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South Park's underpants gnomes had a questionable business plan:

  1. Collect Underpants
  2. ?
  3. Profit

Source: South Park

Investors in Salesforce.com (NYSE:CRM) are relying on a similar vision for the future, with revenue growth as the dominant theme overriding considerations of returns on capital, profit margins, and shareholder dilution. I hope to convince readers below that when analyzed through a variety of different metrics, something is seriously wrong with CRM's business model, making the elusive profit much harder to achieve than Marc Benioff may want you to believe.

A successful short investment requires a thesis for valuation meaningfully below the current market price and a catalyst causing the market to reassess its view on the business in a manner more closely aligned with the short thesis. The second component of this definition cuts to the heart of the "never short on valuation" mantra, as overvalued businesses can remain overvalued for extended periods while the underlying operating performance catches up with the valuation. While the interim equity performance will underwhelm during this period, the lack of a catalyst prevents the short position to realize the merits of what at a given point in time may have been a valid thesis.

CRM for years has been overvalued on any reasonable set of assumptions regarding the future. The lack of a catalyst, however, coupled with a highly dynamic and proselytizing leader has propelled the stock higher during this time.

First, let's acknowledge the positive attributes of the business. The company was at the forefront of the shift towards on-demand (cloud) computing. They have rapidly grown to a multi-billion dollar software company with a broad stable of loyal customers. Further, the economics of SAAS providers - high gross margins and negative working capital - should in theory provide phenomenal returns on invested capital (ROIC). However, as seen below, CRM's ROIC does not reflect a strong business model, with persistently inferior ROIC certainly below the company's cost of capital, and a trend that is rapidly deteriorating.

Source: Cowen & Co.

Why is it that the "world's #1 CRM platform" (the company's own words), during the "heyday of the Cloud, the Renaissance, the Great Time" (all words from CEO Marc Benioff in 2012), cannot generate returns on capital that create value? Part of the bullish argument is that CRM's outsized operating expenses, which caused the company to report GAAP operating losses every quarter since early 2011, are required to support the company's revenue growth. However, if we look at other truly revolutionary technology companies - Google (NASDAQ:GOOG) and Microsoft (NASDAQ:MSFT) - we see that these companies in their early years (GOOG beginning in 2001 and MSFT beginning in 1982, as I was unable to locate financial data prior to then) were able to generate substantial operating margins while growing at rates similar to CRM.

Source: SEC filings

Companies with outstanding business models and defensible competitive advantages do not persistently generate inferior ROIC and operating losses. Microsoft held a near-monopoly position during the advent of the personal computing industry. Google redefined internet search and largely created the online advertising market. Salesforce, on the other hand, spends massively on sales and marketing to capture share from entrenched competitors in a largely mature market for software to assist salespeople. This is not a winning long-term strategy.

Source: SEC filings

Further, CRM's operating losses would be even worse if they were not able to capitalize R&D and other expenses acquired through acquisitions. To help maintain the company's declining revenue growth rates, CRM has looked to increasingly large acquisitions, culminating in June of this year with the company's $2.4 billion acquisition of ExactTarget. The effect of these acquisitions on the company's balance sheet is staggering, with more than 50% of CRM's total assets now comprised of goodwill and intangible assets.

(click to enlarge)

Source: SEC filings

Some argue that acquisitions should not be a factor in calculating free cash flow, if the net assets acquired are already generating their own returns. CRM's acquisitions, however, have largely been purchases of people and ideas, with revenue contribution (until recently) minimal and profits in all cases nowhere to be found. Therefore, CRM's acquisitions truly are more like traditional capital expenditures. However, because the goodwill associated with these substantial capital outlays is added to the balance sheet but never amortized, the company substantially underreports true operating expenses. This of course conforms to GAAP, but it is important to recognize large portions of these substantial investments are not having any effect on reported operating expenses. Their impact will, however, continue to be evident via the poor returns on invested capital referenced above.

Additionally, intangible assets acquired through acquisitions represent another source of underreported expenses. As of July 31st, 2013, CRM had capitalized nearly $540 million in software development and acquired technology expenses, as well as nearly $450 million in unidentified intangible assets acquired through acquisitions. Thus, nearly $1 billion in expenses are sitting on CRM's balance sheet waiting to be slowly amortized as operating expenses over multiple years in the future. The fact that the company generates operating losses without the full impact of these capitalized expenses should concern shareholders.

