The world's equity markets often present investors with a form of theater that cannot be found anywhere else. Only here can investors watch billionaires battle over whether or not a company is a pyramid scheme, whether or not the world's most iconic technology company is losing its edge, or when the stock many see as the poster child of corporate greed and malfeasance will finally collapse. It is this third example that we wish to focus on in this article.
Salesforce.com (CRM) is a unique stock to follow. Led by charismatic CEO Marc Benioff, the company's shares have soared since its 2004 IPO, all while the company's GAAP earnings have gone in the opposite direction. Critics of Salesforce deride the company for its focus on non-GAAP earnings, vociferously attack the company's management team, and argue that the collapse of Salesforce is imminent. And through all this, shares of Salesforce continue to climb, and are currently sitting near all-time highs, on the back of a well-received (by the markets) quarter and a fresh round of analyst price target and estimate increases. For the record, we have no position in shares of Salesforce because we believe, as do the company's critics, that its shares are overvalued. However, we believe that the best investment in Salesforce is no investment at all. Salesforce critics who argue that the stock must be shorted have, in a quest to prove their indignation with the company, lost sight of one of the (if not the) most important rule in investing: it is more important to generate profits than be right. And while those 2 goals are often in alignment, they sometimes diverge. And few companies serve as better examples of this divergence than Salesforce.
Emotions and Hyperbole: Why They Need to be Removed
We have laid out this view several times in previous articles on Salesforce, where we laid out our argument that while the short thesis for Salesforce is theoretically correct, it is virtually impossible for it to become a profitable thesis as long as the present dynamics surrounding shares of Salesforce remain in effect. While many readers praised our work, there were many that condemned it. It seems that for some, any research that does not espouse a bearish view of Salesforce is seen as an affront, and an attempt to manipulate investors into buying shares of Salesforce so that the company's existing investors can unload their stakes. We have been accused of not only being agents of Fidelity (Salesforce's largest investor), publishing articles here on Seeking Alpha to help the company unload its 15%+ stake in the company, but of secretly being a part of Salesforce's public relations team, publishing articles here on Seeking Alpha in an attempt to suppress negative coverage of the company. In our view, such statements highlight the irrationality that many in the Salesforce short community hold. For many critics of the company, the desire to see shares of the company collapse has clouded their judgment, and blinded them to several of the dynamics surrounding Salesforce.
- By emphasizing non-GAAP earnings, Salesforce is committing fraud: Virtually every article we have seen here on Seeking Alpha concerning Salesforce insinuates that the company is committing fraud by emphasizing its non-GAAP earnings. However, this is not fraud. SEC regulations require Salesforce to disclose its GAAP results to its investors, something that the company does in every earnings release, 10-Q, and 10-K. However, there is no law that forces Salesforce to actually discuss those GAAP results. As long as Salesforce's investors have unrestricted access to the company's GAAP income statements, the company is in compliance with SEC regulations. Whether or not investors choose to rely on those GAAP income statements is beyond the scope of the SEC's authority or purview. And Salesforce makes it clear at the start of every conference call that the company will be discussing its non-GAAP results; John Cummings, the company's head of Investor Relations, stated on Salesforce's Q4 2013 earnings call that investors should note that, "our commentary today will primarily be in non-GAAP terms. Reconciliations between GAAP and non-GAAP metrics for both reported results and our forward guidance can be found in our earnings press release issued about an hour ago." Salesforce, like virtually every publicly-traded company presents its non-GAAP results because, in the company's eyes, they provide a better underlying review of the company's operational performance. Salesforce is simply more vocal in its emphasis on non-GAAP results. Is this disingenuous? Perhaps. But it is not illegal.
- Stock-based compensation should not count as operating cash flow: One of the more interesting paradoxes in the saga of Salesforce is the discrepancy between the company's GAAP losses, which are driven by stock-based compensation, and the company's operating cash flow, which continues to grow. In fiscal 2013, Salesforce's net loss surged to $270.445 million ($1.92 per share) from $11.572 million (9 cents per share), driven by a 65.47% surge in stock-based compensation to $379.35 million. However, operating cash flow increased by 24.58% to $736.897 million. The debate over the quality of Salesforce's operating cash flow is a valid one. After all, stock-based compensation accounted for 51.48% of the company's fiscal 2013 operating cash flow, up from 38.76% in fiscal 2012. But that does not alter the absolute amount of operating cash flow that the company generates. Salesforce's stock-based compensation, while technically a GAAP expense, is a non-cash item. It does not affect that amount of cash & investments that Salesforce holds in its bank and other financial accounts. Do we agree that cash generated from stock-based compensation is, on balance, of lower quality than operating cash generated from other sources? Indeed we do. But we do not believe that such cash should simply be ignored. When Salesforce pays its employees with stock, it is conserving cash by issuing new shares and/or options, choosing to dilute its investors rather then reduce the amount of cash & investments that the company holds. Operating cash flow statements exist to reconcile the accrual and non-cash nature of certain GAAP expenses with the amount of cash a company actually produces in any given period. If cash flow that arises from stock-based compensation is ignored, it creates a fundamental disconnect between the reported amount of cash a company generates and the cash that it actually holds on deposit with financial institutions.
