At a time when IT departments are tightening their belts in regard to spending, Salesforce.com (CRM), which we profiled in more detail before, continues to grow its top line robustly. Promotional CEO Marc Benioff won't hesitate to let you know how well Saleforce is executing, and later I'll state my case as to why I believe he is so aggressive in these efforts to boost perceptions of the company he runs. Unfortunately for long-term investors, revenue growth with negative profitability is not a winning combination, when combined with a stratospheric valuation. Few companies have been as successful or foresighted in predicting the technological shift to mobile and the cloud, but at what point do basic accounting principles and financial analysis matter? The thought that it doesn't, or that there is something else at play is what led to problems for speculators in the late 1990s, and I'm afraid that the lesson will be learned like it was when Netlfix (NFLX) was trading above $300 per share. Much of Salesforce.com's ability to acquire businesses and compensate employees richly is related to the nonsensical valuation. If the gravitational impact of semi-efficient markets creeps into the picture, Saleforce.com shareholders might find themselves holding the bag for management's profligate spending practices.
On November 20th, CRM reported very strong growth. Total Q3 revenue was $788MM, up 35% YoY, led by subscription and support revenues of $741MM. The numbers would have been even better if not for about $13MM in FX headwinds. What was really impressive was CRM's growth across a broad geographic. In the Americas, revenue grew by 38%; Asia by 29%; and most extraordinarily, 29% in Europe. Once again, these numbers were even better, excluding FX changes. Very few technology companies are holding flat in Europe, let alone growing by nearly 30%! You have to give credit to Saleforce.com's product assortment and marketing program, and it isn't difficult to imagine growth accelerating over the short-term if the global economy actually sees some tangible improvement.
Attrition is a huge obstacle for any subscription business and CRM is no exception, with a low-teens percentage. This accounts for a big reason why CRM must continue to spend so aggressively on marketing. The company can't just rely on keeping its current clients, but must grow at a rate above attrition or raise prices to maintain revenue growth. Salesforce.com's number one business is its sales platform, which is a nice product, but it is also somewhat commoditized by other similar offerings, in my estimation. Benioff has done a great job expanding the offering portfolio to marketing, HR, etc., which has helped keep things moving in the right direction. Fortunately, the company is seeing the attrition rate improve, which augurs well for future revenue growth.
The GAAP loss in the quarter was ($1.55) and non-GAAP diluted earnings per share were $0.33, or $77MM. Part of the reason for the GAAP loss was a one-time, non-cash $149MM charge as an allowance against its deferred tax assets. It seems reasonable that the company will recoup that charge in the future. Another big reason for the disconnect between GAAP and non-GAAP numbers is CRM's absurd accounting practices of eliminating stock compensation as an expense in the non-GAAP figures. This would be relevant for bond investors where the ability to pay off debt is all that matters, but for stock analysts, it is impossible to deny that stock compensation is an expense, and CRM's extremely liberal utilization of stock compensation is one of the worst examples that I have ever seen. Every quarter, shareholders are finding their ownership stakes reduced, and the reason why this doesn't cause outrage among the masses is that the stock has performed very well. Unimpressively, non-GAAP operating margins were 10% in the quarter, and while there were some charges that impacted results, CRM's farcical non-GAAP accounting doesn't even make the company look highly profitable on its "imaginary" basis.
Operating cash flow in the quarter was $106MM, down 18% YoY. For the full year, Salesforce.com expects operating cash flow growth of about 20%. CapEx in the quarter was about 6% of revenue, or $51MM. Saleforce.com likes equating free cash flow as operating cash flow -- CapEx -- so this would result in $56MM in the quarter. Not bad, except when you factor in the reality that $105MM was expensed as stock compensation. Therefore in relevant accounting, free cash flow was a negative $49MM.
