break down.
By innovating on the service platform, Com-
paq created a superior value curve and ex-
panded its market. Companies lacking exper-
tise in information technology had been
skeptical of their ability to configure and man-
age a network server. SmartStart and Insight
Manager helped put those companies at ease.
The ProLiant 1000 came out a winner.
As more and more companies acquired serv-
ers, Compaq observed that its customers often
lacked the space to store the equipment prop-
erly. Stuffed into closets or left on the floor
with tangled wires, expensive servers were
often damaged, were certainly not secure, and
were difficult to service.
By focusing on customer value—not on
competitors—Compaq saw that it was time for
another value innovation on the product plat-
form. The company introduced the ProLiant
1000 rack-mountable server, which allows com-
panies to store servers in a tall, lean cabinet in
a central location. The product makes efficient
use of space and ensures that machines are
protected and are easy to monitor, repair, and
enhance. Compaq designed the rack mount to
fit both its products and those of other manu-
facturers, thus attracting even more buyers and
discouraging imitation. The company’s sales
and profits rose again as its new value curve di-
verged from the industry’s.
Compaq is now looking to the delivery plat-
form for a value innovation that will dramati-
cally reduce the lead time between a customer’s
order and the arrival of the equipment. Lead
times have forced customers to forecast their
needs—a difficult task—and have often re-
quired them to patch together costly solutions
while waiting for their orders to be filled. Now
that servers are widely used and the demands
placed on them are multiplying rapidly, Com-
paq believes that shorter lead times will provide
a quantum leap in value for customers. The
company is currently working on a delivery op-
tion that will permit its products to be built to
customers’ specifications and shipped within 48
hours of the order. That value innovation will
allow Compaq to reduce its inventory costs and
minimize the accumulation of outdated stock.
By achieving value innovations on all three
platforms, Compaq has been able to maintain
a gap between its value curve and those of
other players. Despite the pace of competition
in its industry, Compaq’s repeated value inno-
vations are allowing the company to remain
the number one maker of servers worldwide.
Since the company’s turnaround, overall sales
and profits have almost quadrupled.
By following its first value innovation… …with another …and then another.
Reliability
El
em
en
ts
o
f p
ro
du
ct
o
r s
er
vi
ce
Configurability
Manageability
Expandability
General application
compatibility
File and print
compatibility
Performance
Price
Storability
Serviceability
Security
low � high low � high low � high
Relative Level
1989:
SystemPro
1992:
ProSignia
1993:
ProLiant 1000
1993:
ProLiant 1000
Feature
innovations
Feature
innovations
1992:
ProSignia
1994:
ProLiant 1000
rack-mountable
server
How Has Compaq Stayed on Top of the Server Industry?
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Value Innovation
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harvard business review • top-line growth • july–august 2004 page 10
Driving a Company for High Growth
One of the most striking findings of our re-
search is that despite the profound impact of a
company’s strategic logic, that logic is often
not articulated. And because it goes unstated
and unexamined, a company does not neces-
sarily apply a consistent strategic logic across
its businesses.
How can senior executives promote value
innovation? First, they must identify and artic-
ulate the company’s prevailing strategic logic.
Then they must challenge it. They must stop
and think about the industry’s assumptions,
the company’s strategic focus, and the ap-
proaches—to customers, assets and capabili-
ties, and product and service offerings—that
are taken as given. Having reframed the com-
pany’s strategic logic around value innovation,
senior executives must ask the four questions
that translate that thinking into a new value
curve: Which of the factors that our industry
takes for granted should be eliminated? Which
factors should be reduced well below the in-
dustry’s standard? Which should be raised well
above the industry’s standard? Which factors
should be created that the industry has never
offered? Asking the full set of questions—
rather than singling out one or two—is neces-
sary for profitable growth. Value innovation is
the simultaneous pursuit of radically superior
value for buyers and lower costs for companies.
For managers of diversified corporations,
the logic of value innovation can be used to
identify the most promising possibilities for
growth across a portfolio of businesses. The
value innovators we studied all have been pio-
neers in their industries, not necessarily in de-
veloping new technologies but in pushing the
value they offer customers to new frontiers. Ex-
tending the pioneer metaphor can provide a
useful way of talking about the growth poten-
tial of current and future businesses.
A company’s pioneers are the businesses
that offer unprecedented value. They are the
most powerful sources of profitable growth. At
the other extreme are settlers—businesses
with value curves that conform to the basic
shape of the industry’s. Settlers will not gener-
ally contribute much to a company’s growth.
The potential of migrators lies somewhere in
between. Such businesses extend the industry’s
curve by giving customers more for less, but
they don’t alter its basic shape.
A useful exercise for a management team
pursuing growth is to plot the company’s
current and planned portfolios on a pioneer-
migrator-settler map. (See the exhibit “Testing
the Growth Potential of a Portfolio of Busi-
nesses.”) If both the current portfolio and the
planned offerings consist mainly of settlers, the
company has a low growth trajectory and
needs to push for value innovation. The com-
pany may well have fallen into the trap of com-
peting. If current and planned offerings consist
of a lot of migrators, reasonable growth can be
expected. But the company is not exploiting its
potential for growth and risks being marginal-
ized by a value innovator. This exercise is espe-
cially valuable for managers who want to see
beyond today’s performance numbers. Reve-
nue, profitability, market share, and customer
satisfaction are all measures of a company’s
current position. Contrary to what conven-
tional strategic thinking suggests, those mea-
sures cannot point the way to the future. The
pioneer-migrator-settler map can help a com-
pany predict and plan future growth and
profit, a task that is especially difficult—and
crucial—in a fast-changing economy.
Reprint R0407P
Harvard Business Review
OnPoint 7251
To order, see the next page
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Current portfolio Planned portfolio
High growth
trajectory
Pioneers
Businesses
that represent
value innovations
Migrators
Businesses
with value
improvements
Settlers
Businesses that
offer me-too
products and
services
Testing the Growth Potential
of a Portfolio of Businesses
Co
py
rig
ht
©
2
00
4
H
ar
va
rd
B
us
in
es
s
Sc
ho
ol
Pu
bl
is
hi
ng
C
or
po
ra
tio
n.
A
ll
rig
ht
s
re
se
rv
ed
.
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FOR DISCLOSURES AND OTHER IMPORTANT INFORMATION, PLEASE REFER TO THE BACK OF THIS REPORT.
November 1, 2016
GLOBAL FINANCIAL STRATEGIES
www.credit-suisse.com
Measuring the Moat
Assessing the Magnitude and Sustainability of Value Creation
Authors
Michael J. Mauboussin
michael.mauboussin@credit-suisse.com
Dan Callahan, CFA
daniel.callahan@credit-suisse.com
Darius Majd
darius.majd@credit-suisse.com
“The most important thing to me is figuring out how big a moat there is around
the business. What I love, of course, is a big castle and a big moat with piranhas
and crocodiles.”
Warren E. Buffett
Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994
Sustainable value creation is of prime interest to investors who seek to
anticipate expectations revisions.
This report develops a systematic framework to determine the size of a
company’s moat.
We cover industry analysis, firm-specific analysis, and firm interaction.
mailto:michael.mauboussin@credit-suisse.com
mailto:daniel.callahan@credit-suisse.com
mailto:darius.majd@credit-suisse.com
November 1, 2016
Measuring the Moat 2
Table of Contents
Executive Summary ……………………………………………………………………………………………………………….. 3
Introduction ………………………………………………………………………………………………………………………….. 4
Competitive Life Cycle ………………………………………………………………………………………………….. 4
Economic Moats …………………………………………………………………………………………………………. 7
What Dictates a Company’s Destiny? ………………………………………………………………………………. 8
Industry Analysis ………………………………………………………………………………………………………………….. 10
The Lay of the Land …………………………………………………………………………………………………… 11
Industry Map ………………………………………………………………………………………………….. 11
Profit Pool …………………………………………………………………………………………………….. 13
Industry Stability ……………………………………………………………………………………………… 15
Industry Classification ………………………………………………………………………………………. 17
Industry Structure – Five Forces Analysis ………………………………………………………………………… 18
Entry and Exit ………………………………………………………………………………………………… 19
Competitive Rivalry ………………………………………………………………………………………….. 25
Disruption and Disintegration ……………………………………………………………………………………….. 27
Firm-Specific Analysis …………………………………………………………………………………………………………… 32
A Framework for Added-Value Analysis ………………………………………………………………………….. 32
Value Chain ……………………………………………………………………………………………………………… 33
Sources of Added Value ……………………………………………………………………………………………… 34
Production Advantages …………………………………………………………………………………….. 34
Consumer Advantages ……………………………………………………………………………………… 38
Government …………………………………………………………………………………………………… 41
Firm Interaction – Competition and Cooperation ………………………………………………………………………….. 42
Brands ………………………………………………………………………………………………………………………………. 46
Management Skill and Luck ……………………………………………………………………………………………………. 48
Regression Toward the Mean …………………………………………………………………………………………………. 50
Bringing It All Back Together ………………………………………………………………………………………………….. 51
Warren Buffett on Economic Moats ………………………………………………………………………………………….. 52
Appendix A: Checklist for Assessing Value Creation …………………………………………………………………….. 53
Appendix B: Profit Pool Analysis for Health Care …………………………………………………………………………. 55
Endnotes …………………………………………………………………………………………………………………………… 59
References ………………………………………………………………………………………………………………………… 65
Books …………………………………………………………………………………………………………………….. 65
Articles and Papers ……………………………………………………………………………………………………. 69
November 1, 2016
Measuring the Moat 3
Executive Summary
Sustainable value creation has two dimensions: the magnitude of the spread between a company’s return
on invested capital and the cost of capital and how long it can maintain a positive spread. Both
dimensions are of prime interest to investors and corporate executives.
Sustainable value creation as the result solely of managerial skill is rare. Competitive forces and
endogenous variance drive returns toward the cost of capital. Investors should be careful about how
much they pay for future value creation.
Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable
value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that
he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never
stable. Because of competition, they are getting a little bit wider or narrower every day. This report
develops a systematic framework to determine
the size of a company’s moat.
Companies and investors use competitive strategy analysis for two very different purposes. Companies
try to generate returns in excess of the cost of capital, while investors try to anticipate revisions in
expectations for financial performance. If a company’s share price already captures its prospects for
sustainable value creation, investors should expect to earn a market rate of return, adjusted for risk.
Industry effects are the most important in the sustainability of high performance and a close second in
the emergence of high performance. However, industry effects are much smaller than firm-specific
factors for low performers. For companies that are below average, strategies and resources explain
90 percent or more of their returns.
The industry is the correct place to start an analysis of sustainable value creation. We recommend
understanding the lay of the land, which includes getting a grasp of the participants and how they interact,
an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the
five forces and a discussion of the disruptive innovation framework.
A clear understanding of how a company creates shareholder value is core to understanding sustainable
value creation. We define three broad sources of added value: production advantages, consumer
advantages, and external
advantages.
How firms interact plays a vital role in shaping sustainable value creation. We consider interaction through
game theory, co-opetition, and co-evolution.
Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific
job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase
customer willingness to pay or if they reduce the cost to provide the good or
service
.
Regression toward the mean is a powerful force. Empirical results show which industries regress at the
fastest rate, providing a useful quantitative complement to the qualitative assessment here.
Appendix A provides a complete checklist of questions to guide the strategic analysis.
November 1, 2016
Measuring the Moat 4
Introduction
Corporate managers seek to allocate resources so as to generate attractive long-term returns on investment.
Investors search for stocks of companies that are mispriced relative to expectations for financial results
embedded in the shares. In both cases, sustainable value creation is of prime interest.
What exactly is sustainable value creation? We can think of it in two dimensions. First is the magnitude of
returns in excess of the cost of capital that a company does, or will, generate. Magnitude considers not only
the return on investment but also how much a company can invest at a rate above the cost of capital. Growth
only creates value when a company generates returns on investment that exceed the cost of capital.
The second dimension of sustainable value creation is how long a company can earn returns in excess of the
cost of capital. This concept is also known as fade rate, competitive advantage period (CAP), value growth
duration, and T.1 Despite the unquestionable significance of the longevity dimension, researchers and
investors give it insufficient attention.
How is sustainable value creation distinct from the more popular notion of sustainable competitive advantage?
A company must have two characteristics to claim that it has a competitive advantage. The first is that it must
generate, or have an ability to generate, returns in excess of the cost of capital. Second, the company must
earn an economic return that is higher than the average of its competitors.2
As our focus is on sustainable value creation, we want to understand a company’s economic performance
relative to the cost of capital, not relative to its competitors. Naturally, these concepts are closely linked.
Sustainable value creation is rare, and sustainable competitive advantage is even rarer.
Competitive Life Cycle
We can visualize sustainable value creation by looking at a company’s competitive life cycle. (See Exhibit 1.)
Companies are generally in one of four phases:
Innovation. Young companies typically realize a rapid rise in return on investment and significant
investment opportunities. Substantial entry into and exit out of the industry are common at this point in
the life cycle.
Fading returns. High returns attract competition, generally causing economic returns to move toward
the cost of capital. In this phase, companies still earn excess returns, but the return trajectory is down.
Investment needs also moderate, and the rate of entry and exit slows.
Mature. In this phase, the market in which the companies compete approaches competitive equilibrium.
As a result, companies earn a return on investment similar to the industry average, and competition within
the industry ensures that aggregate returns are no higher. Investment needs continue to moderate.
Subpar. Competitive forces and technological change can drive returns below the cost of capital,
requiring companies to restructure. These companies can improve returns by shedding assets, shifting
their business model, reducing investment levels, or putting themselves up for sale. Alternatively, these
firms can file for bankruptcy to reorganize the business or liquidate the firm’s assets.
November 1, 2016
Measuring the Moat 5
Exhibit 1: A Firm’s Competitive Life Cycle
Source: Credit Suisse HOLT®.
Regression toward the mean says that an outcome that is far from average will be followed by an outcome
that has an expected value closer to the average. There are two explanations for regression toward the mean
in corporate performance. The first is purely statistical. If the correlation between cash flow return on
investment (CFROI®
) in two consecutive years is not perfect, there is regression toward the mean.
Think of it this way: there are aspects of running the business within management’s control, including
selecting the product markets it chooses to compete in, pricing, investment spending, and overall execution.
Call that skill. There are also aspects of the business that are beyond management’s control, such as
macroeconomic developments, customer reactions, and technological change. Call that luck. Whenever luck
contributes to outcomes, there is regression toward the mean. If year-to-year CFROIs are highly correlated,
regression toward the mean happens slowly. If CFROIs are volatile, causing the correlation to be low,
regression toward the mean is rapid.
The second explanation for regression toward the mean is that competition drives a company’s return on
investment toward the opportunity cost of capital. This is based on microeconomic theory and is intuitive. The
idea is that companies that generate a high economic return will attract competitors willing to take a lesser,
albeit still attractive, return. Ultimately, this process drives industry returns toward the opportunity cost of
capital. Researchers have documented the accuracy of this prediction.3 Companies must find a way to defy
these powerful competitive forces in order to achieve sustainable value creation.
Recent research on the rate of regression reveals some important observations. First, the time that an average
company can sustain excess returns is shrinking. This phenomenon is not relegated to high technology but is
evident across a wide range of industries.4 This reduction in the period of sustained value creation reflects the
greater pace of innovation brought about in part by increased access to, and utilization of, information
technology.
CFROI
®
is a registered trademark in the United States and other countries (excluding the United Kingdom) of Credit Suisse
Group AG or its affiliates.
Above-
Averag
e
but Fading
Returns
Below-Average
Returns
Average
Returns
High Innovation Fading Returns Mature Needs Restructuring
Econom
ic
Return
Discount Rate
(Required
Rate of Return
)
Reinvestment
Rates
November 1, 2016
Measuring the Moat 6
Second, the absolute level of returns and the level of investment are positively related to the rate of fade.5 A
company that generates a high return on investment while investing heavily signals an attractive opportunity to
both existing and potential competitors. Success sows the seeds of competition.
Why is sustainable value creation so important for investors? To start, investors pay for value creation. Exhibit
2 looks at the S&P 500 since 1961 and provides a proxy for how much value creation investors have been
willing to pay for. We establish a steady-state value by capitalizing the last four quarters of operating net
income for the S&P 500 by an estimate of the cost of equity capital.6 We then attribute any value above the
steady-state to expected value creation.
The exhibit shows that 40 percent of the value of the S&P 500 today reflects anticipated value creation,
above the average of the last 55 years. Following a sharp drop in 2011 to a level near a 50-year low, the
expectations for value creation have risen to a level modestly above the long-term average.
Exhibit 2: Rolling Four Quarter Anticipated Value Creation, 1961-2017E
Source: Standard & Poor’s, Aswath Damodaran, Credit Suisse.
Note: As of November 1, 2016.
More significant, sustained value creation is an important source of expectations revisions. There is a crucial
distinction between product markets and capital markets. Companies try to understand the industry and
competitive landscape in their product markets so as to allocate resources in a way that maximizes long-term
economic profit. Investors seek to understand whether today’s price properly reflects the future and whether
expectations are likely to be revised up or down.
Companies and investors use competitive strategy analysis for two very different purposes. Companies try to
generate returns above the cost of capital, while investors try to anticipate revisions in expectations. Investors
-2
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November 1, 2016
Measuring the Moat 7
should anticipate earning a market return, adjusted for risk, if a company’s share price already captures its
prospects for sustainable value creation. But companies that can create value longer than the market expects
generate excess returns with volatility that is lower than expected.7
We will spend most of our time trying to understand how and why companies attain sustainable value creation
in product markets. But we should never lose sight of the fact that our goal as investors is to anticipate
revisions in expectations. Exhibit 3 shows the process and emphasizes the goal of finding and exploiting
expectations mismatches.
Exhibit 3: The Link between Market Expectations and Competitive Strategy
Source: Credit Suisse.
Economic Moats
Warren Buffett, the chairman of Berkshire Hathaway, has emphasized over the years that he looks for
businesses with sustainable competitive advantages. He suggests that buying a business is akin to buying a
castle surrounded by a moat. Buffett wants the economic moat to be deep and wide to fend off all
competition. He goes a step further by noting that economic moats are almost never stable. Moats either get
a little bit wider or a little bit narrower every day.8 This report develops a systematic framework to determine
the size of a company’s moat.
Market-Implied
Expectations
for Value Creation
Industry
Analysis
Firm-Specific
Analysis
Potential for
Expectations Revisions
November 1, 2016
Measuring the Moat 8
What Dictates a Company’s Destiny?
Peter Lynch, who skillfully ran Fidelity’s Magellan mutual fund for more than a decade, quipped that investors
are well advised to buy a business that’s so good that an idiot can run it, because sooner or later an idiot will
run it.9 Lynch’s comment introduces an important question: What dictates a firm’s economic returns? We are
not asking what determines a company’s share price performance, which is a function of expectations
revisions, but rather its economic profitability.10
Before we answer the question, we can make some empirical observations. The top panel of Exhibit 4 shows
the spread between CFROI and the cost of capital for 68 global industries, as defined by MSCI’s Global
Industry Classification Standard (GICS), using median returns over the past five fiscal years. The sample
includes more than 10,000 public companies. We see that some industries have positive economic return
spreads, some are neutral, and some don’t earn the cost of capital.
Exhibit 4: Industry Returns Vary from Value-Creating to Value-Destroying
Source: Credit Suisse HOLT.
Note: Data through latest fiscal year as of 10/25/16.
