What would you pay for a company that had just over $3 billion in annual revenue last year, and lost $270MM? If you are a long-term shareholder since 2004, you've been diluted by around 35%. In a low asset industry, the return on assets has averaged 2.35% over the last decade, while the return on invested capital has averaged less than 4% over the same time period. Operating margins have never exceeded 9% and the business operates in a rapidly changing, ultra-competitive market environment. If you answered roughly $25-$26 billion, then it is very likely that you could be a shareholder, or even better an analyst with a buy rating, covering Salesforce.com (NYSE:CRM). In my investing experience, there are no bigger warning signs than when a CEO is outrageously promotional, or when a company's expense structure is inexplicable in contrast with a complete lack of profitability. CEO Marc Benioff might be able to sell an Eskimo air-conditioning, but the numbers tell me the stock is a house of cards, waiting to fall once all of the alchemy in non-GAAP earnings doesn't turn the company into gold.
There is a very big difference in revenue and profit growth, and per-share revenue and per-share profit growth for Salesforce.com. Salesforce.com has grown revenue robustly, but profitability, and just as importantly per share profitability, has been abysmal. It is one thing to use non-GAAP earnings to exclude one-time charges, or possibly even amortization of intangibles to measure cash flow, but to exclude recurring stock-based compensation when it is one of your highest annual expenses, while being abnormally promotional on presenting the company's financial results is extremely misleading. The company epitomizes everything that was good and bad about the technology bubble of the late 1990's. Rapid innovation that enhances its users' experience is offset by a speculative excess in the stock price, which will most likely lead to disaster for Salesforce shareholders. Snake-oil salesmen charms and outrageous claims from the CEO are described as simply being gregarious or quirky, instead of slimy or misleading, because of a rapidly ascending share price. Reading the transcripts of the analysts' Q&A on a Salesforce.com earnings call is like what I imagine Justin Bieber's twitter to be like, full of love-drunk praise, without any hard-hitting commentary such as, when will this fast growing company actually turn a profit? While tech dinosaurs such as Hewlett-Packard (NYSE:HPQ), Microsoft (NASDAQ:MSFT), and Cisco (NASDAQ:CSCO) produce prodigious free cash flows and economic profits, yet trade at less than 10 times earnings, Salesforce.com shows no sign of becoming profitable. When you think about software as a service (SAAS), no company is more prominent than Salesforce.com, but when I look at the financial statements I see a low margin business, that is growing through acquisitions and huge compensation expenses, which are propelling its sales efforts.
The whole idea of the "cloud" sounds so exciting. The cloud serves as a portal for customers to access technology without uploading from a disk, or having to create an internal IT infrastructure to execute tasks. I have no question that cloud-based technologies will lead to tremendous profit margins for a great deal of companies, but the fact that Salesforce is unable to crack the profitability code raises serious alarm flags about its products and business structure. Having been a user of Salesforce's products and its competitors' versions, I've noticed very little distinguishable differences. There are even free versions of CRM products, which is Salesforce.com's bread and butter, that are not that bad for an individual user. Good technology businesses generate free cash flow. Salesforce.com does not generate material amounts of organic free cash flow; therefore it has to access cash from the capital markets to fund its growth initiatives. Because Salesforce is a technology based company with a relatively short history, equity capital is the ideal source to fund this growth. It is here where Marc Benioff, non-GAAP accounting, and some of the worst stock analysts in the business converge to create one of the great "growth" stories. The use of non-GAAP accounting and its acceptance by the analyst community allows Salesforce to pay top-dollar to talented sales reps, which can push the company's competitive products. Sales is a people profession, and just like Goldman Sachs (NYSE:GS) attracts the top talent to pitch various investments, Salesforce.com does the same thing to promote its software and services. Funding the salaries would be impossible if the company were primarily using its cash flows, so diluting shareholders with stock issuances for employees is the only way to accomplish this. The Silicon Valley talent pool does not generally concern itself with the fundamentals of the hot stock they are being paid with, so as long as there is the perception of success and extremely high compensation, there is no reason for them not to pursue a potentially lucrative career at Salesforce. All of this leads to the illusion of growth and innovation, in excess of what is really occurring. Look no further than Benioff's claim "Salesforce.com is on the path towards $10 billion in revenue." If housing prices did nothing but go up, Lehman Brothers might still be thriving but gravity impacts everything, and Mr. Market might be in a coma when it comes to its valuation on Salesforce, but when he wakes up to reality, the drop could be quite steep.
