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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

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

[email protected]

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:[email protected]

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Page 2 of 45

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 13% 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) 18%

Digital Content Creation

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

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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

Enterprise Content

Management 4%

Enterprise Resource

Planning (ERP) 17%

Office Suites

10%

Other Application

Software 21%

Project and Portfolio

Management 1%

Supply Chain

Management 7%

Web Conferencing,

Collaboration/Social Software Suites

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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

Other Application

Software 13%

Project and Portfolio

Management 2%

Supply Chain

Management 7%

Web Conferencing,

Teaming Platforms, and Social Software Suites

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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.

10%

15%

20%

25%

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* Cloud-Based CRM Spending On-Premises CRM Spending Salesforce Growth Cloud-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 2015

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 Callidus

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% $4,442,016,184

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)

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

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10.0%

12.0%

14.0%

16.0%

18.0%

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CY 2010 CY 2011 CY 2012 CY 2013 CY 2014 CY 2015

Salesforce.com Oracle SAP Nice 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)

10%

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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.

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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)

10%

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5,000,000

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20,000,000

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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

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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.

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Total Retail Sales Ex-EC Total E-Commerce Sales YoY Retail Sales Growth Ex-EC YoY E-Commerce Sales 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.

10%

15%

20%

25%

30%

35%

40%

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

10%

15%

20%

25%

30%

35%

40%

$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/Analytics 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.

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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 Cumulative On-Premises Costs Cumulative SaaS 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 Cumulative On-Premises Costs Cumulative SaaS 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

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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

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VEEVDATA

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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-Axis)

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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.

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20%

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35%

40%

45%

50%

- 5 10 15 20 25 30

Revenue Growth (Y-Axis) vs. Price to 2016 Sales Multiple (X-Axis)

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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.

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-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

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0.0%

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60.0%

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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%

10%

15%

20%

25%

30%

35%

40%

45%

$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.)

Bull Case Revenue Base Case Revenue Bear Case Revenue Bull 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 Economic 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

[email protected] 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

Income Statement

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

Company-Specific Metrics

Sales Cloud Rev enue

Commerce Cloud Rev enue

App Cloud/Other Rev enue

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differentiated by a consistent focus on sustainable competitive advantages, or Economic Moats.

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