Buffett's Moat: Analyzing Salesforce's Competitive Advantage (CRM)

Salesforce.com Inc. (NYSE: CRM) is a leader in the customer relationship management (CRM) software industry, with more than double the market share of its closest competitor. The company has built an economic moat thanks to the network effect, economies of scale and strong brand identity, but it operates in a highly competitive and quickly evolving market that could threaten the stability of that moat. Salesforce's prioritization of growth and market share gains over short-term profits make it difficult to draw conclusions from quantitative economic moat indicators, but high price points on long-term contracts are a promising sign for investors.

The economic moat is a concept popularized by Warren Buffett that relates to sustainable competitive advantages. Buffett identified investment candidates by analyzing the width and potential longevity of their moats, which allow companies to sustain sufficient profitability and drive returns for long-term investors. Economic moats can be established through factors such as economies of scale, network effects, intellectual property, brand strength or regulatory advantages. These advantages can be prohibitive to competitors, rendering them unable to compete on price, availability, quality or perception among customers.

Salesforce has created its most substantial competitive advantages from economies of scale and network effects. The company closed 2015 with a 19.7% global CRM software market share. This leads the global CRM industry, followed by SAP SE (NYSE: SAP) at 10.2%, Oracle Corporation (NYSE: ORCL) at 7.8%, Microsoft Corporation (NASDAQ: MSFT) and Adobe Systems Incorporated (NASDAQ: ADBE) at 3.6%. The market grew 12.3% in 2015, and Salesforce added 150 basis points in market share.

Salesforce was one of the earliest movers in the industry, allowing it to establish and build its market share lead. The company's scale has allowed it to develop and acquire a broad range of services that add value to clients, and high switching costs support high customer retention rates. Salesforce can also dedicate substantial internal resources to developing custom solutions for large customers, and continually augment its offering based on customer feedback and requests. This innovative process contributes to a strong brand, with the company coming to be recognized as both an innovative leader in the space and a reliable long-term partner for clients.

The company's expansive customer base creates a network effect that has helped improve the breadth and quality of its offering. The broad user base yields a large amount of customer data and suggestions, and product development can be guided by this information. This has also provided Salesforce with an advantage in social CRM. The popularity of the platform has led third parties to ensure compatibility so that their products can be integrated, which creates a barrier for competitors who are not compatible.

Salesforce does not benefit materially from any regulatory barriers, and no single piece of intellectual property is considered essential to competitive position. Moreover, the economies of scale that the company enjoys do not necessarily create a moat relative to its closest large competitors, which are larger companies by sales and market cap. Oracle, Microsoft, SAP and Adobe have wider scopes than Salesforce and therefore may not dedicate the same amount of resources to directly competitive services. However, these technology giants have the ability to whittle away at the market leader's share and margins in the future.

Salesforce has invested heavily in product improvements and marketing strategies to drive its high-sustained revenue growth rate, which had a 36% 10-year average as of March 2016. The company's trailing 12-month gross margin was 75% in March 2016, which is the lowest of the past decade and more than five percentage points below the high point. The company's 1.92% operating margin is narrow, and it had previously grown as high as 8.8% and fallen as low as -7%. Narrow profit margins result in a low return on invested capital (ROIC) of 0.74%, which is below its opportunity cost of capital. ROIC below cost of capital indicates an eroded moat for mature companies, but growth companies that prioritize growth over short-term profits can defy this rule. Salesforce's relatively high price points mean Salesforce is able to charge a premium, which is a quantitative indicator of an economic moat.