The bottom panel of Exhibit 4 shows the spread between CFROI and the cost of capital for the companies in
three industries: one that creates value, one that is value neutral, and one that destroys value. The central
observation is that even the best industries include companies that destroy value and the worst industries have
companies that create value. That some companies buck the economics of their industry provides insight into
the potential sources of economic performance. Industry is not destiny.
Finding a company in an industry with high returns or avoiding a company in an industry with low returns is not
enough. Finding a good business capable of sustaining high performance requires a thorough understanding
of the conditions for the industry and the firm.
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Marine
November 1, 2016
Measuring the Moat 9
A final word before we proceed. Our unit of analysis will be the firm. In most cases, the proper unit of analysis
is the strategic business unit. This is especially true for multidivisional companies that compete in disparate
industries. The following framework is applicable on a divisional level. So we recommend conducting the
analysis for each strategic business unit of a multidivisional company and aggregating the results.
November 1, 2016
Measuring the Moat 10
Industry Analysis
We have established that industry effects and firm effects are relevant in understanding corporate
performance. The question is in what proportion.11
Anita McGahan and Michael Porter, two prominent scholars of business strategy, analyzed roughly 58,000
firm-year observations for U.S. businesses from 1981-1994.12 They assessed the impact of four factors on
the sustainability and emergence of abnormal profitability:
Year. The year effect captures the economic cycle. You can think of it as the macroeconomic factors that
influence all businesses in the economy.
Industry. Industry effects refer to how being part of a particular industry affects firm performance. A firm
may benefit from industry effects if the industry has an attractive structure, including high barriers to entry.
Corporate-parent. A corporate-parent effect arises when a business within a diversified firm on average
underperforms or outperforms its industry. For example, the corporate-parent effect was positive for Taco
Bell, which saw its profitability improve in the 1980s following its acquisition by PepsiCo.
Segment-specific. This effect captures the characteristics unique to a firm that drive its performance
relative to rivals within the same industry. Such characteristics may include a firm’s resources, positioning,
or how effectively its managers execute strategy.
Exhibit 5 summarizes McGahan and Porter’s results. They define sustainability of profits as “the tendency of
abnormally high or low profits to continue in subsequent periods.” Emergence looks backward from the current
year and measures the contributions to abnormal profits through time. High performers are those companies
that generate profits in excess of the median of their industry, and low performers are those below the median.
Exhibit 5: Importance of Various Factors on Abnormal Profitability
Source: Anita M. McGahan and Michael E. Porter, “The emergence and sustainability of abnormal profits,” Strategic Organization, Vol. 1, No. 1,
February 2003, 79-108.
McGahan and Porter found that industry effects are most important in the sustainability of high performance
and a close second in the emergence of high performance behind segment-specific effects. However,
industry effects are much smaller than segment-specific effects for low performers. The strategies and
resources of below-average companies explain 90 percent or more of their returns in the case of either
sustainability or emergence. Business managers and analysts searching for emerging or sustained competitive
advantages might also note that the economic cycle is not important to the sustainability or emergence of
performance.
High Performers Low Performers High Performers Low Performers
Year 3% -7% 2% -5%
Industry 44% 12% 37% 13%
Corporate-Parent 19% -4% 18% 2%
Segment-Specific 34% 99% 43%
90%
EmergenceSustainability
November 1, 2016
Measuring the Moat 11
We break the industry analysis into three parts:
1. Get the lay of the land. This includes creating an industry map to understand the competitive landscape,
constructing profit pools to see how the distribution of economic profits has changed over time,
measuring industry stability, and classifying the industry so as to improve alertness to the main issues and
opportunities.
2. Assess industry attractiveness through an analysis of the five forces. Of the five forces, we spend
the bulk of our time assessing barriers to entry and rivalry.
3. Consider the likelihood of being disrupted by innovation. We consider the role of disruptive
innovation and why industries transition from vertical to horizontal integration.
The
Lay of the Land
Industry Map
Creating an industry map is a useful way to start competitive analysis.13 A map should include all the
companies and constituents that might have an impact on a company’s profitability. The goal of an industry
map is to understand the current and potential interactions that ultimately shape the sustainable value creation
prospects for the whole industry as well as for the individual companies within the industry.
From an industry point of view, you can think of three types of interactions: supplier (how much it will cost to
get inputs), customer (how much someone is willing to pay for a good or service), and external (other factors
that come into play, such as government action). Exhibit 6 shows an illustration for the U.S. airline industry.
Clients can create industry maps for specific companies using Credit Suisse’s PEERs tool, which analyzes a
company’s supply chain. Peers can be accessed within RAVE, Credit Suisse’s research database, which also
provides access to the forecasts of Credit Suisse analysts and a variety of other tools.
Here are some points to bear in mind as you develop an industry map:
List firms in order of dominance, typically defined as size or market share;
Consider potential new entrants as well as existing players;
Understand the nature of the economic interaction between the firms (e.g., incentives, payment terms);
Evaluate any other factors that might influence profitability (e.g., labor, regulations).
A study by Lauren Cohen and Andrea Frazzini, professors of finance, suggests that investors may benefit from
paying close attention to industry maps. The researchers examined how shocks to one firm rippled through to
other firms via supply or demand links. They tested whether the market adequately incorporated the
information that one firm released into the stock prices of its partner firms. They found that investors fail to
adequately incorporate such information, creating a profitable trading strategy.
Cohen and Frazzini state that “the monthly strategy of buying firms whose customers had the most positive
returns in the previous month, and selling short firms whose customers had the most negative returns, yields
abnormal returns of 1.55% per month, or an annualized return of 18.6% per year.” There is also evidence that
analysts who cover both suppliers and customers provide more accurate earnings forecasts.14
November 1, 2016
Measuring the Moat 12
Exhibit 6: U.S. Airline Industry Map
Source: Credit Suisse.
Note: LCC = low-cost carrier.
Airlines
American (hub)
United Continental (hub)
Delta (hub)
Southwest (LCC)
JetBlue
(LCC)
Alaska Air (hub)
SkyWest (regional)
Spirit (LCC)
Hawaiian Holdings (regional)
Virgin America (LCC)
Allegiant Travel (LCC)
Republic Airways (mix)
Frontier (LCC)
Aircraft
Boeing
Airbus
Bombardier
AVIC
Embraer
Parts suppliers
Engines
General Electric
Pratt & Whitney (UTX)
Rolls-Royce
Other
UTC Aerospace (UTX)
Honeywel
l
General Dynamics
Textron
Precision Castparts
Spirit AeroSystems
Rockwell Collins
Parker-Hannifin
L-3 Communications
Triumph Group
B/E Aerospace
Moog
CAE
TransDigm
Hexcel
Heico
Air freight and logistics
UPS
FedEx
C.H. Robinson
UTi Worldwide
Expeditors
Echo Global Logistics
Forward Air
Global distribution systems
Sabre
Amadeus
TravelportAirports
Gates, takeoff/landing slots
Financing
Leasing, banks, investors
Labor
Cabin crew, pilots
Ground staff, other
services
External providers
Atlas Air
Air Transport Services Group
Unions
Jet fuel
Government
Regulation
Mandated services (e.g.,
security, air traffic control)
Fliers
Commercial
Business
Travel intermediaries
Travel agents
Corporate travel departments
Website aggregators
Priceline.com
Expedia
Orbitz
TripAdvisor
November 1, 2016
Measuring the Moat 13
Profit Pool
The next step is to construct a profit pool.15 A profit pool shows the distribution of an industry’s value creation
at a point in time. The horizontal axis measures size, typically invested capital or sales as a percentage of the
industry, and the vertical axis measures economic profitability (e.g., CFROI minus the discount rate). As a
result, the area of each rectangle—the product of invested capital and economic return—is the total value
added for that sector or company. For example, a company that has $200 million of invested capital and a
spread of 5 percentage points between its CFROI and discount rate generates $10 million in economic profit
($10 million = $200 million x .05). The total profit pool of the industry is the sum of the added value for all of
the companies.
To understand the overall profitability of an industry, it is useful to analyze the average profitability over a full
business cycle, which is generally three to five years.16 But average profitability doesn’t reveal how value has
migrated over time. Profit pools are particularly effective because they allow you to trace the increases or
decreases in the components of the value-added pie. One effective approach is to construct a profit pool for
today, five years ago, and ten years ago and then compare the results over time.
Exhibit 7 is a profit pool for the airlines industry. (See Appendix B for the health care sector.) It shows the
main components in the industry’s value chain including airlines, airports, and a variety of services. You can
see from the horizontal axis that airlines and airports use the majority of the capital invested in the industry.
These are also the businesses with among the lowest economic returns, which the vertical axis reflects.
Some businesses generate strong returns, including computer reservations systems (CRS), travel agents,
freight forwarders, and various service jobs. But with so little capital invested, they are too small to offset the
value destruction from airlines and airports. As a consequence, the industry as a whole destroyed an average
of $17 billion of shareholder capital per year through the 2004-11 business cycle, according to the
International Air Transport Association.17
Exhibit 7: Airline Industry Profit Pool by Activity, 2004-2011
Source: Based on IATA, “Profitability and the air transport value chain,” IATA Economics Briefing No. 10, June 2013, 19-20.
CRS = computer reservations systems; ANSP = air navigation service provider.
-10
-5
0
5
10
15
20
25
30
35
40
R
O
IC
–
W
A
C
C
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
Airlines
Manufacturers
ANSPs
Airports
Freight
forwarders
100%
Maintenance
Lessors
Ground
services
CRS
Travel agents
C
a
te
ri
n
g
November 1, 2016
Measuring the Moat 14
We can also construct a profit pool of the leading companies within an industry. Exhibit 8 shows profit pools
for the U.S. airline companies for 2005, 2010, and 2015. The horizontal axis represents 100 percent of the
capital invested in the industry by public companies. These charts provide a bottom-up view of the industry’s
migration from value destruction to value creation.
Exhibit 8: Airline Industry Profit Pools by Company, 2005-2015
Source: Credit Suisse HOLT.
-6
–
4
-2
0
2
4
6
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2005
American
Alaska
Other
United
South-
west
US Air
100%
Continental
JetBlue
-6
-4
-2
0
2
4
6
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2010
American
Alaska
Other
United Continental
South-
west
US Air
100%
Del
ta
JetBlue
-6
-4
-2
0
2
4
6
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2015
American
Alaska
Other
United Continental
South-
west
100%
Delta
JetBlue
November 1, 2016
Measuring the Moat 15
Most airlines destroyed value over the first half of the decade, consistent with the industry’s history of weak
returns on capital as the result of low barriers to entry and high fixed costs. Even the low-cost, point-to-point
carriers struggled despite a history of outperforming the legacy carriers. But the performance of all the major
airlines improved considerably in recent years, with the six largest companies earning above their cost of
capital by 2015. Factors that drove the improvement include a sharp decline in the price of oil, better capacity
utilization, and extensive consolidation following a slew of bankruptcies.18 The x-axis shows that the top four
carriers increased their market share from roughly 70 percent in 2005 to 80 percent in 2015.
Industry Stability
Industry stability is another important metric. Generally speaking, stable industries are more conducive to
sustainable value creation. Unstable industries present substantial competitive challenges and opportunities.
The value migration in unstable industries is greater than that of stable industries, making sustainable value
creation that much more elusive.
We can measure industry stability a couple of ways. One simple but useful proxy is the steadiness of market
share. This analysis looks at the absolute change in market share for the companies within an industry over
some period. (We typically use five years.) We then add up the absolute changes and divide the sum by the
number of competitors. The lower the average absolute change in market share, the more stable the industry.
Exhibit 9 shows the market share stability for four industries. There is relative stability in automobile
manufacturing, while personal computers and mobile phones show moderate change, and there is substantial
change in the smartphone market. Our rule of thumb is that absolute average changes of 2.0 or less over five
years constitute a stable industry.
November 1, 2016
Measuring the Moat 16
Exhibit 9: Market Share Stability, 2010-2015
Source: Company data, Gartner, Nielsen, Credit Suisse.
Another way to measure industry stability is the trend in pricing. Price changes reflect a host of factors,
including cost structure (fixed versus variable), entry and exit dynamics, macroeconomic variables,
technological change (e.g., Moore’s Law and Wright’s Law), and rivalry. All else being equal, more stable
pricing reflects more stable industries. Warren Buffett places special emphasis on pricing power. He said,
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise
prices without losing business to a competitor, you’ve got a very good business. And if you have to have a
prayer session before raising the price 10 percent, then you’ve got a terrible business.”19 Exhibit 10 shows the
pricing trends for a variety of industries, classified as slow-, medium-, and fast-cycle businesses. Sustaining
value creation in a fast-cycle industry is a challenge.
Auto Manufacturers (U.S. Market) 2010 2015 5-Year Change
General Motors 19% 18% 2%
Ford Motor Company 17% 15% 2%
Toyota Motor Corporation 15% 14% 1%
Honda Motor Company 11% 9% 2%
Chrysler Group/FCA 9% 13% 3%
Nissan Motor Company 8% 9% 1%
Hyundai-Kia 8% 8% 0%
Volkswagen Group 3% 3% 0%
BMW-Mini 2% 2% 0%
Subaru 2% 3% 1%
Mazda 2% 2% 0%
Daimler 2% 2% 0%
Other 2% 2% 1%
Total 100% 100%
Average Absolute Change 1%
Personal Computers (Global by Units) 2010 2015 5-Year Change
Others 48% 52% 4%
Hewlett-Packard 16% 13% 3%
Acer Group 12% 5% 7%
Dell Inc 11% 10% 1%
Lenovo Group 9% 14%
6%
Asus 5% 5% 1%
Total 100% 100%
Average Absolute Change 3%
Mobile Phones (Global) 2010 2015 5-Year Change
Other 40% 49% 9%
Nokia/Microsoft 29% 7% 22%
Samsung 18% 21% 3%
LG Electronics 7% 4% 3%
Apple 3% 11%
8%
ZTE 2% 3% 1%
Huawei 2% 5% 4%
Total 100% 100%
Average Absolute Change 7%
Smartphones (Global) 2010 2015 5-Year Change
Nokia 34% 0% 34%
Other 27% 48% 21%
Research in Motion 17% 0%
16%
Apple 15% 16% 1%
Samsung 7% 23% 16%
Huawei 0% 7% 7%
Xiaomi 0% 5% 5%
Total 100% 100%
Average Absolute Change 14%
November 1, 2016
Measuring the Moat 17
Exhibit 10: Pricing Stability, 2009-2014
Source: U.S. Department of Commerce Bureau of Economic Analysis; Based on Jeffrey R. Williams, Renewable Advantage (New York: The Free
Press, 2000), 11.
Industry Classification
Before turning to an industry analysis using the five forces framework, it’s useful to classify the industry you’re
analyzing. The analytical process remains the same no matter which category the industry falls into. But the
classification does provide guidance as to what issues you need to emphasize as you step through the
analysis. For example, the challenges in a mature industry are likely to be quite distinct from those in an
emerging industry. Exhibit 11 provides some broad classifications and the types of opportunities you should
associate with each.
Exhibit 11: Industry Structure and Strategic Opportunities
Source: Jay B. Barney, Gaining and Sustaining Competitive Advantage (Upper Saddle River, NJ: Prentice-Hall, Inc., 2002), 110.
Industry
Average Annual
Price Change
Slow-cycle markets
Dental Laboratories 7.7%
Rail and Transportation 4.4%
Breweries 3.4%
Standard-cycle markets
Highways and Streets 3.0%
Motor and Generator Manufacturing 2.8%
Bread and Bakery Product Manufacturing 2.5%
Fast-cycle markets
Warehousing and Storage -1.3%
Wireless Telecommunications Carriers (Except Satellite) -2.3%
Electronics and Appliance Stores -2.5%
Industry Structure Opportunities
Fragmented industry Consolidation:
– Discover new economies of scale
– Alter ownership structure
Emerging industry First-mover advantages:
– Technological leadership
– Preemption of strategically valuable assets
– Creation of customer switching costs
Mature industry Product refinement
Investment in service quality
Process innovation
Declining industry Leadership strategy
Niche strategy
Harvest strategy
Divestment strategy
International industry Multinational opportunities
Global opportunities
Transnational opportunities
Network industry First-mover advantages
“Winner-takes-all” strategies
Hypercompetitive industry Flexibility
Proactive disruption
November 1, 2016
Measuring the Moat 18
Industry Structure—Five Forces Analysis
Michael Porter is well known for his five-forces framework (see Exhibit 12), which remains one of the best
ways to assess an industry’s underlying structure.20 While some analysts employ the framework to declare an
industry attractive or unattractive, Porter recommends using industry analysis to understand “the underpinnings
of competition and the root causes of profitability.” Porter argues that the collective strength of the five forces
determines an industry’s potential for value creation. But the industry does not seal the fate of its members.
An individual company can achieve superior profitability compared to the industry average by defending against
the competitive forces and shaping them to its advantage.21
Exhibit 12: Michael Porter’s Five Forces That Shape Industry Structure
Source: Michael E. Porter, Competitive Strategy (New York: The Free Press, 1980), 4.
While analysts commonly treat Porter’s five forces with equal emphasis, we believe that the threat of entry and
rivalry are so important that they warrant deeper consideration than the others. Further, our section on firm-
specific analysis will put a finer point on some of the other forces. For now, here is a quick look at supplier
power, buyer power, and substitution threat:22
Supplier power is the degree of leverage a supplier has with its customers in areas such as price, quality,
and service. An industry that cannot pass on price increases from its powerful suppliers is destined to be
unattractive. Suppliers are well positioned if they are more concentrated than the industry they sell to, if
substitute products do not burden them, or if their products have significant switching costs. They are also
in a good position if the industry they serve represents a relatively small percentage of their sales volume
or if the product is critical to the buyer. Sellers of commodity goods to a concentrated number of buyers
are in a much more difficult position than sellers of differentiated products to a diverse buyer base.
Buyer power is the bargaining strength of the buyers of a product or service. It is a function of buyer
concentration, switching costs, levels of information, substitute products, and the offering’s importance to
the buyer. Informed, large buyers have much more leverage over their suppliers than do uninformed,
diffused buyers.
Bargaining power
of suppliers
Threat of
new entrants
Threat of
substitutes
Bargaining power
of buyers
Rivalry among
existing firms
November 1, 2016
Measuring the Moat 19
Substitution threat addresses the existence of substitute products or services, as well as the likelihood
that a potential buyer will switch to a substitute product. A business faces a substitution threat if its prices
are not competitive and if comparable products are available from competitors. Substitute products limit
the prices that companies can charge, placing a ceiling on potential
returns.
The threat of new entrants, or barriers to entry, is arguably the most important of Porter’s five forces. Before
we delve into the factors that determine impediments to entry, it is worthwhile to review the empirical research
on entry and exit.
Entry and Exit
Exhibit 13 shows the rate of entry and exit for U.S. establishments across all industries since 1977, using the
U.S. Census’s Business Dynamics Statistics (BDS). Most studies on corporate demography use
establishments as the unit of analysis because that is the way that the Census Bureau collects and reports the
data. Establishments are the physical sites where corporations operate whereas firms are the aggregations of
all the establishments a parent company owns. Most firms, and especially young ones, have only one
establishment. Note that not all exits are failures. For example, some exits are planned or are the result of the
sale of a viable business.23
A useful way to think about entry and exit is to imagine an industry with 100 firms today. Based on the annual
rates since 2000, an average of 11 new firms will enter the industry in each year and 10 will leave. This brings
the total number of firms to 101. Because the rate of entry typically exceeds that of exit, the number of
establishments in the U.S. has increased over time.
