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Perhaps no stock is as criticized here on Seeking Alpha as Salesforce.com (NYSE:CRM). There is no shortage of critics who argue that CEO Marc Benioff and his executive team are lining their pockets at the expense of the company's investors. These critics argue that the company is overvalued, with little to no competitive moat, and that its shares must fall, and that the fall must be steep.

We have written about Salesforce several times, outlining our thinking as to why the stock has not collapsed, even if the merits of the short thesis are solid. At its core, the shares have not fallen for several reasons: the collective "ignorance" of the company's institutional investors who, along with Marc Benioff, own much of the company's shares, and sell-side analysts that emphasize non-GAAP earnings and metrics to make their bullish cases for the stock. Readers who wish to learn more about these issues can read our prior articles, linked to above.

In this article, however, we will offer a preview of Salesforce's Q3 earnings, and what the company needs to deliver to keep gravity at bay once again. For the record, we hold shares of Salesforce indirectly, via a stake in the Fidelity Growth Company Fund, but hold no direct stake, and have no plans to go long or short the stock.

Setting the Stage

Salesforce's performance over the past month defies logic, at least from a short-seller's point of view. As the S&P 500 has sold off due to worries regarding the fiscal cliff (and other issues), it would make sense that Salesforce will underperform the index by a large degree. After all, as a high beta technology stock, it is reasonable to assume that it will underperform. And when the company's weak fundamentals are added to the mix, this should, in theory, spark a decent-sized fall.

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As the chart above shows, this has not been the case. While Salesforce has underperformed the S&P 500 over the past month, it has dropped by less than 1% beyond the S&P 500, and has slightly outperformed the NASDAQ. Once again, Salesforce has traded far better than what its fundamentals would indicate. But, with Q3 earnings set for Tuesday, November 20, there will be a fresh opportunity for the shares to fall, depending on what kind of earnings release the company reveals.

But, the shares could also rise. With Salesforce, it is important to remember that while short-sellers may not value the metrics that keep the stock propped up, they are deemed to be worthy indicators of performance for analysts and institutional investors, who view Salesforce through the prism of these metrics.

Q3 Earnings: What to Watch for Regarding Guidance

According to Reuters consensus data, Salesforce is estimated to post non-GAAP EPS of 32 cents per share for Q3 2013 (fiscal). That matches almost precisely with Salesforce's own guidance of 31-32 cents per share for Q3 2013, which it gave when it released Q2 results at the end of August

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Salesforce will also give Q4 guidance when it releases earnings on November 20, and the current consensus estimate is for non-GAAP EPS of 40 cents per share. Salesforce has shown an ability to "talk" its way out of weak quarters in the past, offering convincing (if not necessarily valid) explanations as to why guidance is lighter than expected.

With each quarterly earnings release, Salesforce also offers updated guidance for the full fiscal year. Currently, analysts estimate non-GAAP EPS of $1.50 for fiscal 2013 on revenues of $3 billion, which matches closely with Salesforce's existing guidance of $1.48-$1.51 in non-GAAP EPS on revenues of $3.025-$3.035 billion.

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Traditionally, Salesforce also uses its Q3 earnings to initiate guidance for the next fiscal year, and we expect this tradition to continue this quarter with initial guidance for fiscal 2014 to be announced.

Watching the Metrics: Unbilled Revenue, Deferred Revenue, and Cash Flow

Most sectors of the market have different financial metrics that investors use to gauge performance and financial strength. Airline investors look at metrics such as EBITDAR (earnings before interest, taxes, depreciation, and aircraft rent) and CASM (cost per available seat mile). Bank investors look at Tier 1 Capital, and the percentage of loans that are non-performing. And investors in Salesforce look at unbilled deferred revenue, a key metric that measures the amount of revenues that have been contracted, but not yet billed.

Essentially, it is a measure of Salesforce's backlog, as it represents future revenue that is not yet on the balance sheet as deferred revenue. Unbilled deferred revenue has no financial impact to Salesforce on either a GAAP or non-GAAP basis. It is off the company's balance sheet, and is not included in measurements of operating cash flow. IF this is the case, what is its purpose? Salesforce's investors (primarily institutional investors) and sell-side analysts utilize unbilled deferred revenue as an indicator of future prospects at Salesforce.

Deferred revenue, which does show up in both the company's balance sheet and operating cash flow, plays a major role in the Salesforce bullish thesis. After all, the company's own earnings releases give deferred revenue the third bullet point of the company's list of accomplishments during the quarter, behind only revenue and operating cash flow. In the last quarter, Salesforce's deferred revenue rose by 43% compared to the previous year, to $1.34 billion. Salesforce needs to deliver continued growth in deferred revenues to maintain the bullish thesis. It should be noted that Salesforce's deferred revenues have, over the past several quarters, benefited from a change in the company's invoicing policies. Salesforce is shifting its invoicing to an annualized basis, which has no real effect on the company's finances over the life of the contract in question.

But, the shift towards annualized billing, which is an ongoing process, serves to benefit deferred revenue. For example, consider a contract that Salesforce signed a contract with a customer for $10 million of service over the course of a fiscal year. If the company bills its customer twice a year (in Q1 and Q3, for 2 quarters of service at a time), it would place $2.5 million of that bill as deferred revenue during the quarter in which it sent the bill (assuming that the bill was sent at the beginning of the first quarter). But, suppose that Salesforce now sends its customer a single bill, for the entire fiscal year. In its first quarter, the company would still recognize $2.5 million of revenue, but place $7.5 million as deferred revenue.

From a fundamental standpoint, business has not grown. There will still be $10 million of revenue during the fiscal year, the only thing that has changed is the timing of revenue recognition. However, deferred revenue is now higher than what it would be if billing cycles were shortened. Given that investors view deferred revenue as a sign of growth at Salesforce, expectations could be inflated due to what is, in the end, a zero-sum change to Salesforce's finances.

As CEO Marc Benioff stated on the company's Q2 2013 call, "operating cash flow is one of the best measurements of success at Salesforce." And yet, CFO Graham Smith indicated on the company's Q2 call that operating cash flow for the third quarter would be down both sequentially (from $136.197 million) and year-over-year due to 3 reasons: the acquisition of Radian6, which will reduce cash flow by $5 million, a $15 million headwind due to working capital changes (particularly in accounts payable and prepaid expenses) and a $10 million payment due to the final part of a settlement with the state of California regarding wages.

Based on CFO Graham Smith's statements, it would seem as if Salesforce's cash flows are to be impacted only by one-time issues, and that cash flow is not down because of a fundamental deterioration in the company's core business. Investors will most likely be watching Salesforce's cash flow closely to see just exactly what has impacted cash flow. Is it truly down only because of the issues that Smith discussed on the company's Q2 call, or are other, more material factors at work?

Conclusions

Do we think that Salesforce is a buy? Given the current share price, as well as the company's fundamentals, it is difficult, in our view, to formulate a credible bullish thesis for the company's stock. But, that does not imply that we think investors should short the stock. For us, the best investment in Salesforce is no investment at all, from either the long or short side.

As we have stated several times in prior article, a confluence of factors serve to create a floor in Salesforce's stock, and it is a floor made not of sand or dirt, but concrete and steel. And tomorrow, when Salesforce releases its Q3 2013 results, investors in Salesforce, both from the long and short side, will be able to determine whether or not cracks in that floor are forming.

Source: Salesforce Q3 Earnings Preview: What Does The Company Need To Deliver To Keep The Stock Afloat?

Additional disclosure: We hold shares of Salesforce via the Fidelity Growth Company Fund.