- Marc Benioff is defrauding investors: Many critics of Salesforce contend that CEO Marc Benioff is committing fraud by emphasizing the company's non-GAAP earnings. However, Salesforce's rise of over 1,000% since its 2004 IPO (over 400% more than that of 2004's other famous technology IPO) begs to differ. Fraud occurs when a company deliberately falsifies its financial statements to mask operational weakness or enrich management (or both). Salesforce discloses its GAAP financials in every earnings release and SEC filing. That is what the company is required to do by law. But there is no law that requires Marc Benioff to discuss those financial statements. And if the participants on Salesforce's earnings calls do not ask about them, then there is little reason for him to mention them. As long as the company makes it clear that it is discussing non-GAAP results, then no financial laws and/or regulations are being broken. While most companies use non-GAAP earnings to highlight underlying business trends when one-time items obscure underlying performance, Salesforce chooses to focus on non-GAAP earnings exclusively. And while this may be a disingenuous practice, it is not illegal. The company's GAAP financial statements are easily available to investors and analysts. What they choose to do (or not do) with those statements is beyond the control of Marc Benioff.
Fundamentally, we believe that the short thesis for Salesforce is correct. Salesforce is overvalued on both a GAAP and non-GAAP basis (the shares currently trade at 95.32x fiscal 2014 non-GAAP EPS guidance of $1.95). But that does not mean that it is wise to short Salesforce. The company's long investors are deeply entrenched, and as we have discussed several times before, it is these investors that are standing in the way of the short thesis.
Focusing on the Whales
Salesforce's shares are underpinned by a large and deep base of institutional investors, who are led by Fidelity, which owns 21,298,679 shares of Salesforce, or more than 15% of total shares outstanding (in Q4 2012, Fidelity boosted its stake in Salesforce by nearly 500,000 shares). We have stated several times that one of the key ingredients needed to drive the short thesis for Salesforce is capitulation from the company's institutional investors. However, as of Q4 2012, that has not happened. Over the course of Q4 2012, 13-F filers boosted their holdings of Salesforce by 4.59% to an aggregate of 147,257,236 shares. Based on the share count provided in Salesforce's Q4 2013 earnings release (the company has yet to file its 10-K for fiscal 2013), 13-F filers collectively own 96.12% of the company's shares.
For the short thesis regarding Salesforce to become a profitable one, the company's stock must decline. But that is something that is difficult to achieve when long-term investors who are, on average, adding to their positions, hold virtually all of the company's outstanding shares. Until there is a meaningful decline in the amount of shares held by investors such as Fidelity, we believe that it will be difficult for the short thesis regarding Salesforce to be a profitable one.
Measuring Salesforce's Value Creation: Can it be Done?
One of the hardest aspects of measuring the value of Salesforce is that it is not easy to determine the right metric. GAAP earnings cannot be used, for there are none. Non-GAAP earnings are, the company's critics charge, a deceitful tool used by management to sustain the company's share price. And because most of Salesforce's operating cash flow is generated through stock-based compensation, the company's critics charge that it should be ignored. However, the amount of stockholder's equity that Salesforce has on its balance sheet is, in our view, an appropriate measure. The company's stockholder's equity allows for the conflicting aspects of Salesforce's GAAP income and its operating cash flow to be reconciled. It incorporates the accumulated deficit that Salesforce has generated through its GAAP losses (caused in large part by stock-based compensation), but also accounts for the cash that the company generates (largely due to stock-based compensation). The table below shows Salesforce's book value over the last 5 fiscal years.
Salesforce Book Value (in Thousands of $)
Tangible Stockholder's Equity
Book value per Share
Tangible Book Value per Share
*Share count based on the outstanding share calculations presented in Salesforce's Q4 2013 earnings release; the company's 10-K for fiscal 2013 has yet to be filed
As the table above shows, the reconciliation between Salesforce's cash flow and its GAAP losses shows that the company is failing when it comes to growing tangible book value per share. While it is true that on a non-tangible basis, Salesforce is growing its book value per share at a solid rate, that growth is based on a surge in goodwill, which now comprises the majority of Salesforce's stockholder equity. When the effects of Salesforce's acquisition spree are excluded, book value has been falling since fiscal 2010, on both a per share and absolute basis. The surge in Salesforce's goodwill highlights the fragile nature of the bullish thesis for Salesforce. But that does not make the stock a viable short.
Playing With Fire: Warnings for Both Sides
In our view, the best investment in Salesforce is none at all. For bulls, it is easy to be reigned in by the company's continued revenue growth and operating cash flows, as well as continued support from sell-side analysts. But this thesis is built on a house of cards. Salesforce's incessant issuance of stock has negatively affected even its book value per share, which we see as a way of reconciling the GAAP and non-GAAP effects of the company's stock issuance. While it may be true that Salesforce does not burn cash through the issuance of stock, the company is issuing so much of it that the amount of cash that can be claimed by each share of Salesforce is falling. And all of the growth in Salesforce's nominal book value can be traced to the surge in the goodwill that the company holds on its balance sheet. In our view, no bullish thesis for Salesforce can be valid given such dynamics. However, shorting shares of Salesforce is not the answer to this.
As we have stated several times, institutional investors are preventing the short thesis for Salesforce from playing out. In Q4 2012, these investors increased their holdings of Salesforce by over 4%, and control virtually all of the company's outstanding shares. And these institutional investors, for better or worse, listen to what sell-side analysts say and write about Salesforce. And given that Salesforce is continuing to meet the demands of the sell-side when it comes to non-GAAP earnings, deferred revenue, and other metrics, price targets and non-GAAP estimates are likely to continue to rise, thereby providing continued support to the company's share price. Short-sellers should also consider the opportunity cost of shorting Salesforce. We see little reason to tie up capital in shorting a stock where the dynamics are "stacked against" short-sellers in such a meaningful way, and we believe that there are a variety of investing opportunities (on both the long and short side) than shorting Salesforce. The best investment in Salesforce is no investment. The bullish thesis for the company is weak, but there has been little, if anything to suggest that the short thesis will be able to play out. We believe that investors considering an investment in Salesforce should avoid the temptation to play with fire and look elsewhere.