Exhibit 13: Rate of Entry and Exit for Establishments in the U.S., 1977-2014
Source: U.S. Census Bureau, Center for Economic Studies, Business Dynamics Statistics; Credit Suisse.
6%
8%
10%
12%
14%
16%
18%
1
9
7
7
1
9
7
8
1
9
7
9
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
2
0
1
4
Entry Rate
Exit Rate
November 1, 2016
Measuring the Moat 20
It is also important to understand the history of entry and exit for the specific industry you are analyzing. These
rates vary widely based on where the industry is in its life cycle and on the industry’s barriers to entry and exit.
Research shows that the number of firms in new industries follows a consistent path.
The market is uncertain about the products it favors in the early stage of industry development, which
encourages small and flexible firms to enter the industry and innovate. As the industry matures, the market
selects the products it wants and demand stabilizes. The older firms benefit from economies of scale and
entrenched advantages, causing a high rate of exit and a move toward a stable oligopoly.24 Exhibit 14 shows
the entry and exit rates for a variety of sectors, grouped according to Standard Industrial Classification (SIC)
codes.
Exhibit 14: Annual Average Rate of Entry and Exit by Sector in the U.S., 1977-2014
Source: U.S. Census Bureau, Center for Economic Studies, Business Dynamics Statistics; Credit Suisse.
There is a strong correlation between the rate of entry and exit for each sector. For instance, manufacturing
has low rates of entry and exit, while construction has very high rates, suggesting that the manufacturing
sector possesses stronger barriers to entry and exit.
Perhaps the most widely cited study of entry and exit rates is that of Timothy Dunne, Mark Roberts, and Larry
Samuelson (DRS). They examined more than 250,000 U.S. manufacturing firms over a 20-year span ended
in the early 1980s.25
A useful way to summarize the findings of DRS is to imagine a hypothetical industry in the year 2016 that has
100 firms with sales of $1 million each. Should the patterns of entry and exit in U.S. industries during the
period of their study apply to the future, the following will occur:26
Entry and exit will be pervasive. After five years, between 30 and 45 new firms will have entered the
industry and will have combined annual sales of $15-20 million. Half of these entrants will be diversified
firms competing in other markets, and half will be new firms. During the same time, 30 to 40 firms with
Agricultural
Services,
Forestry,
Fishing
Mining
Construction
Manufacturing
Transportion,
Public Utilities
Wholesale trade
Retail tradeFinance,
Insurance, Real
Estate
Services
8%
10%
12%
14%
16%
8% 10% 12% 14% 16%
E
n
tr
y
R
a
te
Exit Rate
November 1, 2016
Measuring the Moat 21
aggregate sales of $15-20 million will leave the industry. So the industry will experience a 30-45 percent
turnover in firms, with the entering and exiting firms representing 15-20 percent of the industry’s volume.
Companies entering and exiting tend to be smaller than the established firms. A typical entrant
is only about one-third the size of an incumbent, with the exception of diversifying firms that build new
plants. These diversifying firms, which represent less than 10 percent of total new entrants, tend to be
roughly the same size as the incumbents.
Entry and exit rates vary substantially by industry. Consistent with Exhibit 14, research by DRS
shows that low barriers to entry and low barriers to exit tend to go together.
Most entrants do not survive ten years, but those that do thrive. Of the 30 to 45 firms that enter
between 2016 and 2021, roughly 80 percent will exit by 2026. But the survivors will more than double
their relative size by 2026.
Other studies have found similarly low chances of survival for new firms.27 Research by Credit Suisse HOLT®
shows that less than 50 percent of public firms survive beyond ten years. Our analysis of the BDS data also
reveals low survival rates. Exhibit 15 shows one-year and five-year survival rates based on the birth year of the
establishment. The rate today is similar to that of 1977. The latest figures show one-year survival rates of
about 80 percent and five-year survival rates of roughly 50 percent.
Exhibit 15: Survival Rates for Establishments in the U.S. by Birth Year, 1977-2014
Source: U.S. Census Bureau, Center for Economic Studies, Business Dynamics Statistics; Credit Suisse.
What influences the decision of a challenger to enter in the first place? On a broad level, potential entrants
weigh the expected reactions of the incumbents, the anticipated payoffs, and the magnitude of exit costs.28
Researchers also find that challengers neglect the high base rates of business failure, leading to
overconfidence and a rate of entry that appears higher than what is objectively warranted. We’ll explore each
of these factors.
40%
50%
60%
70%
80%
90%
100%
1
9
7
7
1
9
7
8
1
9
7
9
1
9
8
0
1
9
8
1
1
9
8
2
1
9
8
3
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9
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4
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5
1
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8
6
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9
8
7
1
9
8
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9
8
9
1
9
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0
1
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1
1
9
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4
1
9
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5
1
9
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6
1
9
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7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
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3
2
0
0
4
2
0
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5
2
0
0
6
2
0
0
7
2
0
0
8
2
0
0
9
2
0
1
0
2
0
1
1
2
0
1
2
2
0
1
3
One-year rate
Five-year rate
November 1, 2016
Measuring the Moat 22
Let’s first look at the expectations of incumbent reaction to a potential new entry. Four specific factors predict
the likely ferocity of incumbent reaction: asset specificity, the level of the minimum efficient production scale,
excess capacity, and incumbent reputation.
For a long time, economists thought that a firm’s commitment to a market was related to how much money
the company had invested in assets. More careful analysis revealed that it’s not the quantity of assets that
matters but how specific those assets are to the market. A firm that has assets that are valuable only in a
specific market will fight vigorously in order to maintain its position.
A clear illustration is a railroad versus an airline route. Say a company builds a railroad track from New York to
Chicago. It can use that asset for only one thing: to move a train back and forth between those two cities. As
a result, that company will go to great lengths to protect its position.29 Now consider an airline that flies from
New York to Chicago. If that route proves uneconomic, the airline can reroute the plane to a more attractive
destination.
Asset specificity takes a number of forms, including site specificity, where a company locates assets next to a
customer for efficiency; physical specificity, where a company tailors assets to a specific transaction;
dedicated assets, where a company acquires assets to satisfy the needs of a particular buyer; and human
specificity, where a company develops the skills, knowledge, or know-how of its employees.30
The next factor is production scale. For many industries, unit costs decline as output rises. But this only
occurs up to a point. This is especially relevant for industries with high fixed costs. A firm enjoys economies of
scale when its unit costs decline with volume gains. At some point, however, unit costs stop declining with
incremental output and companies get to constant returns to scale. The minimum efficient scale of production
is the smallest amount of volume a company must produce in order to minimize its unit costs. (See Exhibit
16.)
The minimum efficient scale of production tells a potential entrant how much market share it must gain in
order to price its goods competitively and make a profit. It also indicates the size of an entrant’s upfront capital
commitment. When the minimum efficient scale of production is high relative to the size of the total market, a
potential entrant is looking at the daunting prospect of pricing its product below average cost for some time to
get to scale. The steeper the decline in the cost curve, the less likely the entry. The main way an entrant can
try to offset its production cost disadvantage is to differentiate its product, allowing it to charge a price
premium versus the rest of the industry.
Minimum efficient scale is generally associated with manufacturing businesses, including automobile and
semiconductor fabrication plants. For example, the cost for Intel to produce its first Xeon microprocessor was
more than $10 billion, including the fabrication plant and associated research and development. But once the
chip was designed and the fab was up and running, the cost to produce incremental units dropped sharply.
The concept of minimum efficient scale also applies to knowledge businesses where a company creates
content once at a very high cost and then replicates it for the market. The same cost curve exists for software
as for hardware and it is even steeper in most cases.
November 1, 2016
Measuring the Moat 23
Exhibit 16: Minimum Efficient Scale as a Barrier to Entry
Source: Sharon M. Oster, Modern Competitive Analysis (Oxford: Oxford University Press, 1999), 62.
A third factor in assessing incumbent reaction is excess capacity. The logic here is quite straightforward.
Assuming that demand remains stable, an entrant that comes into an industry that has too much capacity
increases the excess capacity of the incumbents. If the industry has economies of scale in production, the
cost of idle capacity rises for the existing companies. As a result, the incumbents are motivated to maintain
their market share. So the prospect of a new entrant will trigger a price drop. This prospect deters entry.
The final factor is incumbent reputation. Firms usually compete in various markets over time. As a
consequence, they gain reputations as being ready to fight at the least provocation or as being
accommodating. A firm’s reputation, backed by actions as well as words, can color an entrant’s decision.
Another important shaper of barriers to entry is the magnitude of the entrant’s anticipated payoff. An entrant
cannot be sure that it will earn an attractive economic profit if the incumbent has an insurmountable
advantage. Incumbent advantages come in the form of precommitment contracts, licenses and patents,
learning curve benefits, and network
effects.
The first incumbent advantage is precommitment contracts. Often, companies secure future business through
long-term contracts. These contracts can be efficient in reducing search costs for both the supplier and the
customer. A strong incumbent with a contract in place discourages entry.
Precommitment contracts take a number of forms. One is if an incumbent has favorable access to an
essential raw material. An example of this occurred shortly following World War II. Alcoa, an aluminum
producer, signed exclusive contracts with all of the producers of an essential material in aluminum production
called high-grade bauxite. The inability to access bauxite on such favorable terms deterred potential entrants.
Another form of precommitment contract is a long-term deal with customers. In the mid-1980s, Monsanto
(NutraSweet) and Holland Sweetener Company were two producers of the sweetener aspartame. After the
patent on aspartame expired in Europe in 1987, Holland entered the market to compete against Monsanto.
The competition drove down the price of aspartame 60 percent, and Holland lost money.
Average
Cost
C
o
s
t
p
e
r
u
n
it
Q
Output
Minimum
Efficient
Scale
November 1, 2016
Measuring the Moat 24
But Holland had its eye on the real prize, the U.S. market, where the patent was to expire in 1992. In a classic
precommitment move, Monsanto signed long-term contracts to supply the largest buyers of aspartame,
Coca-Cola and PepsiCo, and effectively shut Holland out of the United States. This suggests a crucial lesson
for companies and investors: all buyers want to have multiple suppliers, but it doesn’t mean that they will use
multiple suppliers. Holland created a great deal of value for Coke and Pepsi but none for itself.31
Precommitment also includes quasi-contracts, such as a pledge to always provide a good or service at the
lowest cost. Such pledges, if credible, deter entry because new entrants rarely have the scale to compete with
incumbents.
Licenses and patents also shape a potential entrant’s payoff for reasons that make common sense. A number
of industries require a license or certification from the government to do business. Acquiring licenses or
certifications is costly, hence creating a barrier for an entrant.
Patents are also an important entry barrier. But the spirit of a patent is different from that of a license. The
intent of a patent is to allow an innovator to earn an appropriate return on investment. Most innovations require
substantial upfront costs. So a free market system needs a means to compensate innovators to encourage
their activities. Patents do not discourage innovation, but they do deter entry for a limited time into activities
that are protected.
Learning curves can also serve as a barrier to entry. The learning curve refers to an ability to reduce unit costs
as a function of cumulative experience. Researchers have studied the learning curve for hundreds of products.
The data show that, for the median firm, a doubling of cumulative output reduces unit costs by about
20 percent.32 A company can enjoy the benefits of the learning curve without capturing economies of scale,
and vice versa. But generally the two go hand in hand.
Network effects are another important incumbent advantage that can weigh on an entrant’s payoff. Network
effects exist when the value of a good or service increases as more members use that good or service. As an
example, Uber is attractive to passengers precisely because so many riders and drivers congregate on the
platform. In a particular business, positive feedback often ensures that one network becomes dominant. For
example, in the U.S. Uber has not only weathered competitive onslaught, it has also strengthened its position.
Size, network structure, and connectivity contribute to network strength.33
Good examples today are the online social networks, including Facebook and Instagram, which become more
valuable to a user as more people join. We also see network effects in the smartphone market between the
dominant operating systems and application developers. Because the vast majority of users own devices
operating on Android or iOS, application developers are far more likely to build applications for them than for
other operating systems. This creates a powerful ecosystem that is daunting for aspiring entrants.34
The last point, consistent with DRS’s analysis of entry and exit, is the link between barriers to entry and
barriers to exit. High exit costs discourage entry. The magnitude of investment an entrant requires and the
specificity of the assets determine the size of exit barriers. Low investment needs and non-specific assets are
consistent with low barriers to entry.
Robert Smiley, a retired economist who specialized in competitive strategy, surveyed product managers about
their strategies to deter entry.35 While his analysis was limited to consumer products companies, the results
are instructive nonetheless. (See Exhibit 17.) The first three strategies—learning curve, advertising, and
R&D/patents—create high entry costs. The last three—reputation, limit pricing, and excess capacity—
November 1, 2016
Measuring the Moat 25
influence judgments of post-entry payoffs. Virtually all managers reported using one or more of these
strategies to deter entry.
Exhibit 17: Reported Use of Entry-Deterring Strategy
Source: Robert Smiley, “Empirical Evidence on Strategic Entry Deterrence”, International Journal of Industrial Organization, Vol. 6, June 1988, 172.
Behavioral factors also play a role in the decision to enter a business. A pair of economists, Colin Camerer and
Dan Lovallo, designed an experiment to understand why subjects enter a game.36 When the scientists
informed the subjects that the payoffs were based on skill, the individuals overestimated their probability of
success. As a result, they entered the game at a higher rate than those who were told that the payoffs were
random. Most subjects who entered the game believed they would have positive profits despite the negative
total profit among all entrants.
The researchers attributed the overconfidence of the entrants to “reference group neglect.” The idea is that
the entrants focused on what they perceived to be their unique skills while ignoring the abilities of their
competitors and the high failure rate of new entries as reflected in the reference group. The failure to consider
a proper reference class pervades many of the forecasts we make.37 In the business world, reference class
neglect shows up as unwarranted optimism for the length of time it takes to develop a new product, the
chance that a merger succeeds, and the likelihood of an investment portfolio outperforming the market.38
Competitive
Rivalry
Rivalry among firms addresses how fiercely companies compete with one another along dimensions such as
price, service, new product introductions, promotion, and advertising. In almost all industries, coordination in
these areas improves the collective economic profit of the firms. For example, competitors increase their
profits by coordinating their pricing. Of course, coordination must be tacit, not explicit.
There is a tension between coordinating and cheating in most industries. A firm that “cheats” by lowering the
price on its product stands to earn disproportionate profits if the other firms do not react. We can think of
rivalry as understanding, for each firm, the trade-offs between coordination and cheating. Lots of coordination
suggests low rivalry and attractive economic returns. Intense rivalry makes it difficult for firms to generate high
returns.
Coordination is difficult if there are lots of competitors. In this case, each firm perceives itself to be a minor
player and is more likely to think individualistically. Naturally, the flip side suggests that the existence of fewer
firms leads to more opportunity for coordination. Research shows that most cases of price fixing that the
government prosecutes involve industries with fewer firms than average.39
Learning
Curve Advertising
R&D/
Patents Reputation
Limit
Pricing
Excess
Capacity
New Products
Frequently
Occasionally
Seldom
Existing Products
Frequently
Occasionally
Seldom
26%
29
45
62%
16
22
52%
26
21
56%
15
29
31%
16
54
27%
27
47
27%
22
52
8%
19
73
21%
21
58
22%
20
58
21%
17
62
November 1, 2016
Measuring the Moat 26
A concentration ratio is a common way to measure the number and relative power of firms in an industry. The
Herfindahl-Hirschman Index (HHI) is a popular method to estimate industry concentration. The HHI considers
not only the number of firms but also the distribution of the sizes of firms. A dominant firm in an otherwise
fragmented industry may be able to impose discipline on others. In industries with several firms of similar size,
rivalry tends to be intense.
Exhibit 18 shows the HHI for 20 industries. Many economists characterize readings in excess of 1,800 as
industries with reduced rivalry. The index is equal to 10,000 times the sum of the squares of the market
shares of the 50 largest firms in an industry. If there are fewer than 50 firms, the amount is summed for all
firms in the industry. For instance, for an industry with four companies and market shares of 40 percent,
30 percent, 20 percent, and 10 percent, the index would be 3,000. (Take 10,000 x [(.4)2 + (.3) 2 + (.2) 2 +
(.1)2].)
Exhibit 18: Herfindahl-Hirschman Index for Selected Industries
Source: U.S. Census Bureau, Concentration Ratios – 2012 Economic Census.
If industry concentration is a reliable indicator of the degree of rivalry, you’d expect to see some link between
concentration and profitability. Researchers have shown this to be the case. Two professors of finance, Kewei
Hou and David Robinson, examined industries for the years 1963-2001 and found that concentrated
industries earned above average profits and less concentrated industries earned below average profits.40
Another influence of rivalry is firm homogeneity. Rivalry tends to be less intense in industries with companies
that have similar goals, incentive programs, ownership structures, and corporate philosophies. But in many
instances, competitors have very different objectives. For example, an industry may have companies that are
public, privately held, or owned by private equity firms. These competitors may have disparate financial
objectives, incentive structures, and time horizons. The strategies that companies within an industry pursue will
reflect the heterogeneity of objectives.41
Industry (Manufacturing) Herfindahl-Hirschman Index
Breakfast cereal 2,333
Household appliances 1,576
Tires 1,377
Automobiles 1,178
Plastic bottles 934
Flour milling 772
Explosives 771
Book printing 623
Poultry processing 600
Stationery products 497
Iron founderies 454
Sporting and athletic goods 373
Animal food 369
Basic chemicals 362
Fabric mills 275
Motor vehicle bodies 207
Adhesives 182
Machinery 91
Computer and electronic products 72
Retail bakeries 12
November 1, 2016
Measuring the Moat 27
Asset specificity plays a role in rivalry. Specific assets encourage a company to stay in an industry even when
conditions become trying because there is no alternative use for the assets. Assets include physical assets,
such as railroad tracks, as well as intangible assets such as brands.
Demand variability shapes coordination costs and hence has an influence on rivalry. When demand variability is
high, companies have a difficult time coordinating internally and have little opportunity to effectively coordinate
with competitors. Variable demand is a particularly important consideration in industries with high fixed costs.
In these industries, companies often add too much capacity at points of peak demand. While companies use
this capacity at the peak, the capacity is excessive at the trough and spurs even more intense competition at
the bottom of the cycle. The conditions of variable demand and high fixed costs describe many commodity
industries, which is why their rivalry is so bitter and consistent positive economic returns are so elusive.
Industry growth is a final consideration. When the pie of potential excess economic profits grows, companies
can create shareholder value without undermining their competitors. The game is not zero-sum. In contrast,
stagnant industries are zero-sum games and the only way to increase value is to take it from others. So a rise
in rivalry often accompanies a decelerating industry growth rate.
Disruption and Disintegration
Most strategy frameworks focus primarily on figuring out which industries are attractive and which companies
are well positioned. Clayton Christensen, a professor of management, developed a theory to explain why great
companies fail and how companies succeed through innovation. Christensen wondered why it was common
for companies with substantial resources and smart management teams to lose to companies with simpler,
cheaper, and inferior products. His theory of disruptive innovation explains that process. 42
Christensen starts by distinguishing between sustaining and disruptive innovations. Sustaining innovations
foster product improvement. They can be incremental, discontinuous, or even radical. But the main point is
that a sustaining innovation operates within a defined value network—the “context within which a firm
identifies and responds to customers’ needs, solves problems, procures input, reacts to competitors, and
strives for profit.”43
A disruptive innovation, by contrast, approaches the same market with a different value network. Consider
book selling as an example. The evolution from mom-and-pop bookstores to superstores was a clear
innovation, but the value network was the same. Amazon.com introduced a new value network when it started
selling books online. It is common for disruptors to trade lower operating profit margins for high capital
turnover in their bid to earn returns on invested capital in excess of the cost of capital.