Perhaps Google and Microsoft in their early years are poor proxies. What about other current enterprise software companies, facing the same economic conditions as CRM? Again, the results are striking (hint: CRM is the blue diamond below the 0% EBIT margin threshold).

(click to enlarge)

Source: Capital IQ

CRM is in a class of its own, as the only publicly traded enterprise software company (as defined by Capital IQ) with revenue in excess of $500 million that does not generate operating profits. The scatterplot above generally illustrates operating leverage amongst the group, as the larger companies (by revenue) tend to generate higher operating margins. CRM is an outlier, of course, further raising serious questions about the health of their business model.

Another bull argument is that GAAP income statements mask the company's substantial ability to generate cash. First, let's dispel the notion that CRM generates substantial free cash flow. Once we account for cash outflows for acquisitions, which in CRM's case are much more like traditional capital expenditures (and thus part of the free cash flow calculation), free cash flow as seen below in recent years has been negative, and sharply negative over the last 12 months.

(click to enlarge)

Source: SEC filings

Second, although CRM historically generates operating cash flow, understanding the nature of that cash flow is vital. As seen below, generally more than 100% of the company's operating cash flow is from stock compensation and the growth of deferred revenue. The former is a source of ongoing shareholder dilution, while the latter is an unreliable cash source that can easily become a cash use if growth slows. Neither are high quality, sustainable sources of operating cash flow one would expect to see from a leading business.

(click to enlarge)

Source: SEC filings

Lastly, management actions and disclosures raise significant red flags. Conference calls are surprisingly void of questions regarding lack of profitability, as analysts at Cowen, J.P. Morgan, and Bernstein, who have all taken a more sober approach to valuation, are not called upon during the question and answer periods. Benioff's use of superlatives to describe business performance borders on comical. Insider sales are rampant, including more recently exercising and selling stock options that do not expire until 2017.

For all of Benioff's talk about the future, and for all of the money the company has spent to pivot from being a one-trick CRM pony, why do their SEC filings never break revenue and profitability by business unit? If I were an investor, and saw billions of my capital spent on acquisitions far outside of CRM's traditional business model, I would want to understand the returns these investments were generating.

I realize I began my article stating a successful short requires both a thesis regarding significant overvaluation and a catalyst. Regarding valuation, here's a simple exercise, looking at three possible scenarios. In each case, I assume 605 MM shares out (based on CRM's basic share count in their FY2014 guidance), and a 10% cost of equity (generous in my opinion, but that's another discussion):

Scenario A: Benioff's growth aspirations continue relatively unabated, growing revenue 25% annually through FY2021. The company is able to contain growth in sales and marketing expenses, leading to steadily rising net margins reaching 15% by FY2021.

Scenario B: Growth moderates (as it always does over the long term) to 10% annually by FY2021. The company eventually turns profitable, but net margins end at 10% by FY2021.

Scenario C: The highly competitive enterprise software market makes future growth difficult, yielding GDP-type growth of 3% by FY2021. The company eventually earns 5% net margins by FY2021.

Results:

A: FY2021 revenue of $19.2 billion with net income of $2.9 billion. Applying a 15x multiple on those earnings, discounting terminal value and net income up to that point at a 10% cost of equity, and dividing by 605 MM shares ~ $42.5 share price today.

B: FY2021 revenue of $12.4 billion with net income of $1.2 billion. Using the same procedure in A ~ $19 share price today.

C: FY2021 revenue of $10.7 billion with net income of $533 MM. Using the same procedure in A ~ $8.50 share price today.

CRM would have to wildly exceed even Marc Benioff's superlative-laden expectations of the future to justify a stock price 22% below today's value. A more realistic outlook argues for a current share price 65% below today's value, and a more downbeat - but certainly not unreasonable given the creative destruction rampant in the technology world - results in a share price 85% below today's value.

With a thesis for overvaluation intact, what is the catalyst? I believe the company's balance sheet has finally become an albatross weighing heavily on Benioff's talk about the wonders of the future. I would not be surprised to see significant write-downs in their $3.5 billion goodwill balance. Further, I believe sophisticated investors are finally waking to the fact this dog doesn't hunt. Given the substantial institutional ownership of the company's stock, one has to wonder who is the buyer of last resort for sizable blocks of equity? Day traders and algorithmic quant funds don't tend to make good long-term investors.

Source: Salesforce.com - The Underpants Gnomes Of Wall Street