Sometimes when you see a CEO who is abundantly promotional in every setting, it makes sense to ask why. What necessitates that attitude instead of letting performance stand for itself? As a long-term investor, I enjoy seeing my stocks decline when I'm acquiring positions, and I've never been interested in having an executive play the role of cheerleader. Instead, a clear and concise statement of facts is the most effective way to deal with issues, and a perfect example of this is how the CEO of Jefferies (JEF), Richard Handler dealt with Sean Egan's inaccurate research report in the fall of 2011. For those not aware of what happened, Handler broke down in amazingly clear detail the company's trading positions, funding structure, liquidity options, and other details that is rarely, if ever, done on Wall Street. So why does Benioff utilize this silly accounting gimmick when such a huge percentage of expenses are stock compensation?
When companies don't generate substantial free cash flow, they must rely on the financial markets to fund their operations. For a growth company that relies on attracting top talent, acquiring emerging technologies in the hottest space, and that doesn't have a cash flow to support debt, the only solution is to tap the equity markets. It is alarming to shareholders when companies conduct stock offerings, as it highlights the fact that their ownership stake is being diluted, and that the company doesn't generate enough internal cash flow to fund its operations and growth initiatives. In Silicon Valley, many employees are willing to accept stock as a large part of their compensation, as long as they are optimistic that the stock will be worth something or it is perceived as hot to own. If the stock performance isn't good, then top employees might want compensation to be weighted towards cash, forcing Salesforce to adjust its operations to focus on cash generation and profits, versus top line revenue growth. Therefore, it is necessary for companies like Salesoforce.com and others to develop and utilize a non-GAAP accounting system that misleads unsophisticated investors. This inflates the currency, allowing the company to pay compensation and for acquisitions with what equates to "monopoly money." By paying fake currency for real businesses and talent, Salesforce.com's operations just continue to improve. Everything works great as long as that currency stays inflated. But like we saw with Greek bonds, at some point markets get it right, and when that happens, you don't want to be caught holding the bag.
Since 2003, shares outstanding have grown from 26MM to 155MM. Yes, revenue has grown from $51MM to an annual run rate of $3 billion, but this is not a business that grows organically. The company's "real" free cash flow generation is negligible, so the top-line revenue growth, which is the basis for the valuation, is highly reliant on this inflated currency for acquisitions and compensation. After CRM's stellar third quarter non-GAAP "earnings," the stock rallied to $158.80. At this price, the company has a market cap of $24.6 billion.
As Warren Buffett says, "price is what you pay and value is what you get." Well in this case, the investor is getting $3 billion in annual revenue, which is growing nicely, operating losses, and a group of employees whose motivation would end up highly deflated if the stock were to drop precipitously. Great businesses generate earnings over time, and they generally aren't highly reliant on capital markets to propel growth. They certainly shouldn't have to consistently access equity capital because of poor cash flow generation. Eight times forward sales, over 100 times an inaccurately high earnings estimate, 11.8 times book value, and 30 times cash flow are prices that should only be paid for a great company. Maybe Microsoft (MSFT) or Intel (INTC) at the IPO would have warranted such a price, but those were businesses that ultimately had much greater economic fundamentals than CRM.
If I were Marc Benioff, I'd use that stock to acquire profit-producing businesses. Currently, the valuation of CRM is similar to that of Hewlett-Packard (HPQ), despite HPQ generating $7.5 billion in free cash flow over the last 12 months. Imagine how much better the financial statements would look for CRM if it had HPQ's cash flows and normalized earnings power. At that point in time, CRM would likely not need to constantly dilute its shareholders to fund the company's operations.
For long-term investors, I'd suggest ignoring the hype of CRM. You might miss out on some short-term profits, but a disciplined and value-oriented approach ultimately leads to the best performance. You aren't going to win a popularity contest at your neighborhood barbecue talking about out of favor financials, or large-cap tech, but hopefully over time, you'll be able to fund your children's college tuition and retire in some comfort. I wouldn't short CRM directly, but I have sold calls on it occasionally and with success. I believe that as long as you are willing to ultimately get exercised and go short, selling calls to manufacture a better short entry point makes some sense at these levels.