Christensen distinguishes between the two types of disruptive innovation: low-end disruption and new-market
disruption. A low-end disruptor offers a product that already exists. For instance, when Southwest Airlines
entered the airline industry, it provided limited flights with no frills at a very low cost. Southwest couldn’t, and
didn’t, compete with the large legacy carriers.
A new-market disruption, on the other hand, competes initially against “non-consumption.”44 It appeals to
customers who previously did not buy or use a product because of a shortage of funds or skills. A new-market
disruptive product is cheap or simple enough to enable a new group to own and use it.
The transistor radio, introduced in the 1950s, is an example of a new-market disruption. Manufacturers such
as Sony targeted teenagers, a group who wanted to listen to music on their own but who couldn’t afford
November 1, 2016
Measuring the Moat 28
tabletop radios. Teenagers were so thrilled that they could listen to these pocket-sized radios away from their
parents that they ignored the static and poor sound quality.45
Disruptive innovations initially appeal to relatively few customers who value features such as low price, smaller
size, or greater convenience. Christensen finds that these innovations generally underperform established
products in the near term but are good enough for a segment of the market.
Exhibit 19 presents Christensen’s model visually. The horizontal axis is time, and the vertical axis is product
performance. The shaded area represents customer needs and takes the shape of a distribution that includes
low-end, average, and high-end customers.
The upward-sloping line at the top is the performance trajectory of sustaining innovations. The parallel,
upward-sloping line below it is the performance trajectory for a disruptive innovation.
Exhibit 19: Christensen’s Model of Disruptive Innovation
Source: Clayton M. Christensen, The Innovator’s Dilemma (Boston, MA: Harvard Business School Press, 1997), xvi.
One of the key insights of the model is that innovations often improve at a rate faster than the consumer
demands. Established companies, through sustaining technologies, commonly provide customers with more
than they need or more than they are ultimately willing to pay for. When innovation drives performance for a
sustaining technology past the needs of mainstream customers, the product is “overshot.” Indications that a
market is overshot include customers who are unwilling to pay for a product’s new features and who don’t use
many of the available features.
When the performance of a sustaining innovation exceeds the high end of the consumer’s threshold, the basis
of competition shifts from performance to speed-to-market and delivery flexibility. For instance, as the
personal computer market became overshot in the 1990s, manufacturers focused on performance, such as
Compaq, lost to manufacturers with more efficient delivery models, such as Dell.
Mainstream
Customer
Needs
Sustaining
InnovationPerformance
Disruptive
Innovation
Time
Meet customer
needs at lower price
Overshoot customer
performance needs
November 1, 2016
Measuring the Moat 29
The trajectory of product improvement allows disruptive innovations to emerge because even if they fail to
meet the demands of mainstream users today they become competitive tomorrow. Further, disruptive
innovations end up squeezing the established producers because the disruptors have lower cost structures.
Christensen likes to use the example of the mini-mills versus integrated mills in the steel industry. Mini-mills
melt scrap steel, so they are a fraction of the size of the integrated mills that make steel in blast furnaces.
Because the integrated mills controlled the whole process, they started with the substantial advantage of
producing steel of high quality.
The mini-mills launched their simpler and cheaper model in the 1970s. Their inferior quality initially limited
them to making rebar, the bars that reinforce concrete. This is the least expensive and least valuable market
for steel. Indeed, the operating profit margins for integrated mills improved after they left the market for rebar
to the mini-mills. As Christensen says, “It felt good to get in and good to get out.”
But the good feeling didn’t last long. Just as the theory predicts, the mini-mills rapidly improved their ability to
make better steel and started to compete in markets that had more value. That process continued over time
until the mini-mills shouldered into the high end of the market and destroyed the profitability of the integrated
mills.
A crucial point of Christensen’s work is that passing over disruptive innovations may appear completely rational
for established companies. The reason is that disruptive products generally offer lower margins than
established ones, operate in insignificant or emerging markets, and are not in demand by the company’s most
profitable customers. As a result, companies that listen to their customers and practice conventional financial
discipline are apt to disregard disruptive innovations.
Exhibit 20 summarizes Christensen’s three categories of innovation, sustaining, low-end, and new-market,
and considers the customers they serve, the technology they utilize to attract customers, the business models
they employ, and the expected incumbent response to each. The incumbent response warrants specific
attention. If a new competitor comes along with a sustaining innovation, incumbents are highly motivated to
defend their turf. Christensen suggests it is very rare to see an incumbent lose this battle to a challenger.
For low-end disruptions, the motivation of incumbents is generally to flee. This is what the integrated mills did.
In the short run, fleeing helps profit margins by encouraging the incumbent to focus on the most lucrative
segment of the market. In the long run, it provides resources for the disruptor to build capabilities that allow it
to penetrate the mainstream market on a cost-effective basis.
Incumbents are typically content to ignore new-market disruptions. The example of the transistor radio shows
why. Because the portable radios did not encroach on the base of the established tabletop radio customers,
the incumbent firms were motivated to disregard the new product.
November 1, 2016
Measuring the Moat 30
Exhibit 20: Innovation Categories and Characteristics
Source: Based on Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution (Boston, MA: Harvard Business School Press, 2003), 51.
Christensen has also done insightful work on understanding and anticipating the circumstances under which
an industry is likely to shift from vertical to horizontal integration.46 This framework is relevant for assessing the
virtue of outsourcing. While outsourcing has provided some companies with great benefits, including lower
capital costs and faster time to market, it has also created difficulty for companies that tried to outsource
under the wrong circumstances.
Firms that are vertically integrated dominate when industries are developing because the costs of coordination
are so high. Consider the computer industry in 1980. (See Exhibit 21.) Most computer companies were
vertically integrated to ensure that their products would actually work.
But as an industry develops, various components become modules. The process of modularization allows an
industry to flip from vertical to horizontal. This happened in the computer industry by the mid-1990s.
Modularization, which is not simple from an engineering standpoint, allows for standardization and the
assembly of products off the shelf.
Sustaining
Innovation
Low – End
Disruption
New – Market
Disruption
Customers
Undershot
customer
Overshot customer
at low end of
existing market
Non-consumer or
non-producer
Technology
(product/service
/process)
Improvement along
primary basis of
competition
Good enough
performance at
lower prices
Simpler, customizable;
lets people “do it
themselves”
Business Model
Extension of
winning
business model
Attractive returns at
lower prices
Completely new
model, different from
core business
Competitor
Response
Motivated
to respond
Motivated to flee Motivated to ignore
November 1, 2016
Measuring the Moat 31
Exhibit 21: Disintegration of the Computer Industry
Source: Andrew S. Grove, Only the Paranoid Survive (New York: Doubleday, 1999), 44.
Boeing’s ordeal with the 787 Dreamliner is a cautionary tale about the perils of outsourcing too early.47
Historically, Boeing used a process called “build-to-print,” where the company did all of the design for an
aircraft in-house and sent suppliers very specific instructions. For the 787, Boeing decided to outsource the
design and construction of various sections of the plane, with the goal of lowering costs and quickening
assembly times.
The program was a mess. The first plane was supposed to arrive in 1,200 parts but showed up in 30,000
pieces. Boeing had to bring substantial parts of the design back in-house at a large cost of money and time.
The company failed to realize that outsourcing doesn’t make sense for products that require complex
integration of disparate subcomponents. The coordination costs are simply too high.
Industry analysis provides important background for understanding a company’s current or potential
performance. Now we turn to analyzing the firm.
Sales and
distribution
Application
software
Operating
system
Computer
Chips
Sales and
distribution
Application
software
Operating
system
Computer
Chips
IBM DEC
Sperry
Univac
Wang
Retail
Stores
Superstores Dealers Mail Order
Word Word Perfect Etc.
DOS and Windows OS/2 Mac UNIX
Compaq Dell Packard Bell
Hewlett –
Packard
IBM Etc.
Intel Architecture Motorola RISCs
The Vertical Computer Industry – Circa 1980 The Horizontal Computer Industry – Circa 1995
November 1, 2016
Measuring the Moat 32
Firm-Specific Analysis
Core to understanding sustainable value creation is a clear understanding of how a company creates
shareholder value. A company’s ability to create value is a function of the strategies it pursues, its interaction
with competitors, and how it deals with non-competitors.48
Much of what companies discuss as strategy is not strategy at all. As Michael Porter emphasizes, strategy is
different than aspirations, more than a particular action, and distinct from vision or values. Further, Porter
differentiates between operational effectiveness and strategic positioning. Operational effectiveness describes
how well a company does the same activity as others. Strategic positioning focuses on how a company’s
activities differ from those of its competitors. And where there are differences, there are trade-offs.49
We first provide a fundamental framework for value creation. We then consider the various ways a company
can add value. Finally, we delve into firm interaction using game theory and principles of co-evolution.
A Framework for Added-Value Analysis
Adam Brandenburger and Harborne Stuart, professors of strategy, offer a very concrete and sound definition
of how a firm adds value.50 Their equation is simple:
Value created = willingness-to-pay – opportunity cost
The equation basically says that the value a company creates is the difference between what it gets for its
product or service and what it costs to produce that product (including the opportunity cost of capital).
Understanding what each of the terms means is fundamental to appreciating the equation.
Let’s start with willingness to pay. Imagine someone hands you a brand new tennis racket. Clearly, that is
good. Now imagine that the same person starts withdrawing money from your bank account in small
increments. The amount of money at which you are indifferent to having the racket or the cash is the definition
of willingness to pay. If you can buy a product or service for less than your willingness to pay, you enjoy a
consumer surplus.
The flip side describes opportunity cost. A firm takes some resource from its supplier. Opportunity cost is the
cash amount that makes the supplier perceive the new situation (cash) as equivalent to the old situation
(resource).
Brandenburger and Stuart then go on to define four strategies to create more value: increase the willingness
to pay of your customers; reduce the willingness to pay of the customers of your competitors; reduce the
opportunity cost of your suppliers; and increase the opportunity cost of suppliers to your competitors. This
framework also fits well with Porter’s generic strategies to achieve competitive advantage—cost leadership
(production advantage) and differentiation (consumer advantage).
Brandenburger teamed up with his colleague Barry Nalebuff to create what they call a “value net.”51 We
present the value net slightly differently than the authors do, but the components and configuration are
identical. (See Exhibit 22.) On the left are the firm’s suppliers. On the right are the firm’s customers. Between
the suppliers and customers are the company, its competitors, and its complementors—a term we will define
in more detail. For now, the point is that companies beyond a firm’s suppliers, customers, and competitors
can affect the amount of added value that it can capture.
November 1, 2016
Measuring the Moat 33
Exhibit 22: Added-Value Analysis – The Value Net
Source: Adapted from Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Doubleday, 1996), 17.
The value net fits comfortably into Michael Porter’s traditional analyses but adds an important element:
strategy is not only about risk and downside but also about opportunity and upside. Research in industrial
organization emphasizes non-cooperative game theory, a reasonable approach for well-established industries
near product price equilibrium. But cooperative game theory recognizes that many industries are dynamic and
offer opportunities to cooperate as well as to compete.
The Value Chain
Michael Porter also developed value chain analysis, a powerful tool for identifying a company’s sources of
competitive advantage. The value chain is “the sequence of activities your company performs to design,
produce, sell, deliver, and support its products.”52 (Exhibit 23 depicts a generic value chain.) Porter
recommends focusing on discrete activities rather than broad functions such as marketing or logistics, which
he considers too abstract. The objective is to assess each activity’s specific contribution to the company’s
ability to capture and sustain competitive advantage, be it through higher prices or lower costs.
Exhibit 23: The Value Chain
Source: Joan Magretta, Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston, MA: Harvard Business Review Press,
2012).
Creating an effective value chain analysis involves the following steps:
Create a map of the industry’s value chain. Show the sequence of activities that most of the
companies in the industry perform, paying careful attention to the activities specific to the industry that
create value.
Compare your company to the industry. Examine your company’s configuration of activities and see
how it compares to others in the industry. Look for points of difference that may reflect a competitive
advantage or disadvantage. If a company’s value chain closely resembles that of its peers, then the
companies are likely engaged in what Porter calls a “competition to be the best.” This is when rivals
Complementors
Company
Competitors
CustomersSuppliers
R&D
Supply chain
management
Operations
Marketing &
sales
Post-sales
service
November 1, 2016
Measuring the Moat 34
pursue similar strategies across the same activities, and it often leads to price wars and destructive,
zero-sum competition.53
Identify the drivers of price or sources of differentiation. To create superior value, a company
should look for existing or potential ways to perform activities differently or to perform different activities.
This can come anywhere along the value chain, starting with product design and ending with post-sales
service.
Identify the drivers of cost. Estimate as closely as possible the full costs associated with each activity.
Look for existing or potential differences between the cost structure of the company and that of
competitors. Pinpointing the specific drivers of a cost advantage or disadvantage can yield crucial insights.
This allows a manager to rethink how, or why, a company performs a particular activity.
Sources of Added Value
There are three broad sources of added value: production advantages, consumer advantages, and external
(e.g., government) factors. Note that there is substantial overlap between this analysis and the industry
analysis, but here we focus on the firm.
Production Advantages
Firms with production advantages create value by delivering products that have a larger spread between
perceived consumer benefit and cost than their competitors, primarily by outperforming them on the cost side.
We distill production advantages into two parts: process and scale economies.
Here are some issues to consider when determining whether a firm has a process advantage:
Indivisibility. Economies of scale are particularly relevant for businesses with high fixed costs. One
important determinant of fixed costs is indivisibility in the production process. Indivisibility means that a
company cannot scale its production costs below a minimum level even if output is low. The baking
business is an example. If a bakery wants to service a region, it must have a bakery, trucks, and drivers.
These parts are indivisible, and a firm must bear their cost no matter what bread demand looks like. At the
same time, if the trucks go from half empty to completely full, fixed costs don’t change much.
Complexity. Simple processes are easy to imitate and are unlikely to be a source of advantage. More
complex processes, in contrast, require more know-how or coordination capabilities and can be a source
of advantage. For instance, Procter & Gamble (P&G) reportedly spent eight years and hundreds of
millions of dollars to develop Tide Pods, a unit-dose capsule form of laundry detergent. Much of the
spending went toward a dedicated staff of technical professionals, testing on thousands of consumers,
and hundreds of packaging and product sketches. The government granted P&G numerous patents on
detergent chemistry, the pod’s casing, and the manufacturing process. Bob McDonald, P&G’s CEO at
the time, demonstrated his confidence in the intellectual property when he said, “I don’t imagine that this
is going to be able to be copied in any way that it will become a threat.” 54
Rate of change in process cost. For some industries, production costs decline over time as a result of
technological advances. For example, the process-related cost of building an e-commerce company today
is less than in the past because you can purchase most of the necessary components off the shelf. But
the cost in the future is likely to be lower than the cost today for the same reason. For industries with
declining process costs, the incumbent has learning curve advantages, while the challenger has the
November 1, 2016
Measuring the Moat 35
advantage of potentially lower future costs. So the analysis must focus on the trade-off between learning
advantages and future cost advantages.
Protection. Look for patents, copyrights, trademarks, and operating rights that protect a firm’s process.
Research suggests that products with patent protection generate higher economic returns as a group than
any single industry.55
Resource uniqueness. Alcoa’s bauxite contract is a good illustration of access to a unique resource.
Economies of scale are the second category of potential production advantage. Exhibit 24 illustrates the
distinction between supply- and demand-side scale economies. A firm creates value if it has a positive spread
between its sales and costs, including opportunity costs.56 A firm can create more value by either reducing its
costs or increasing the price it receives. Evidence suggests that differences in customer willingness to pay
account for more of the profit variability among competitors than disparities in cost levels.57
The well-known cost curve depicted in Exhibit 24 shows that, as a manufacturing company increases its
output, its marginal and average unit costs decline up to a point. This is classic increasing returns to scale, as
the company benefits from positive feedback on the supply side. It is all about lowering costs. However,
positive feedback tends to dissipate for manufacturing companies because of bureaucracy, complexity, or
input scarcity. This generally happens at a level well before dominance: market shares in the industrial world
rarely top 50 percent. Positive feedback on the demand side comes primarily from network effects, a point we
will develop further in our discussion of consumer advantages.
Exhibit 24: Supply- versus Demand-Side Driven Scale Economies
Source: Credit Suisse.
Output
Price
UsersOutput
Opportunity cost Cost
Supplier’s share Firm’s share Buyer’s share
Total Value Created
W
ill
in
g
n
e
s
s
t
o
P
a
y
Users
Supply-Side Demand-Side
Willingness to pay
A
ve
ra
g
e
C
o
s
t
p
e
r
U
n
it
November 1, 2016
Measuring the Moat 36
Some areas to consider when determining whether or not a company has supply-side scale advantages
include:
Distribution. Start by determining whether the firm has local, regional, or national distribution scale. We
would note that very few firms have national distribution scale. One good example is retailing. Wal-Mart
built its business in the 1970s and 1980s through regional distribution advantages. Most retailers have
only regional advantages and often fail to generate meaningful economic profits outside their core
markets.
One useful way to assess distribution strength is to look at the firm’s operations and revenues on a map.
Firms likely have some advantages where assets and revenue are clustered.58
Purchasing. Some firms can purchase raw materials at lower prices as the result of scale. For instance,
Home Depot was able to add over 200 basis points to its gross margin in the late 1990s by lowering its
cost of merchandising through product line reviews and increased procurement of imported products.
Home Depot used its size to get the best possible price from its suppliers. Increasingly, large firms are
lowering their supplier’s opportunity cost by providing the supplier with better information about demand.
Research and development. Economies of scope, related to economies of scale, exist when a
company lowers its unit costs as it pursues a variety of activities. A significant example is research and
development spillovers, where the ideas from one research project transfer to other projects. For example,
Pfizer sought a drug to treat hypertension, then thought it might treat angina, and then found an unusual
side effect which led to the blockbuster drug, Viagra.59 Companies with diverse research portfolios can
often find applications for their ideas more effectively than companies with smaller research portfolios.
Advertising. The advertising cost per consumer for a product is a function of the cost per consumer of
sending the message and the reach. If the fixed costs in advertising, including advertisement preparation
and negotiating with the broadcaster, are roughly the same for small and large companies, then large
companies have an advantage in cost per potential consumer because they can spread their costs over a
much larger base.
For example, say both McDonald’s and Wendy’s have equally effective national advertising campaigns in
the United States. That McDonald’s has almost three times as many stores as Wendy’s does means that
McDonald’s advertising cost per store is lower.
Companies that enjoy economies of scale in their local geographic or product markets should also be aware of
the impact of globalization on their industries. Analysis by McKinsey, a consulting firm, suggests that about
one-third of all industries are global, one-third national, and one-third regional. (See Exhibit 25.) Their
research also shows that industries are becoming increasingly global over time.
November 1, 2016
Measuring the Moat 37
Exhibit 25: Various Industries and Their Stages of Globalization
Source: Lowell Bryan, Jane Fraser, Jeremy Oppenheim, and Wilhelm Rall, Race for the World (Boston, MA: Harvard Business School Press, 1999),
45.
Globalization ties to economies of scale in two important ways. First, companies enjoying economies of scale
in their local markets often find it extremely challenging to replicate those advantages in new product or
geographic markets. Even Wal-Mart has struggled overseas, where competitors dominant in those regions
enjoy cost advantages in areas such as advertising and distribution. Any institutional advantages Wal-Mart has
in terms of efficiency or use of technology are offset by the local economies of scale its competitors have
earned.
Second, increasing globalization may undercut the advantages of economies of scale in some industries. This
is tied to the idea that an industry leader can more easily maintain dominance in a market of restricted size. In
a restricted market, an upstart needs to capture a significant amount of market share to reach economies of
scale, a challenge given it must wrestle share from the leader itself. But as an industry undergoes
globalization, economies of scale are actually easier to obtain for new competitors, as they no longer need to
capture a significant share of a local market.60
If you believe a firm has a production advantage, think carefully about why its costs are lower than those of its
competitors. Firms with production advantages often have lower gross margins than companies with consumer
advantages.
Industry
Physical commodities
Scale-driven business
goods and services
Manufactured
commodities
Labor skill/productivity-driven
consumer goods
Brandable, largely regulated
consumer goods
Professional business services
Historically highly regulated
(nationally) industries
High interaction cost consumer
goods and services
Locally regulated or high trans-
portation cost goods and services
Government services
Petroleum, mineral ores, timber
Aircraft engines, construction equipment, semiconductors,
airframes, shipping, refineries, machine tools, telecom equipment
Refined petroleum products, aluminum, specialty steel, bulk
pharmaceuticals, pulp, specialty chemicals
Consumer electronics, personal computers, cameras, automobiles,
televisions
Beer, shoes, luxury goods, pharmaceuticals, movie production
Investment banking, legal services, accounting services, consulting
services
Personal financial services, telecommunications service providers,
electric power service providers
Food, television production, retail distribution, funeral homes,
small business services
Construction materials, real property, education, household
services, medical care
Civil servants, national defense
Examples
1
2
3
4
5
6
7
8
9
10
GLOBAL
LOCAL
~33%
Globally
defined
~33%
Nationally
defined
~33%
Locally
defined
November 1, 2016
Measuring the Moat 38
Consumer Advantages
Consumer advantage is the second broad source of added value. Firms with consumer advantages create
value by delivering products with a spread between perceived consumer benefit and cost that is larger than
that of its competitors. They do so primarily by outperforming competitors on the benefit side.
Here are some common features of companies with consumer advantages:
Habit and high horizontal differentiation. A product is “horizontally differentiated” when some
consumers prefer it to competing products. This source of advantage is particularly significant if
consumers use the product habitually. A product need not be unambiguously better than competing
products; it just has to have features that some consumers find attractive. Soft drinks are an example.
Competing with Coca-Cola is hard because many consumers habitually drink Coke and are fiercely
attached to the product.61
Experience goods. An experience good is a product that consumers can assess only when they’ve tried
it. Search goods, in contrast, are products that a consumer can easily assess at the time of purchase
(e.g., hockey pucks or office furniture). With experience goods, a company can enjoy differentiation
based on image, reputation, or credibility. Experience goods are often technologically complex.
Switching costs and customer lock-in. Customers must bear costs when they switch from one
product to another. The magnitude of switching costs determines the degree to which a customer is
locked in. Sometimes switching costs are large and obvious (e.g., $100 million for a company to replace
its network), and sometimes they’re small but significant (e.g., $100 per customer for 1 million
customers to switch insurance providers).
An example of a product with high switching costs is an enterprise resource planning (ERP) system. In
addition to the high initial cost for the license, a company implementing a new ERP system must also
expend a significant amount of internal resources for things such as user training and IT support.
Moreover, because a company must customize an ERP system to its business processes, it makes it
even more costly to switch providers. Exhibit 26 provides a breakdown of various forms of lock-in and
their associated switching costs.
November 1, 2016
Measuring the Moat 39
Exhibit 26: Types of Lock-In and Associated Switching Costs
Source: Carl Shapiro and Hal R. Varian, Information Rules (Boston, MA: Harvard Business School Press, 1999), 117.
Network effects. Network effects can be an important source of consumer advantage, especially in
businesses based on information. You can think of two types of networks. (See Exhibit 27.) The first is a
hub-and-spoke network, where a hub feeds the nodes. Examples include most airlines and retailers. In
these networks, network effects exist but are modest.
Exhibit 27: Network Effects Are Stronger for Interactive Networks than for Radial Networks
Source: Credit Suisse.
The second type is an interactive network, where the nodes are either physically (telephone wires) or virtually
(the same software) connected to one another. Network effects tend to be significant for interactive networks
because the good or service becomes more valuable as more people use it. For example, Visa and
MasterCard have formidable advantages in the market for payment systems as a result of their strong network
effects.
Positive feedback is critical in interactive networks. If more than one interactive network is competing for
customers, the network that pulls ahead will benefit from positive feedback, leading to a winner-take-most
Switching Costs
Information and databases
Specialized suppliers
as the durable ages
Learning a new system, both direct costs and
Converting data to new format; tends to rise
over time as collection grows
Funding of new supplier; may rise over time
if capabilities are hard to find/maintain
includes learning about quality of alternatives
Any lost benefits from incumbent supplier,
plus possible need to rebuild cumulative use
Type of Lock – In
Contractual commitments
Durable purchases
Brand – specific training
Search costs
Loyalty programs
Compensatory or liquidated damages
Replacement of equipment; tends to decline
lost productivity; tends to rise over time
Combined buyer and seller search costs;
Radial Interactive
November 1, 2016
Measuring the Moat 40
outcome. The dominant network benefits from having the most users and scale, and the switching costs for
its customers rise as the network grows. The classic example of this de facto standard setting is Microsoft’s
personal computer operating system business.
The pattern of cumulative users of an interactive network follows an S-curve, similar to the diffusion of other
innovations. However, the S-curve tends to be steeper for interactive networks.62 Everett Rogers, a prominent
sociologist, found that the plot of new adopters to a technology or network follows a normal distribution.
Judging the source and longevity of a company’s added value is central to understanding the likelihood of
sustainable value creation. A number of companies, including AOL, MySpace, and Friendster, appeared to
have built valuable networks only to see their value fizzle.
If you believe a firm has a consumer advantage, consider why the consumer’s willingness to pay is high and
likely to stay high. Consumer advantages generally appear in the form of high gross margins.
Exhibit 28 allows us to see which companies have production or consumer advantages by disaggregating the
sources of economic return on investment. (CFROI = CFROI Margin x Asset Turnover.) The vertical axis is
asset turnover. Companies with a production advantage generally have high asset turnover. The horizontal axis
is profit margin. High margins are consistent with a consumer advantage. The isocurve shows all the points
that equal a six percent CFROI. Using data from Credit Suisse HOLT, the exhibit plots the profit margins and
asset turnover for the largest 100 non-financial companies in the world, by market capitalization, for the latest
fiscal year. All companies that fall above or to the right of the isocurve earn CFROIs in excess of six percent.
The panel at the bottom of Exhibit 28 shows how companies can take different paths to the same economic
return. For instance, Nike and Alphabet have CFROIs of 17 percent. But Nike has a relatively low margin and
high asset turnover, whereas Alphabet has a high margin and low turnover.
November 1, 2016
Measuring the Moat 41
Exhibit 28: Sources of Economic Return for the Largest 100 Firms in the World
Source: Credit Suisse HOLT.
Note: Data for latest fiscal year as of 10/25/16.
Government
The final source of added value is external, or government related. Issues here include subsidies, tariffs,
quotas, and both competitive and environmental regulation. Changes in government policies can have a
meaningful impact on added value. Consider the impact of deregulation on the airline and trucking industries,
Basel III on financial services, the Affordable Care Act on health care, and tariffs on the solar energy
industry.63
0
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CFROI Margin (Percent)
Production
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Consumer
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Home Depot
Wal-Mart
Amgen
McDonald’s Alphabet
Nike
Qualcomm
GE
CFROI (%) Company Margin (%) Turns (x) Company Margin (%) Turns (x)
17 Nike 14 1.2 Alphabet 43 0.4
16 Home Depot 12 1.4 Qualcomm 36 0.4
13 General Electric 15 0.8 Amgen 56 0.2
11 Walgreen Boots Alliance 8 1.5 Roche Holding 38 0.3
10 Wal-Mart 5 1.9 McDonald’s 31 0.3
9 Daimler 9 1.0 Pfiz er 36 0.3
7 Samsung 14 0.5 Union Pacific 35 0.2
Production Advantage Consumer Advantage
November 1, 2016
Measuring the Moat 42
Firm Interaction—Competition and Cooperation
How firms interact with one another plays an important role in shaping sustainable value creation.64 Here we
not only consider how companies interact with their competitors but also how companies co-evolve.
Game theory is one of the best tools to understand interaction. Game theory forces managers to put
themselves in the shoes of other companies rather than viewing competition solely from their own point of
view.
The prisoner’s dilemma is the classic example of two-person interaction in game theory.65 We can consider
the prisoner’s dilemma in a business context by looking at a simple case of capacity addition. Say two
competitors, A and B, are deciding whether to add capacity. If competitor A adds capacity and B doesn’t, A
gets an outsized payoff. (See the bottom left corner of Exhibit 29.) Likewise, if B adds capacity and A
doesn’t, B gets the large payoff (top right corner). If neither expands, the total payoff for A and B is the
highest (top left corner). But if both add capacity, the total payoff is the lowest (bottom right corner).
If a company plays this game once, the optimal strategy is to add capacity. Consider the problem from the
point of view of company A. The expected payoff from adding capacity is higher than the expected value of
not expanding. The same logic applies from B’s standpoint. So adding capacity gets the competitors to the
Nash equilibrium, the point where no competitor can gain by changing its strategy unilaterally.
Exhibit 29: Capacity Addition and the Prisoner’s Dilemma
Source: Credit Suisse.
You might assume that companies always evaluate the potential reactions of their competitors. But that is
frequently not the case. During a roundtable discussion in the mid-1990s, for instance, the chief financial
officer of International Paper revealed that his company considered basic economic conditions when weighing
the decision to build a new paper facility. But he conceded the absence of a game theoretic approach: “What
we never seem to factor in, however, is the response of our competitors. Who else is going to build a plant or
machine at the same time?”66
Pankaj Ghemawat, a professor of strategy, provides a more sophisticated example based on the actual pricing
study of a major pharmaceutical company.67 The situation is that a challenger is readying to launch a
A
B
A
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A
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35
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November 1, 2016
Measuring the Moat 43
substitute for one of the incumbent’s most profitable products. The incumbent’s task is to determine the
pricing strategy that maximizes the value of its established product.
Exhibit 30 shows the payoffs for the incumbent (I) and challenger (C) given various assumptions. For example,
with no price change for the incumbent and very low pricing by the challenger, the model suggests a payoff of
350 for the incumbent and 190 for the challenger (upper left corner). This analysis allowed the incumbent’s
management to view the situation from the challenger’s point of view versus considering only what it hoped
the challenger would do.
Exhibit 30: The Payoff Matrix in the Face of a Challenger Product Launch
Source: Adapted from Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall, Inc., 2009), 71.
In our simple cases of capacity additions and product launches, we treated competitor interaction as if it were
a one-time event. In reality, companies interact with one another all the time. So the next level of analysis
considers repeated games.
Robert Axelrod, a political scientist, ran a tournament to see which strategy was most successful in an iterated
prisoner’s dilemma. Instead of playing just once, the competitors played 200 rounds of the game with payoffs
similar to that in Exhibit 29.68 The winning strategy was tit for tat. Tit for tat starts by cooperating but then
mimics its competitor’s last move. So if a competitor cuts price, a company employing tit for tat would cut
price as well. If the competitor then raises prices, tit for tat immediately follows. In practice, tit for tat is
effective only if companies can judge clearly the intentions of their competitors.
Game theory is particularly useful in considering pricing strategies and capacity additions.69 A thorough review
of a firm’s pricing actions and capacity additions and reductions can provide important insight into rivalry and
rationality. You can do similar analysis at the industry level. Institutional memory, especially for cyclical
businesses, appears too short to distinguish between a one-time and an iterated prisoner’s dilemma game.
Companies and analysts can go beyond a payoff matrix that considers only one-time interaction and build a
tree based on sequential actions. The approach here is similar to strategy in chess: look forward and reason
backward.70
Exhibit 31 is an example of a game tree that Pankaj Ghemawat developed to reflect the payoffs from various
decisions in the early days of the satellite radio industry when two companies, Sirius Satellite Radio and XM
CI 190
350
CI 163
4
18
CI 155
454
CI 50
428
CI 168
507
CI 168
507
CI 138
511
CI 1
24
504
CI 129
585
CI 126
636
CI 129
585
CI 116
624
CI 128
669
No price change
C has large price
advantage
C has small price
advantage
I neutralizes C’s
advantage
Incumbent (I)
Price
Challenger (C) Price
Very Low Low Moderate High
November 1, 2016
Measuring the Moat 44
Satellite Radio, went head-to-head.71 Sirius’s choice was between escalating its investment by acquiring its
own content and following the traditional radio model of licensing content. In either case, XM could have
responded by choosing to escalate its own content investment. The payoffs at the end of the tree show the
economic consequences of the various scenarios. In reality, such analysis is difficult because the range of
alternatives is large. But game trees provide insight into competitive interaction and hence the prospects for
sustainable value creation.
Exhibit 31: Mapping Sequential Moves in Content Acquisition for Satellite Radio Companies
Source: Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall, Inc., 2009), 74-77.
Another good example of game theory is the month-long turmoil in the interbank loan market during the fall of
2008. John Stinespring and Brian Kench, professors of economics, describe the decisions that banks faced
when the bankruptcy of Lehman Brothers sent a jolt of fear through the financial system. One result was that
banks became reluctant to lend overnight to one another. This institutional lending and borrowing is essential
to the liquidity of the financial system.72
Stinespring and Kench frame the decision in the throes of the crisis as a game of Loan or No Loan for two
banks, A and B. (See Exhibit 32.) The payoffs in the table are the expected profits for each bank. (A’s profits
are shown on the left, and B’s are on the right.) If both banks choose “Loan,” liquidity is preserved in the
system, and both banks secure an expected profit of $10. If both banks choose “No Loan,” interbank lending
decreases, liquidity dries up, and both banks incur an expected loss of $10.
Exhibit 32: Prisoner’s Dilemma in Interbank Loan Market
Source: John Robert Stinespring and Brian T. Kench, “Explaining the Interbank Loan Crisis of 2008: A Teaching Note,” February 1, 2009. See:
http://ssrn.com/abstract=1305392.
Sirius
XM
Not escalate
content
XM
Escalate
content
Not escalate
content
Escalate
content
Not escalate
content
Escalate
content
Sirius: $1.4B
XM: $2.1B
Sirius: $1.4B
XM: $1.7B
Sirius: $1.7B
XM: $1.4B
Sirius: $1.4B
XM: $0.8B
Loan
Bank A
Bank B
No Loan
15, -15No Loan -10, -10
10, 10Loan -15, 15
http://ssrn.com/abstract=1305392
November 1, 2016
Measuring the Moat 45
The best result for the system is for both banks to Loan. Nevertheless, when we follow the logic of the payoff
matrix, we see that A is unlikely to choose Loan when it considers what B might do. (The same logic applies
for B.) If A thinks B will choose No Loan, A will select No Loan (-10 versus -15). If A thinks that B will
choose Loan, A’s best response is still No Loan (+15 versus +10). It’s a classic prisoner’s dilemma, where
the optimal strategy in a single interaction is the least attractive in repeated interactions.
Our discussion so far has focused on competition. But thoughtful strategic analysis also recognizes the role of
co-evolution, or cooperation, in business. Not all business relationships are based on conflict. Sometimes
companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.
Consider the example electric car manufacturers and the makers of charging stations. A consumer is more
likely to purchase an electric vehicle when the number and quality of options for charging increases. And
charging stations are more valuable if there are more electric vehicles on the road. Complementors make the
added value pie bigger. Competitors fight over a fixed pie.
November 1, 2016
Measuring the Moat 46
Brands
When queried about sustainable competitive advantage, many executives and investors cite the importance of
brands. The question is whether brands, in and of themselves, are a source of advantage.
Interbrand, a brand consultant, publishes annually its list of the most valuable brands in the world.73 If brands
are clearly linked to value creation, you should see a one-to-one relationship between brand strength and
economic returns. This is not the case empirically. Of the companies that own the top ten most valuable
brands, two barely earned their cost of capital in the latest fiscal year, and there is a weak correlation between
brand ranking and economic return. (See Exhibit 33.) So a brand is clearly not sufficient to ensure that a
company earns economic profits, much less sustainable economic profits.
Exhibit 33: Brand Popularity Does Not Translate into Value Creation
Source: Interbrand, Credit Suisse HOLT; Note: Returns data for financial companies represented by cash flow return on equity minus cost of equity.
Note: Data for latest fiscal year as of 10/25/16.
One way to think about brands is to consider what job a consumer is “hiring” a product or service to do.74
Companies tend to structure their target markets by product category or by customer characteristics. But
consumers do not buy something just because the average consumer in their demographic is supposed to like
it. Instead, they find they need something to get done and they hire a product to do the job. A company can
differentiate itself and build a more enduring brand if it truly understands the job customers want done and
develops its products or services accordingly. A brand, then, represents a product or service that is effective at
getting a job done.
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November 1, 2016
Measuring the Moat 47
From an economic standpoint, the best way to approach brands is to consider the amount of value added. A
brand that represents a business benefiting from network effects or that confers horizontal differentiation may
increase a customer’s willingness to pay. Google, for instance, benefits from the company’s network effects
and adds value to the constituents in its ecosystem. The willingness to pay for a brand is high if you are in the
habit of using it, have an emotional connection to it, trust it, or believe that it confers social status.
It is less common for brands to add value by reducing supplier opportunity cost. A fledgling supplier may try to
land a prestigious company, even at a discounted price, as part of its effort to establish credibility. To the
degree that a brand plays a role in the perception of prestige or credibility, it can reduce supplier opportunity
cost and hence increase added value for the branded company.
November 1, 2016
Measuring the Moat 48
Management Skill and Luck
Managerial skill entails creating a strategy and executing it effectively. But while better strategies will lead to
more successes over time, a good process provides no guarantee of a good outcome. In the highly complex
environment in which companies compete, randomness, or luck, also greatly influences outcomes.75
Customers, competitors, and technological change all contribute to uncertainty in decisions. This suggests
that outsiders should evaluate management teams and the strategies they devise based on the processes they
employ rather than the outcomes they achieve.76
There are numerous books that purport to guide management toward success. Most of the research in these
books follows a common method: find successful businesses, identify the common practices of those
businesses, and recommend that the manager imitate them.
Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of
companies and selected 11 that experienced an improvement from good to great results. He then identified
the common attributes he believed caused those companies to improve and recommended that other
companies embrace those attributes.77 Among the traits were leadership, people, focus, and discipline. While
Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because
performance always depends on both skill and luck, a given strategy will succeed only part of the time.
Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about
assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of
business success fail to answer a critical question: How many of the companies that adopted a particular
strategy actually succeeded?78
Let’s say two companies, A and B, pursue the same strategy and that A succeeds while B fails. A’s financial
performance will look great, while B will die, dropping out of the sample. If we only draw our observations from
the outcome rather than the strategy, we will only see company A. And because we generally associate
success with skill, we will assume that company A’s favorable outcome was the result of skillful strategy.
Naturally, by considering company B’s results as well, we have a better sense of the virtue of the strategy. To
counter this effect, Denrell recommends evaluating all of the companies that pursue a particular strategy so as
to see both successes and failures.
Denrell’s second idea is that it may be difficult to learn from superior performance.79 The notion is that
superior corporate performance is frequently the result of a cumulative process that benefitted from luck. Said
differently, if you were to rewind the tape of time and play it again, the same companies would not succeed
every time. Since some high-performing companies succeed by dint of luck, there is very little to learn from
them. Indeed, companies with good financial performance that compete in industries where cumulative
processes are less pronounced may provide better lessons into the sources of success.
Frustrated by a dearth of rigorous studies on business success, Michael Raynor and Mumtaz Ahmed,
consultants at Deloitte, teamed up with Andrew Henderson, a professor of management, to do a statistical
study to determine which companies achieved levels of superior performance for a sufficient time to
confidently rule out luck. The researchers studied more than 25,000 U.S. publicly traded companies from
1966 to 2010 and used quantile regression to rank them according to their relative performance on return on
assets (ROA). (Bryant Matthews, who manages HOLT Model Development, replicated their process and
found very similar results.)
November 1, 2016
Measuring the Moat 49
This analysis, which controlled for extraneous factors such as survivor bias, company size, and financial
leverage, allowed them to understand the empirical parameters of past corporate performance. They then
weeded out the instances of high performance that were due to randomness in order to find truly great
companies. The bad news is that a large percentage of above average corporate performance is attributable to
luck. The good news is that some companies truly are exceptional performers. Their analysis yielded a sample
of 344 such companies.80
Raynor and Ahmed used their model to see whether the firms hailed as exemplary performers in popular
books on business success were likely simply the beneficiaries of luck. The authors examined 699 companies
featured in 19 popular books on high performance and tested them to see how many were truly great. Of the
companies that they were able to categorize, just 12 percent met their criteria.81
In an earlier paper they wrote, “Our results show that it is easy to be fooled by randomness, and we suspect
that a number of the firms that are identified as sustained superior performers based on 5-year or 10-year
windows may be random walkers rather than the possessors of exceptional resources.”82
Once the researchers identified their sample of truly skillful companies, they did what other authors of the
“success study” genre do: they studied the strategies of those superior companies for common patterns that
might prove useful to business executives trying to replicate such sustained success.
They divided the skillful companies into two groups according to the performance threshold they crossed often
enough to rule out luck: Miracle Workers (top 10 percent of ROA), which consisted of 174 companies, and
Long Runners (top 20-40 percent of ROA), which consisted of 170 companies. They labeled the final group
Average Joes.
By identifying a sample of truly superior companies, the authors were able to study the behaviors that
appeared to be behind their performance advantages. They couldn’t find any commonalities when they looked
at specific actions but made a breakthrough when they examined the general manner in which these
companies thought. The manner was highly consistent and fit with a generic differentiation strategy. Raynor
and Ahmed argue that, when considering business decisions, the skillful companies acted as if they followed
two essential rules:
1. Better before cheaper: compete on differentiators other than price.
2. Revenue before cost: prioritize increasing revenue over reducing costs.
Based on this analysis, they suggest two steps for managers. The first is to gain a clear sense of a company’s
competitive position and profit formula. Following this step, a company should understand clearly the
composition of its returns (return on assets = return on sales x total asset turnover) and its relative competitive
position. Companies often compare their current financial performance to the past rather than to that of
competitors. Business is a game of relative, not absolute, performance.
The second step is to make resource allocation decisions consistent with the rules. So when faced with a
choice between offering a product or service with a low price and minimal standards versus a higher price and
superior benefits, such as a strong brand or greater convenience, executives should opt for the latter. Or a
company should prefer a merger that realizes the opportunity to expand versus one that simply achieves
economies of scale.
November 1, 2016
Measuring the Moat 50
Regression Toward the Mean
There is regression toward the mean any time the correlation between two assessments of the same measure
over time is less than 1.0. The rate of regression is a function of the correlation coefficient. A correlation
coefficient of 1.0 indicates that the next result is exactly predictable from the last, and a correlation of zero
shows that the outcome is random. Activities with high correlations are based more on skill, and those with
low correlations are based more on luck.
The second column of Exhibit 34 shows the year-to-year correlations for CFROI for 25 industries. The data
are intuitive. Industries selling consumer packaged goods are less subject to rapid regression than industries
with exposure to commodities, financials, or technology. What’s valuable is that the exhibit provides a
quantitative means to think about the rate of regression.
The third column of the exhibit shows the average CFROI for each industry. This is essentially the CFROI to
which an individual company’s results regress.
The combination of a qualitative framework in the report and the quantitative results below provides an investor
or executive with a robust framework to assess sustainable value creation.
Exhibit 34: Rate of Regression and Toward What Mean CFROIs Regress for 25 Industries
Source: Bryant Matthews and David A. Holland, “HOLT Industry Profitability Handbook,” Credit Suisse HOLT Market
Commentary, October 4, 2016.
How Much Regression? Toward What Mean?
Sector
One-Year Correlation
Coefficient
Long-Term Average
CFROI (%)
Food, Beverage, & Tobacco 0.95 8.6
Household & Personal Products 0.95 12.3
Food & Staples Retailing 0.93 8.2
Consumer Services 0.92 8.0
Commercial & Professional Services 0.91 11.1
Capital Goods 0.89 6.7
Health Care Equipment & Services 0.89 11.7
Pharmaceuticals, Biotechnology, & Life Sciences 0.89 8.1
Media 0.88 9.9
Transportation 0.87 5.2
Consumer Durables & Apparel 0.87 8.5
Retailing 0.87 8.7
Regulated Utilities 0.86 3.2
Software & Services 0.85 12.3
Automobiles & Components 0.83 5.2
Telecommunication Services 0.83 6.1
Technology Hardware & Equipment 0.82 6.8
Utilities 0.82 4.1
Insurance 0.81 8.5
Energy 0.78 5.7
Materials 0.78 4.9
Semiconductors & Semiconductor Equipment 0.77 6.6
Real Estate 0.77 4.6
Banks 0.76 9.3
Diversified Financials 0.73 9.0
November 1, 2016
Measuring the Moat 51
Bringing It All Back Together
Stock prices reflect expectations for future financial performance. Accordingly, an investor’s task is to
anticipate revisions in those expectations. A firm grasp of the prospects for value creation is a critical facet of
this analysis. But value creation by itself does not lead to superior stock price performance if the market fully
anticipates that value creation.
The expectations investing process has three parts:83
1. Estimate price-implied expectations. We first read the expectations embedded in a stock with a long-
term discounted cash flow model (DCF). We use a DCF model because it mirrors the way the market
prices stocks.
2. Identify expectations opportunities. Once we understand expectations, we apply the appropriate
strategic and financial tools to determine where and when revisions are likely to occur. A proper
expectations analysis reveals whether a stock price is most sensitive to revisions in a company’s sales,
operating costs, or investment needs so that investors can focus on the revisions that matter most. The
strategic analysis in this report is the heart of security analysis and provides the surest means to
anticipate expectations revisions.
3. Buy, sell, or hold. Using expected-value analysis, we are now in a position to make informed buy, sell,
or hold decisions.
A thorough analysis of a company’s prospects for sustainable value creation is essential. This analysis can
then intelligently inform a financial model to determine whether or not a particular stock offers prospects for
superior returns.
November 1, 2016
Measuring the Moat 52
Warren Buffett on Economic Moats
What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something
that differentiates the company from its nearest competitors – either in service or low cost or taste or
some other perceived virtue that the product possesses in the mind of the consumer versus the next best
alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing –
even though you can’t see it.
Outstanding Investor Digest, June 30, 1993
Look for the durability of the franchise. The most important thing to me is figuring out how big a moat
there is around the business. What I love, of course, is a big castle and a big moat with piranhas and
crocodiles.
Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994
The key to investing is not assessing how much an industry is going to affect society, or how much it will
grow, but rather determining the competitive advantage of any given company and, above all, the
durability of that advantage. The products or services that have wide, sustainable moats around them are
the ones that deliver rewards to investors.
Warren Buffett and Carol Loomis, “Mr. Buffett on the Stock Market,” Fortune, November 22, 1999
We think of every business as an economic castle. And castles are subject to marauders. And in
capitalism, with any castle . . . you have to expect . . . that millions of people out there . . . are thinking
about ways to take your castle away.
Then the question is, “What kind of moat do you have around that castle that protects it?”
Outstanding Investor Digest, December 18, 2000
When our long-term competitive position improves . . . we describe the phenomenon as “widening the
moat.” And doing that is essential if we are to have the kind of business we want a decade or two from
now. We always, of course, hope to earn more money in the short-term. But when short-term and long-
term conflict, widening the moat must take precedence.
Berkshire Hathaway Letter to Shareholders, 2005
A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that
is earning high returns . . . Our criterion of “enduring” causes us to rule out companies in industries prone
to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society,
it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at
all . . . Additionally, this criterion eliminates the business whose success depends on having a great
manager.
Berkshire Hathaway Letter to Shareholders, 2007
November 1, 2016
Measuring the Moat 53
Appendix A: Checklist for Assessing Value Creation
Overview
In what stage of the competitive life cycle is the company?
Is the company currently earning a return above its cost of capital?
Are returns on invested capital increasing, decreasing, or stable? Why?
What is the trend in the company’s investment spending, including mergers and acquisitions?
Lay of the Land
What percentage of the industry does each player represent?
What is each player’s level of profitability?
What have the historical trends in market share been?
How stable is the industry?
How stable is market share?
What do pricing trends look like?
What class does the industry fall into—fragmented, emerging, mature, declining, international, network,
or hypercompetitive?
The First Three of the Five Forces
How much leverage do suppliers have?
Can companies pass price increases from their suppliers on to their customers?
Are there substitute products available?
Are there switching costs?
How much leverage do buyers have?
How informed are the buyers?
Barriers to Entry
What are the rates of entry and exit in the industry?
How will the incumbents react to the threat of new entrants?
What is the reputation of incumbents?
How specific are the assets?
What is the minimum efficient production scale?
Does the industry have excess capacity?
Is there a way to differentiate the product?
What is the anticipated payoff for a new entrant?
Do incumbents have precommitment contracts?
Do incumbents have costly licenses or patents?
Are there benefits from the learning curve?
Rivalry
Is there pricing coordination?
What is the industry concentration?
What is the size distribution of firms?
How similar are the firms in incentives, corporate philosophy, and ownership structure?
Is there demand variability?
Are there high fixed costs?
Is the industry growing?
November 1, 2016
Measuring the Moat 54
Disruption and Disintegration
Is the industry vulnerable to disruptive innovation?
Do new innovations foster product improvements?
Is the innovation progressing faster than the market’s needs?
Have established players passed the performance threshold?
Is the industry organized vertically, or has there been a shift to horizontal markets?
Firm Specific
Does the firm have production advantages?
Is there instability in the business structure?
Is there complexity requiring know-how or coordination capabilities?
How quickly are the process costs changing?
Does the firm have any patents, copyrights, trademarks, etc.?
Are there economies of scale?
What does the firm’s distribution scale look like?
Are assets and revenue clustered geographically?
Are there purchasing advantages with size?
Are there economies of scope?
Are there diverse research profiles?
Are there consumer advantages?
Is there habit or horizontal differentiation?
Do people prefer the product to competing products?
Are there lots of product attributes that customers weigh?
Can customers only assess the product through trial?
Is there customer lock-in? Are there high switching costs?
Is the network radial or interactive?
What is the source and longevity of added value?
Are there external sources of added value (subsidies, tariffs, quotas, and competitive or
environmental regulations)?
Firm Interaction—Competition and Coordination
Does the industry include complementors?
Is the value of the pie growing because of companies that are not competitors? Or, are new companies
taking share from a pie with fixed value?
Brands
Do customers want to “hire” the brand for the job to be done?
Does the brand increase willingness to pay?
Do customers have an emotional connection to the brand?
Do customers trust the product because of the name?
Does the brand imply social status?
Can you reduce supplier operating cost with your name?
November 1, 2016
Measuring the Moat 55
Appendix B: Profit Pool Analysis for Health Care
Our profit pool example in the body of this report showed one of the most value-destructive industries (airlines).
Here, we conduct a similar exercise for the U.S. health care sector, which has consistently created value, as
well as pharmaceuticals, the sector’s largest constituent industry. We begin by using Credit Suisse HOLT data
to examine the returns across various activities in the health care value chain. (See Exhibit 35.)
Exhibit 35: U.S. Health Care Sector Profit Pools by Activity, 2005-2015
Source: Credit Suisse HOLT.
0
3
6
9
12
15
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2010
Pharmaceuticals
HC
tech
HC providers
& services
100%
HC equipment
& supplies
Biotech
Life
sciences
0
3
6
9
12
15
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
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rc
e
n
t)
Share of Industry Gross Investment
2015
Pharmaceuticals
HC
tech
HC providers
& services
100%
HC equipment
& supplies
Biotech
Life
sciences
0
3
6
9
12
15
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2005
Pharmaceuticals
HC
tech
HC providers
& services
100%
HC equipment
& supplies
Biotech
Life
sciences
November 1, 2016
Measuring the Moat 56
We see from the horizontal axis that each activity’s share of the industry’s total investment has shifted slightly
over the past decade, with pharmaceuticals shrinking and health care equipment & supplies and biotech
growing. The vertical axis tells a similar story, with economic returns falling for pharmaceuticals and rising for
biotech, indicating that biotech is capturing a much greater share of the value pie within the overall sector.
We can demonstrate this with some simple calculations. By summing the area of each of the blocks, we find
that the total value pie for the sector was roughly $100 billion in 2005, $120 billion in 2010, and $190 billion
in 2015. The pharmaceutical industry saw its share of that pie fall from roughly one-half in 2005 to about
one-third in 2015, while the biotechnology industry rose from about one-tenth to one-quarter.
We can zoom in on the U.S. pharmaceuticals industry. (See Exhibit 36). Creating a narrative to explain the rise
and fall of the various competitors can provide important clues about what it takes to generate sustainable
value creation. At a group level, it is clear that the pharmaceuticals industry has consistently earned above its
cost of capital. However, those returns have fallen over the last decade due in part to a dearth of blockbuster
drugs and increased generic competition following some key patent expirations.84
November 1, 2016
Measuring the Moat 57
Exhibit 36: U.S. Pharmaceuticals Industry Profit Pools by Company, 2005-2015
Source: Credit Suisse HOLT.
Note: J&J = Johnson & Johnson.
0
5
10
15
20
25
30
35
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2005
Pfizer
Bristol-
Myers
Other
J&J
Eli Lilly
100%
Merck
Wyeth
Schering-
Plough
Allergan,
Inc
Actavis
Valeant
0
5
10
15
20
25
30
35
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
e
rc
e
n
t)
Share of Industry Gross Investment
2010
Pfizer Bristol-
Myers Other
J&J Eli Lilly
100%
Merck
Allergan,
Inc
Actavis
Valeant
0
5
10
15
20
25
30
35
C
F
R
O
I
m
in
u
s
D
is
c
o
u
n
t
R
a
te
(
P
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rc
e
n
t)
Share of Industry Gross Investment
2015
Pfizer
Bristol-
Myers Other
J&J
Eli Lilly
100%
Merck
Allergan
PLC
Valeant
November 1, 2016
Measuring the Moat 58
Another thing that stands out is the consolidation and declining returns at the top of the industry. The largest
three firms increased their overall share of the industry substantially, due largely to merger activity. But over
that time, their economic returns fell more sharply than did the returns of the smaller firms in the industry.
We can also determine the total size of the profit pool by measuring and summing the value of each block.
The total economic profit of the industry rose from roughly $50 billion in 2005 to $53 billion in 2010, and rose
to $60 billion in 2015. The top three firms represented 61 percent of the industry’s total economic value in
2015, down from 72 percent in 2005.
November 1, 2016
Measuring the Moat 59
Endnotes
1 Bartley J. Madden, CFROI Valuation: A Total System Approach to Valuing the Firm (New York: Butterworth-
Heinemann, 1999); Michael Mauboussin and Paul Johnson, “Competitive Advantage Period (CAP): The
Neglected Value Driver,” Financial Management, Vol. 26, No. 2, Summer 1997, 67-74; Alfred Rappaport,
Creating Shareholder Value: A Guide for Managers and Investors – Revised and Updated (New York: Free
Press, 1998); William E. Fruhan, Jr., Financial Strategy: Studies in the Creation, Transfer, and Destruction of
Shareholder Value (Homewood, Il.: Richard D. Irwin, Inc., 1979); Merton H. Miller and Franco Modigliani,
“Dividend Policy, Growth, and the Valuation of Shares,” The Journal of Business, Vol. 34, October 1961,
411-433. For empirical research, see Brett C. Olsen, “Firms and the Competitive Advantage Period,” Journal
of Investing, Vol. 22, No. 4, Winter 2013, 41-50 and Michael J. Mauboussin, Dan Callahan, and Darius Majd,
“The Base Rate Book: Integrating the Past to Better Anticipate the Future,” Credit Suisse Global Financial
Strategies, September 26, 2016.
2 David Besanko, David Dranove, Mark Shanley, and Scott Schaefer, Economics of Strategy-6th Ed.
(Hoboken, NJ: John Wiley & Sons, 2013), 294-295.
3 Horace Secrist, The Triumph of Mediocrity in Business (Evanston, IL: Bureau of Business Research,
Northwestern University, 1933); Pankaj Ghemawat, Commitment: The Dynamic of Strategy (New York: Free
Press, 1991), 82; and Bartley J. Madden, “The CFROI Life Cycle,” Journal of Investing, Vol. 5, No. 2,
Summer 1996, 10-20.
4 Robert R. Wiggins and Timothy W. Ruefli, “Schumpeter’s Ghost: Is Hypercompetition Making the Best of
Times Shorter?,” Strategic Management Journal, Vol. 26, No. 10, October 2005, 887-911; Robert R.
Wiggins and Timothy W. Ruefli, “Sustained Competitive Advantage: Temporal Dynamics and the Incidence
and Persistence of Superior Economic Performance,” Organizational Science, Vol. 13, No. 1, January-
February 2002, 82-105; Richard A. D’Aveni, Beat the Commodity Trap: How to Maximize Your Competitive
Position and Increase Your Pricing Power (Boston, MA: Harvard Business Press, 2010); Rita Gunther
McGrath, The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business
(Boston, MA: Harvard Business Review Press, 2013).Wiggins and Ruefli find evidence of sustained
competitive advantage not as the result of one main advantage but rather of smaller, concatenating
advantages. Consistent with this is Kuo-Feng Huang, Romano Dyerson, Lei-Yu Wu, and G. Harindranath,
“From Temporary Competitive Advantage to Sustainable Competitive Advantage,” British Journal of
Management, Vol. 26, No. 4, October 2015, 617-636. See also Tammy L. Madsen and Michael J. Leiblein,
“What Factors Affect the Persistence of an Innovation Advantage? Journal of Management Studies, Vol. 52,
No. 8, December 2015, 1097-1127.
5 Bryant Matthews and Raymond Stokes, “Fade and the Persistence of Corporate Returns,” Credit Suisse
HOLT Notes, Credit Suisse, November 2012; Bartley J. Madden, “The CFROI Life Cycle,” Journal of
Investing, Vol. 5, No. 2, Summer 1996, 10-20.
6 Estimates for the cost of equity capital come from Aswath Damodaran, a professor of finance. See
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html.
7 For expectations, see Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock
Prices for Better Returns (Boston, MA: Harvard Business School Press, 2001), 51-52. For sustained value
creation and excess returns, see Adelina Gschwandtner and Michael Hauser, “Profit Persistence and Stock
Returns,” Applied Economics, Vol. 48, No. 37, February 2016.
8 Outstanding Investor Digest, December 18, 2000; Outstanding Investor Digest, June 30, 1993; Also,
economic moats are a key investment theme for Morningstar, which offers research aimed at uncovering
companies with wide and stable or improving economic moats. See: Matthew Coffina, “The Morningstar Guide
to Wide-Moat Stock Investing,” Morningstar Stock Investor, April 2013; Paul Larson, “Moats: Sources and
Outcomes – Not all moats are created equal, and we delve into the differences,” Morningstar Equity
Research, June 2012; and Heather Brilliant and Elizabeth Collins, Why Moats Matter: The Morningstar
Approach to Stock Investing (Hoboken, NJ: John Wiley & Sons, 2014).
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html
November 1, 2016
Measuring the Moat 60
9 Peter Lynch, with John Rothchild, One Up On Wall Street: How To Use What You Already Know To Make
Money in the Market (New York: Penguin Books USA, 1989), 121.
10 For a study based on total shareholder returns, see Richard Foster and Sarah Kaplan, Creative Destruction:
Why Companies That Are Built to Last Underperform the Market – and How to Successfully Transform Them
(New York: Doubleday, 2001). This work addresses a different question than the one we pose here.
11 Thomas Fritz, The Competitive Advantage Period and the Industry Advantage Period: Assessing the
Sustainability and Determinants of Superior Economic Performance (Wiesbaden, Germany: Gabler, 2008);
Anita M. McGahan and Michael E. Porter, “The emergence and sustainability of abnormal profits,” Strategic
Organization, Vol. 1, No. 1, February 2003, 79-108; Anita M. McGahan and Michael E. Porter, “How Much
Does Industry Matter, Really?” Strategic Management Journal, Vol. 18, Summer Special Issue 1997, 15-30;
Thomas C. Powell, “How Much Does Industry Matter? An Alternative Empirical Test,” Strategic Management
Journal, Vol. 17, No. 4, April 1996, 323-334; Richard P. Rumelt, “How Much Does Industry Matter?”
Strategic Management Journal, Vol. 12, No. 3, March 1991, 167-185; Richard Schmalensee, “Do Markets
Differ Much?” American Economic Review, Vol. 75, No. 3, June 1983, 341-351.
12 Anita M. McGahan and Michael E. Porter, “The emergence and sustainability of abnormal profits,” Strategic
Organization, Vol. 1, No. 1, February 2003, 79-108. In Ekaterina V. Karniouchina, Stephen J. Carson,
Jeremy C. Short, and David J. Ketchen Jr., “Extending the Firm Vs. Industry Debate: Does Industry Life Cycle
Stage Matter?” Strategic Management Journal, Vol. 34, No. 8, August 2013, 1010-1018, the researchers
find that the influence of the industry on the variance in firm performance is progressively stronger as the
industry moves from growth to maturity to decline. In David Schröder and Andrew Yim, “Industry Effects in
Firm and Segment Profitability Forecasting: Corporate Diversification, Industry Classification, and Estimate
Reliability,” Working Paper, March 2016, the authors find considerable industry effects, but only for focused
firms.
13 Bruce Greenwald and Judd Kahn, Competition Demystified: A Radically Simplified Approach to Business
Strategy (New York: Portfolio, 2005), 52-54.
14 Lauren Cohen and Andrea Frazzini, “Economic Links and Predictable Returns,” Journal of Finance, Vol. 63,
No. 4, August 2008, 1977-2011. Also, Yuyan Guan, M. H. Franco Wong, and Yue Zhang, “Analyst
Following Along the Supply Chain,” Review of
Accounting Studies, Vol. 20, No. 1, March 2015, 210-241.
15 Orit Gadiesh and James L. Gilbert, “Profit Pools: A Fresh Look at Strategy,” Harvard Business Review,
May-June 1998, 139-147; Orit Gadiesh and James L. Gilbert, “How To Map Your Industry’s Profit Pool,”
Harvard Business Review, May-June 1998, 149-162; Also Bryant Matthews, David A. Holland, Michael J.
Mauboussin, and Dan Callahan, “Global Industry Profit Pools,” Credit Suisse HOLT Market Commentary, July
2016.
16 Michael E. Porter, “The Five Competitive Forces that Shape Strategy,” Harvard Business Review, January
2008, 78-93.
17 International Air Transport Association, “Profitability and the air transport value chain,” IATA Economics
Briefing No. 10, June 2013, 19-20; Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed.
(Upper Saddle River, NJ: Prentice-Hall, Inc., 2009).
18 International Air Transport Association, “Industry Profitability Improves,” Press Release No. 27, June 2,
2016.
19 Andrew Frye and Dakin Campbell, “Buffett Says Pricing Power More Important than Good Management,”
Bloomberg, February 18, 2011. For more on pricing strategy, see Andreas Hinterhuber and Stephan Liozu,
“Is It Time to Rethink Your Pricing Strategy?” MIT Sloan Management Review, Summer
2012.
20 Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York:
The Free
Press, 1980).
21 Joan Magretta, Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston,
MA: Harvard Business Review Press, 2012); Michael E. Porter, “The Five Competitive Forces That Shape
Strategy,” Harvard Business Review, January 2008, 78-93.
22 This section relies heavily on Rappaport and Mauboussin, 54-57.
November 1, 2016
Measuring the Moat 61
23 Brian Headd, Alfred Nucci, and Richard Boden, “What Matters More: Business Exit Rates or Business
Survival Rates?” BDS Statistical Brief, U.S. Census Bureau, 2010; Glenn R. Carroll and Michael T. Hannan,
The Demography of Corporations and Industries (Princeton, NJ: Princeton University Press, 2000), 51-52;
Deborah Gage, “The Venture Capital Secret: 3 Out of 4 Start-Ups Fail,” Wall Street Journal, September 20,
2012. For a distinction between closure and failure, see Brian Headd, “Redefining Business Success:
Distinguishing Between Closure and Failure,” Small Business Economics, Vol. 21, No. 1, August 2003, 51-
61.
24 Steven Klepper, Experimental Capitalism: The Nanoeconomics of American High-Tech Industries (Princeton,
NJ: Princeton University Press, 2016); Steven Klepper, “Entry, Exit, Growth, and Innovation over the Product
Life Cycle,” American Economic Review, Vol. 86, No. 3, June 1996, 562-583; Steven Klepper, “Industry Life
Cycles,” Industrial and Corporate Change, Vol. 6, No. 1, January 1997, 145-181; Steven Klepper and
Elizabeth Graddy, “The evolution of new industries and the determinants of market structure,” RAND Journal
of Economics, Vol. 21, No. 1, Spring 1990, 27-44; Rajshree Agarwal and Serguey Braguinsky, “Industry
Evolution and Entrepreneurship: Steven Klepper’s Contributions to Industrial Organization, Strategy,
Technological Change, and Entrepreneurship,” Strategic Entrepreneurship Journal, Vol. 9, No. 4, December
2015, 380-397; Robin Gustafsson, Mikko Jääskelainen, Markku Maula, and Juha Uotila, “Emergence of
Industries: A Review and Future Directions,” International Journal of Management Reviews, Vol. 18, No. 1,
January 2016, 28-50; and Mariana Mazzucato, Firm Size, Innovation and Market Structure: The Evolution of
Industry Concentration and Instability (Northampton, MA: Edward Elgar Publishing, 2000), 34.
25 Timothy Dunne, Mark J. Roberts, and Larry Samuelson, “Patterns of firm entry and exit in U.S.
manufacturing industries,” RAND Journal of Economics, Vol. 19, No. 4, Winter 1988, 495-515 and Timothy
Dunne, Shawn D. Klimek, Mark J. Roberts, and Daniel Yi Xu, “Entry, Exit, and the Determinants of Market
Structure,” The RAND Journal of Economics, Vol. 44, No. 3, Fall 2013, 462-487.
26 Here we follow closely the presentation format of Besanko, Dranove, Shanley, and Schaefer, 197-198.
27 Bryant Matthews and Raymond Stokes, “Fade and the Persistence of Corporate Returns,” Credit Suisse
HOLT Notes, Credit Suisse, November 2012; Richard Disney, Jonathan Haskel, and Ylva Heden, “Entry, Exit
and Establishment Survival in UK Manufacturing,” Journal of Industrial Economics, Vol. 51, No. 1, March
2003, 91-112.
28 We base this discussion on Sharon M. Oster, Modern Competitive Analysis (Oxford: Oxford University
Press, 1999), 57-82.
29 A similar example is the competition between CSX and Norfolk Southern to deliver coal to Gainesville,
Florida. See Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition: 1. A Revolutionary Mindset That
Combines Competition and Cooperation. 2. The Game Theory Strategy That’s Changing the Game of
Business (New York: Doubleday, 1996), 76-80. For a survey of the research on co-opetition, see Ricarda B.
Bouncken, Johanna Gast, Sascha Kraus, and Marcel Bogers, “Coopetition: a Systematic Review, Synthesis,
and Future Research Directions,” Review of Managerial Science, Vol. 9, No. 3, July 2015, 577-601 and
Stefanie Dorn, Bastian Schweiger, and Sascha Albers, “Levels, Phases and Themes of Coopetition: A
Systematic Literature Review and Research Agenda,” European Management Journal, Vol. 34, No. 5,
October 2016, 484-500.
30 Besanko, Dranove, Shanley, and Schaefer, 119-120.
31 Brandenburger and Nalebuff, 72-76.
32 Besanko, Dranove, Shanley, and Schaefer, 77-78.
33 Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Boston, MA:
Harvard Business School Press, 1999), 173-225. Also, Michael J. Mauboussin, “Exploring Network
Economics,” Mauboussin on Strategy, October 11, 2004.
34 Frank Linde, Maurice Kock, and Alexandra Gorges, “Network Effects of Digital Information Goods: A
Proposal for the Operationalization of Direct and Indirect Network Effects,” International Journal of Business
Research, Vol. 12, No. 3, July 2012; Allan Afuah, “Are Network Effects Really All About Size? The Role of
Structure and Conduct,” Strategic Management Journal, Vol. 34, No. 3, March 2013, 257-273.
November 1, 2016
Measuring the Moat 62
35 Robert Smiley, “Empirical Evidence on Strategic Entry Deterrence,” International Journal of Industrial
Organization, Vol. 6, No. 2, June 1988, 167-180; J. Anthony Cookson, “Anticipated Entry and Entry
Deterrence: Evidence from the American Casino Industry,” Working Paper, December 2015; and Austan
Goolsbee and Chad Syverson, “How Do Incumbents Respond to the Threat of Entry? Evidence from the Major
Airlines,” Quarterly Journal of Economics, Vol. 123, No. 4, November 2008, 1611-1633.
36 Colin Camerer and Dan Lovallo, “Overconfidence and Excess Entry: An Experimental Approach,” American
Economic Review, Vol. 89, No. 1, March 1999, 306-318. Other relevant papers on entry and exit include
Daniel W. Elfenbein, Anne Marie Knott, and Rachel Croson, “Equity Stakes and Exit: An Experimental
Approach to Decomposing Exit Delay,” Strategic Management Journal, Forthcoming and Daylian M. Cain,
Don A. Moore, and Uriel Haran, “Making Sense of Overconfidence in Market Entry,” Strategic Management
Journal, Vol. 36, No. 1, January 2015, 1-18.
37 Daniel Kahneman and Amos Tversky, “On the Psychology of Prediction,” Psychological Review, Vol. 80,
No. 4, July 1973, 237-251. Also Michael J. Mauboussin, Dan Callahan, and Darius Majd, “The Base Rate
Book: Integrating the Past to Better Anticipate the Future,” Credit Suisse Global Financial Strategies,
September 26, 2016.
38 Michael J. Mauboussin, Think Twice: Harnessing the Power of Counterintuition (Boston, MA: Harvard
Business Press, 2009), 1-16.
39 Oster, 33-34.
40 Kewei Hou and David T. Robinson, “Industry Concentration and Average Stock Returns,” Journal of
Finance,
Vol. 61, No. 4, August 2006, 1927-1956.
41 John Asker, Joan Farre-Mensa, and Alexander Ljungqvist, “Corporate Investment and Stock Market Listing:
A Puzzle?” European Corporate Governance Institute (ECGI) – Finance Research Paper Series, April 22,
2013.
42 Clayton M. Christensen, The Innovator’s Dilemma: When New Technologies Cause Great Companies to
Fail (Boston, MA: Harvard Business School Press, 1997). For additional discussion (including criticism) of the
model, see Clayton M. Christensen, Michael E. Raynor, and Rory McDonald, “What Is Disruptive Innovation?”
Harvard Business Review, December 2015; Andrew A. King and Baljir Baatartogtokh, “How Useful Is the
Theory of Disruptive Innovation,” MIT Sloan Management Review, Vol. 57, No. 1, Fall 2015; Juan Pablo
Vázquez Sampere, Martin J. Bienenstock, and Ezra W. Zuckerman, “Debating Disruptive Innovation,” MIT
Sloan Management Review, Spring 2016. A game called Colonel Blotto has some interesting parallels with
the disruptive innovation model. See Michael J. Mauboussin, The Success Equation: Untangling Skill and
Luck in Business, Sports, and Investing (Boston, MA: Harvard Business Review Press, 2012), 179-185.
43 Christensen, 32.
44 Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution: Creating and Sustaining
Successful Growth (Boston, MA: Harvard Business School Publishing, 2003), 43-46.
45 Clayton M. Christensen, Michael E. Raynor, and Scott D. Anthony, “Six Keys to Building New Markets by
Unleashing Disruptive Innovation,” Harvard Management Update, January 2003.
46 Clayton M. Christensen, Matt Verlinden, and George Westerman, “Disruption, Disintegration and the
Dissipation of Differentiability,” Industrial and Corporate Change, Vol. 11, No. 5, November 2002, 955-993;
Carliss Y. Baldwin and Kim B. Clark, Design Rules: The Power of Modularity (Cambridge, MA: The MIT
Press, 2000).
47 Michael J. Mauboussin, Think Twice: Harnessing the Power of Counterintuition (Boston, MA: Harvard
Business Press, 2009), 89-91.
48 Joseph L. Bower and Clark G. Gilbert, From Resource Allocation to Strategy (Oxford: Oxford University
Press, 2005); Robert A. Burgelman, Strategy Is Destiny: How Strategy-Making Shapes a Company’s Future
(New York: Free Press, 2002); William P. Barrett, The Red Queen among Organizations: How Competition
Evolves (Princeton, NJ: Princeton University Press, 2008).
49 Michael E. Porter, “What is Strategy?” Harvard Business Review, November-December 1996, 61-78;
Richard P. Rumelt, Good Strategy Bad Strategy: The Difference and Why It Matters (New York: Crown
November 1, 2016
Measuring the Moat 63
Business, 2011). On trade-offs, see Frances Frei and Anne Morriss, Uncommon Service: How to Win by
Putting Customers at the Core of Your Business (Boston, MA: Harvard Business Review Press, 2012).
50 Adam M. Brandenburger and Harborne W. Stuart, Jr., “Value-Based Business Strategy,” Journal of
Economics & Management Strategy, Vol. 5, No.1, Spring 1996, 5-24.
51 Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition: 1. A Revolutionary Mindset That Combines
Competition and Cooperation. 2. The Game Theory Strategy That’s Changing the Game of Business (New
York: Doubleday, 1996), 16-19.
52 Magretta, 73-84.
53 Ibid., 21-28.
54 Mae Anderson, “From idea to store shelf: a new product is born,” Associated Press, March 4, 2012;
Procter & Gamble Q3 2011 earnings call, April 28, 2011.
55 Jeffrey Williams, “How Sustainable Is Your Competitive Advantage?” California Management Review, Vol.
34, No. 3, 1992, 29-51.
56 Adam M. Brandenburger and Harborne W. Stuart, Jr., “Value-Based Business Strategy,” Journal of
Economics & Management Strategy, Vol. 5, 1, Spring 1996, 5-24.
57 Richard E. Caves and Pankaj Ghemawat, “Identifying Mobility Barriers,” Strategic Management Journal, Vol.
13, No. 1, 1992, 1-12.
58 For example, see http://flowingdata.com/2013/06/26/grocery-store-geography/.
59 Jim Kling, “From Hypertension to Angina to Viagra,” Modern Drug Discovery, Vol. 1, No. 2, November-
December 1998.
60 Bruce Greenwald and Judd Kahn, “All Strategy Is Local,” Harvard Business Review, September 2005, 94-
104.
61 Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema, Value Investing: From Graham
to Buffett and Beyond (New York: John Wiley & Sons, 2001), 77-78. For interesting, if controversial,
research on brand preference, see: Samuel M. McClure, Jian Li, Damon Tomlin, Kim S. Cypert, Latané M.
Montague, and P. Read Montague, “Neural Correlates of Behavioral Preference for Culturally Familiar Drinks,”
Neuron, Vol. 44, No. 2, October
14, 2004, 379-387.
62 Everett M. Rogers, The Diffusion of Innovations (New York: Free Press, 1995). Also, Michael J.
Mauboussin and Dan Callahan, “Total Addressable Market: Methods to Estimate a Company’s Sales,” Credit
Suisse Global Financial Strategies, September 1, 2015.
63 For a more complete discussion, see Oster, 326-346.
64 A survey by McKinsey shows that companies don’t react to competitive threats as management theory
suggests they should. See “How Companies Respond to Competitors: A McKinsey Global Survey,” McKinsey
Quarterly, April 2008.
65 For an excellent resource see http://plato.stanford.edu/entries/prisoner-dilemma/.
66 “Stern Stewart EVA Roundtable,” Journal of Applied Corporate Finance, Vol. 7, No. 2, Summer 1994, 46-
70.
67 Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall,
2009), 69-72.
68 Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1985).
69 Rappaport and Mauboussin, 57.
70 Avinash K. Dixit and Barry J. Nalebuff, The Art of Strategy: A Game Theorist’s Guide to Success in
Business and Life (New York: W. W. Norton & Co., 2008); Joshua S. Gans and Michael D. Ryall, “Value
Capture Theory: A Strategic Management Review,” Rotman School of Management Working Paper, February
2016.
71 Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall,
2009), 74-77.
72 John Robert Stinespring and Brian T. Kench, “Explaining the Interbank Loan Crisis of 2008: A Teaching
Note,” February 1, 2009. See: http://ssrn.com/abstract=1305392. For a fascinating connection between
http://plato.stanford.edu/entries/prisoner-dilemma/
http://ssrn.com/abstract=1305392
November 1, 2016
Measuring the Moat 64
the Prisoner’s Dilemma and the financial crisis of 2007-2008, see: John Cassidy, “Rational Irrationality,” The
New Yorker, October 5, 2009.
73 Interbrand, “Best Global Brands 2012: The definitive guide to the 100 Best Global Brands.”
74 Clayton M. Christensen, Taddy Hall, Karen Dillon, and David S. Duncan, Competing Against Luck: The
Story of Innovation and Customer Choice (New York: HarperBusiness, 2016); Clayton M. Christensen, Taddy
Hall, Karen Dillon, and David S. Duncan, “Know Your Customers’ ‘Jobs to Be Done’,” Harvard Business
Review, September 2016; and Clayton M. Christensen, Scott D. Anthony, Gerald Berstell, and Denise
Nitterhouse, “Finding the Right Job For Your Product,” MIT Sloan Management Review, Spring 2007, 2-11.
75 Jerker Denrell, Christina Fang, Chengwei Liu, “Perspective—Chance Explanations in the Management
Sciences,” Organizational Science, Vol. 26, No. 3, May-June 2015, 923-940.
76 Michael E. Raynor, The Strategy Paradox: Why Commitment to Success Leads to Failure (and What to Do
About It) (New York: Currency Doubleday, 2007).
77 Jim Collins, Good to Great: Why Some Companies Make the Leap . . . and Others Don’t (New York:
Harper Business, 2001).
78 Jerker Denrell, “Vicarious Learning, Undersampling of Failure, and the Myths of Management,” Organization
Science, Vol. 14, No. 3, May–June 2003, 227–243.
79 Jerker Denrell, Christina Fang, and Zhanyun Zhao, “Inferring Superior Capabilities from Sustained Superior
Performance: A Bayesian Analysis,” Strategic Management Journal, Vol. 34, No. 2, February 2013, 182-
196.
80 Michael E. Raynor and Mumtaz Ahmed, The Three Rules: How Exceptional Companies Think (New York:
Penguin Books, 2013), 42-45.
81 Michael E. Raynor and Mumtaz Ahmed, “Three Rules for Making a Company Truly Great,” Harvard
Business Review, April 2013, 108-117. In categorizing the companies, the probability the results were due to
luck had to be lower than 10 percent. The qualifying length of time depended on the company’s life span. For
example, to be a Miracle Worker, a company with 10 years of data was required to be in the top 10 percent
for every year, but a company with 45 years of data was required to be in the top 10 percent for only 16 years.
82 Michael E. Raynor, Mumtaz Ahmed, and Andrew D. Henderson, “A Random Search for Excellence: Why
‘Great Company’ Research Delivers Fables and Not Facts,” Deloitte Research, December 2009; and Andrew
D. Henderson, Michael E. Raynor, and Mumtaz Ahmed, “How Long Must a Firm Be Great to Rule Out Luck?
Benchmarking Sustained Superior Performance Without Being Fooled By Randomness,” Academy of
Management Proceedings, August 2009, 1–6.
83 Rappaport and Mauboussin, 7-8.
84 George Eliades, Michael Retterath, Norbert Hueltenschmidt, and Karan Singh, “Heathcare 2020,” Bain &
Company Research, 2012.
http://pubsonline.informs.org/action/doSearch?text1=Denrell%2C+Jerker&field1=Contrib
http://pubsonline.informs.org/action/doSearch?text1=Fang%2C+Christina&field1=Contrib
http://pubsonline.informs.org/action/doSearch?text1=Liu%2C+Chengwei&field1=Contrib
November 1, 2016
Measuring the Moat 65
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1
JWI-531
FINANCIAL MANAGEMENT II
CHECKLISTS
CONTENTS
MOAT ANALYSIS AND VALUE CREATION: Weeks 1-3 ………………………………………………………….. 2
VALUE INVESTING AND GROWTH INVESTING: WEEKS 4-10 ……………………………………………… 4
ENTERPRISE RISK MANAGEMENT: WEEK 6 ………………………………………………………………………… 6
FINANCIAL STATEMENT ANALYSIS: WEEK 9 ……………………………………………………………………… 8
* Material in these checklists is taken from Credit Suisse: “Measuring the Moat” and from
original sources for use by JWI-531 students only.
2
MOAT ANALYSIS AND VALUE
CREATION: WEEKS 1-3
Why Moats Matter: Guiding Principles of
Morningstar’s Equity Research
How Can We Identify Which Businesses
Are Great?
When Is the Best Time to Invest in
Great Businesses?
What Makes a Moat?
Sustainable Competitive Advantages
Valuation
Margin of Safety
Moat Sources – Five Key Considerations for
Moat Trends
Intangibles
Cost Advantage
Switching Costs
Network Effect
Efficient Scale
Moat Valuation
Cost of Capital and Returns on Capital
Morningstar’s Valuation Approach
Ratio Analysis – ROIC, Price/Earnings,
Price/Sales, Price/Cash Flow, and
Price/Book value
Forecasting Future Free Cash Flows
The Morningstar Rating ™ for Stocks
Fair Value Uncertainty and Cost of
Equity
Putting Moat and Valuation to Work:
Portfolio Strategies
Wide Moat Focus Index
The Tortoise and Hare Portfolios
Analysis Overview
In what stage of the competitive life
cycle is the company?
Is the company currently earning a
return above its cost of capital?
Are returns on invested capital
increasing, decreasing, or stable? Why?
What is the trend in the company’s
investment spending, including mergers
and acquisitions?
Lay of the Land
What percentage of the industry does
each player represent?
What is each player’s level of
profitability?
What have the historical trends in
market share been?
How stable is the industry?
How stable is market share?
What do pricing trends look like?
What class does the industry fall into:
fragmented, emerging, mature,
declining, international, network, or
hypercompetitive?
Porter’s Five Forces
How much leverage do suppliers have?
Can companies pass price increases
from their suppliers on to their
customers?
Are there substitute products available?
Is there Product differentiation?
Are there switching costs? Is there a
competitive advantage through cost
leadership, or focus
How much leverage do buyers have?
How informed are the buyers?
Boston Consulting Group Approach
Historical emphasis: experience curve,
product life cycle, product portfolio
balance
Impact of the Internet and other
innovations
Performance measurements – cash flow
return on investment (CFROI)
Barriers to Entry
What are the rates of entry and exit in
the industry?
How will the incumbents react to the
threat of new entrants?
What is the reputation of incumbents?
How specific are the assets?
What is the minimum efficient
production scale?
Does the industry have excess
capacity?
Is there a way to differentiate the
product?
3
What is the anticipated payoff for a new
entrant?
Do incumbents have pre-commitment
contracts?
Do incumbents have costly licenses or
patents?
Are there benefits from the learning
curve?
Rivalry
Is there pricing coordination?
What is the industry concentration?
What is the size distribution of firms?
How similar are the firms in incentives,
corporate philosophy, and ownership
structure?
Is there demand variability?
Are there high fixed costs?
Is the industry growing?
Disruption and Disintegration
Is the industry vulnerable to disruptive
innovation?
Do new innovations foster product
improvements?
Is the innovation progressing faster than
the market’s needs?
Have established players passed the
performance threshold?
Is the industry organized vertically, or
has there been a shift to horizontal
markets?
Firm Specific Analysis
Does the analysis of the value chain
reveal what the firms does differently
from its rivals?
Does the firm have production
advantages? Is there instability in the
business structure? Is there complexity
requiring know-how or coordination
capabilities? How quickly are the
process costs changing?
Does the firm have any patents,
copyrights, trademarks, etc.?
Are there economies of scale? What
does the firm’s distribution scale look
like? Are assets and revenue clustered
geographically? Are there purchasing
advantages with size? Are there
economies of scope? Are there diverse
research profiles?
Are there consumer advantages? Is
there habit or horizontal differentiation?
Do people prefer the product to
competing products? Are there lots of
product attributes that customers
weigh? Can customers only assess the
product through trial? Is there customer
lock-in? Are there high switching costs?
Is the network radial or interactive?
What is the source and longevity of
added value?
Are there external sources of added
value (subsidies, tariffs, quotas, and
competitive or environmental
regulations)?
Firm Interaction—Competition and
Coordination
Does the industry include
complementors?
Is the value of the pie growing because
of companies that are not competitors?
Or, are new companies taking share
from a pie with fixed value?
Brands
Do customers want to “hire” the brand
for the job to be done?
Does the brand increase willingness to
pay?
Do customers have an emotional
connection to the brand?
Do customers trust the product because
of the name?
Does the brand imply social status?
Can you reduce supplier operating cost
with your name?
4
VALUE INVESTING AND
GROWTH INVESTING:
WEEKS 4-10
Value Investing
Value Investing and Two Essential
Principles – It’s Like Buying Christmas
Cards in January
P/E averages, avoid temptations
Does Value Investing Really Work?
Performance of High versus Low P/E
stocks
Performance of High versus Low
Market-to-Book Stocks
The Power of Multiple Variables
Growth Investing
How to Identify Growth Stocks
Importance of Track Record: Sales and
Earnings
Is There Potential to Grow Sales and
Earnings for Several Years?
How Are Relations with Employees?
How Does the Company Respond to
Challenges?
Is Management Quality Excellent?
How Important Are Profit Margins?
What Is the Company’s Achilles’ heel?
Intrinsic Value
When to Buy Any Stock: Consider
Margin of Safety
The Buffett Investing = Value + Growth
Value Plus Growth
Risk and Volatility: How to Think Profitably
about Them
Risk and Return: Holding Period impact
Volatility Offers Opportunities. Volatility
is a great time to buy low or sell high
More on Downside Risk
Why Hold Cash: Liquidity Brings
Opportunities
Liquidity and the Opportunities it brings
Berkshire’s Investments in Convertibles
Diversification: How Many Baskets Should
You Hold?
Diversification in your portfolio
How Many Stocks Should You Hold?
Philip Fisher Warns against Too Much
Diversification
Diversification and “Diworsification”
When to Sell
Turnover of Berkshire’s Equity Portfolio:
Why Buffett Holds Almost Forever
Two Main Reasons to Sell
How Efficient Is the Stock Market?
Can I Make Money in the Stock Market?
Most Academics Favor Market
Efficiency Recent Evidence on Market
Inefficiency Conclusions
Arbitrage and Hedge Funds
Arbitrage in Merger Deals
An Example of a Successful Arbitrage
Deal by Buffett
Long-Term Capital Management: The
Story of a Hedge Fund and Berkshire
Hathaway
Should You Invest in Hedge Funds or
Private Equity Funds?
Widen the Moat
What is the profitability of Monopolies?
Dominance Does Not Mean High Profits
How to Look for Monopolies
Do Not Sell a Monopoly in a Hurry
Who Wins in Highly Competitive Industries?
Insurance example: Insurance is a
Commodity Business Like Retailing
Two Main Characteristics of a Leader:
Low Cost and Customer Satisfaction
How Do Companies Keep Costs Low?
Property, Plant, and Equipment: Good or
Bad?
Capital Intensity
Capital Intensity and Management
Quality
Key to Success: ROE and Other Ratios
ROE: Return on Equity. The underlying
Performance of a Business
ROA: Return on Assets. Some
companies create more value with the
assets they have.
Accounting Goodwill: Is It Any Good?
Accounting Goodwill and Its Economic
Value
Goodwill and Earnings
5
Goodwill and Profitability of Acquired
Businesses
Behavioral Finance
Behavioral finance tells us that investors
always don’t behave rationally.
When combined with overconfidence,
anchoring and herding can contribute to
market bubbles.
Examine Your Buying and Selling
Patterns: Can You Change Yourself?
How Psychology May Help You? How to
Think about Psychological Biases?
Herding: The assumption by many is
that others have better information than
ourselves and we should follow another
investor’s lead instead on our own
rationale. This can be a costly mistake
for many as this type of thinking only
adds to the panic inside of a market
bubble.
Bigger Fool Theory: States that
investors periodically loose site of the
long run nature of the stock as
investment and forget that in order to
sell a stock at a profit, one must find a
buyer who will pay a higher price.
Anchoring bias: describes how we
associate past performance to future
predictions. While recent and past
events can give us an idea of what to
expect, this is in no way indicative of
what the future will bring. The addition of
our own over confidence in our ability to
predict makes this an issue.
How to Learn from Mistakes
Mistakes versus Bad Luck: mistakes are
a result of effort
Learning from Mistakes: As managers,
mistakes makes us better managers
Mistakes of Commission and Mistakes
of Omission
Dividends: Do They Make Sense in This Day
and Age?
Why does Berkshire Not Pay
Dividends?
Example of Microsoft and a Special
Dividend
Should You Invest in Companies That
Repurchase Their Own Shares?
Share Repurchasing Is Good News
Share Repurchases by Companies in
Which Berkshire Has Invested
Why Doesn’t Berkshire Repurchase Its
Own Shares?
Corporate Governance: Employees,
Directors, and CEOs
Employee Compensation at Berkshire
Compensation for Directors and
Executive Officers
What Is Wrong with Compensation
through Stock Options?
How to Identify Good CEOs or Other
Senior Managers
Large Shareholders: They Are Your Friends
Founder Control Matters
6
ENTERPRISE RISK
MANAGEMENT: WEEK 6
Financial Risks
Price – is the margin on products
sufficient to meet operating expenses
and generate a profit? Are prices being
pushed up or down by competition or
customers?
Liquidity – Is there positive cash flows
and ability to meet investing, operational
and cash flows? Check Statement of
Cash Flows
Credit Worthiness – compare credit
rating amongst firms
Valuation Risk – does the company’s
stock value have high or low volatility
Business model – is the company
hedging for financial risks such as
foreign currency?
Taxation Risk – taxes can factor into a
business model, products or locations.
Interest Rate Risk: cash flows decline
when interest rates rise.
Downgrade Risk: is there a risk that
agencies will downgrade the ratings.
This might be an indication that the
issuer company might default in the
future.
Inflation Risk: costs or revenues can be
impacted by changes in inflation
Default/Credit Risk: Does the company
have any issues in making interest and
principal payments. Default risk is
inversely related to credit quality.
Currency Exchange (Denomination)
Risks: For example: If we purchase a
corporate bond denominated in Euros,
and if Euro value falls relative to US
dollar, then we will lose money even if
the company does not default on its
bonds.
External Risks
Regulatory: are regulations or tax laws
changing the business model?
Legal: are there large pending lawsuits?
Investor Relations: are there many or
few large investors? Are investors
demanding change in the management?
Competitors: Is the industry highly
competitive where the products and
services are a commodity, or an
oligopoly, or significant product/services
differentiation?
Financial Markets: Are there sources for
borrowing of funds, issuance of bonds
Catastrophic Loss: is there the potential
for large losses? For example, patents
expiring? Large insurance claims?
Sovereign/Political Risk: is the company
exposed to country risks in its
international operations?
Strategic Risks
Market Bubbles: Prices climb rapidly to
heights that would have been
considered extremely unlikely before the
run –up. The volume of trading is much
higher than past volume. Many new
investors enter the market (speculators).
Prices suddenly fall, leaving behind the
new investors with heavy losses.
Leadership: is there poor leadership, or
loss of leaders due to death or illness?
Strategic and Tactical Alignment: are
the tactical initiatives going in the same
direction as the strategy?
Planning: what is the quality of the
financial forecasts?
Communication: is management able to
properly communicate the strategy and
risks?
Business Model: is the company
maximizing the core value drivers?
Reputation risk: is the firm exposed to
activities that can damage its reputation
with consumers or business partners?
Operational risks
Product Pricing: are margins too low? Is
the market so competitive that prices
cannot be increased?
Customer: is the company dependent of
a few large clients? How does the 80/20
rule apply to the client base?
Human Resources: are there issues in
hiring resources domestically,
internationally? Are staff costs
competitive?
Product Development: is the firm
investing in R&D? How does it compare
to the competition?
Supply Chain: does the firm have
advantages in the buying, building,
delivering and stocking inventory?
7
Business Interruption: does the firm
have business continuity plans to
ensure mission critical activities
continue?
Compliance: is the firm meeting
regulatory requirements?
Audit: is the firm meeting internal and
external auditing requirements?
Information Risks
Performance Measurement: are the
right revenue and costs activities being
monitored and managed?
Budget and Planning: is forecasting
realistic and relative to internal and
external factors?
Accounting Information: is accounting
data available in a timely and
consolidated manner?
Financial Reporting: is the reporting
being done in accordance to GAAP and
IFRS and meeting all disclosure
requirements?
Technology Risks
Financial systems: are the financial
applications capable of processing the
right data and producing the proper
management and financial reports?
Access: are there risks of external
hacking and the stealing of sensitive or
financial data?
Availability: do the financial systems
have disaster recovery and business
continuity plans?
Infrastructure: is the age of the
technology mean large and costly
expenditures in the near future?
8
FINANCIAL STATEMENT
ANALYSIS: WEEK 9
Assess the Quality of the financial
statements
Form 10-K Annual Report
Proxy Statements
Prospectus or Registration Statement
Industry Analyst Ratings
Shareholder Letters
Annual Report to Shareholders
Regulatory Reports
Value the Firm
Review Market versus Book Valuation
Historical technical trends on the value
of the stock
Calculate valuation based on
Dividends, Earnings, Cash flows,
Calculate and compare Intrinsic Value
vs DCF
Identify Company Strategy
What is the nature of products or
services?
How is the integration within value
chain?
What is their geographical
diversification?
What is their industry diversification?
Is the firm targeting its products or
services to its domestic market or
integrating horizontally across many
countries?
Essential elements in financial statement
analysis
Assess changes in the environments:
are there new regulations, competitors,
changes in the economy, new markets
they have entered?
Evaluate company capabilities and
limitations: what the company’s primary
capabilities?
Assess of expectations of stakeholders
Analyze company, competitors, industry,
domestic economy and international
economies
Analyze the missions, goals and policies
for the master strategy
Determine critical environmental
changes
Analyze Profitability and Risk
Review or prepare common-size
financial statements
Review percentage change in financial
statements year over year
Review Financial Statement Ratios and
identify variance anomalies and
compare to industry and major
competitors
What are the Profitability Ratios:
EBITDA, Product, EPS, ROCE, and
they in growth or decline?
What are the Risk Ratios: Current Ratio,
Debt to Equity Ratio etc.
Project Future Financial Statements
Identify Economic Characteristics and
Competitive Dynamics in the Industry
Prepare a value chain analysis
Prepare an Economic Attributes
Framework
Conduct an Industry analysis
Conduct a Competitor analysis
Conduct a Supplier analysis
Conduct a Customer analysis
Determine if there are Substitute
products that can impact sales
Determine if there are technology
changes or disruptors that can impact
sales or costs – including those of the
competitors
Determine if societal factors have an
impact on sales
Review the firm’s strengths/weaknesses
relative to present/future industry
conditions
Create a goal/capability analysis: Are
current goals, policies appropriate? Do
goals, policies match resources? Does
timing of goals/policies reflect ability of
firm to change?
Alternative Analytical Frameworks
Product life cycle – introduction, growth,
maturity, decline stages with changing
opportunities, threats
Learning curve – costs decline with
cumulative volume experience (first
mover advantage)
9
Competitive analysis – industry,
suppliers, customers, complementary
products, etc.
Value chain analysis – seek to add
product characteristics valued by
customers
Niche opportunities – specialize in
particular needs or interests of customer
groups
Cost leadership – low-cost advantages
Product differentiation – develop
products that achieve customer
preference
Product breadth – carryover of
organizational capabilities
Correlations with profitability – statistical
studies of factors associated with
profitability
Market share – high market share
associated with competitive superiority
Product quality – customer allegiance
and price differentials for higher quality
Technological leader – keep at
knowledge frontiers
Resource-based view – capabilities are
inimitable
Relatedness matrix – unfamiliar markets
and products involve greatest risk
Focus matrix – narrow versus broad
product families
Growth/share matrix – aim for high
market share in high growth markets
Attractiveness matrix – aim to be strong
in attractive industries