Broadcast.com was a very innovative company developed by Mark Cuban, but what separates Cuban from other paper-billionaires during the tech-boom was that he knew he had to cash out somehow. When his company was acquired by Yahoo, he collared his stock and cashed out when he was able to do so. Marc Benioff and Saleforce.com would be wise to do the same thing by using its inflated stock as a currency to acquire more businesses, with more attractive economics and free cash flows. It is like a game of musical chairs where the last one standing is knocked out of the game, or in this case holding Salesforce.com stock when sober valuations matter. Benioff is already filthy rich as are many long-term employees who have been able to sell their stock, but any reasonable valuation on the company would disillusion recent hires who have been paid with stock that would decline in value substantially, and no longer would seem to have the promise that they assumed it had when they took the position. The reduced valuation would make it more costly and difficult to make acquisitions or hire top talent, and the relatively commoditized flagship CRM product sales growth would very likely slow down materially, perpetuating the decreasing valuation cycle. Innovations such as the Marketing Cloud or Salesforce Chatter would be harder to come by if the stock had to fund R&D efforts using organic cash flow.
On February 28th, Salesforce reported 4th quarter revenue growth of 32% to $835MM, and for the full year revenue grew 35% to $3.05 billion. In constant currency, revenue grew by 37%. Subscription and support revenue accounted for $2.87 billion of the total $3.05 billion of revenue, while professional services and other revenues were $181MM. Deferred revenue grew by 35% to $1.86 billion, while unbilled deferred revenue increased to approximately $3.5 billion. Full year operating cash flow was $737MM and non-GAAP earnings were $0.51 and $1.63 per share, in the 4th quarter and for the full year, respectively. Salesforce's liberal use of non-GAAP earnings in the 4th quarter excluded $108MM in stock-based compensation expense, $21MM in amortization of purchased intangibles, and $6MM in net non-cash interest expense related to the company's convertible notes. For the full fiscal year, the company's non-GAAP results excluded the impact of $379MM in stock-based compensation, $149MM related to the one-time tax valuation allowance established in the 3rd quarter, $88MM in amortization of purchased intangibles, and $24MM in net non-cash interest expense related to the convertible senior notes.
Despite robust revenue growth, Salesforce still cannot generate economic profits, posting losses of ($0.14) per share in the 4th quarter, and ($1.92) per share for the full year. No sensible analyst would take the non-GAAP figures seriously, when the stock-based compensation figures are so consistently large and material. Stock-based compensation of $379MM is equivalent to a whopping 12.4% of total revenues. That would be like United Airlines (NYSE:UAL) excluding fuel in reporting its earnings. As of January 31st, 2013, Salesforce had 9,800 employees. This would mean that on average, each employee is making just under $40K in bonuses, but of course this is highly skewed towards management and the sales staff. Salesforce is known for its lavish parties, amenities, and compensation, which I'm sure, makes it a great place to work. For investors, however, the company is far less-friendly. Diluted shares outstanding have increased from 95MM in 2004, to 145MM in January of 2013. This means that investors in 2004 now own roughly 35% less of the company than they did in 2004. This is probably excused by most investors in the stock due to the wonderful share performance, but when Mr. Market's mood changes, and the company is no longer valued at 90 times a completely fabricated non-GAAP earnings estimate, these type of dilutive measures might be seen in a different light.
To be clear, Salesforce is very wise to use its stock as a currency to pay salaries and to acquire other companies. It is like paying debt in Venezuelan bolivars, where the stated value is beyond any reasonable metrics of valuation based on intrinsic value or fundamental analysis. Because Salesforce is so far away from being profitable, the only reason the company generates free cash flow is because it is able to pay exorbitant salaries using its inflated stock. If this jet fuel were taken away, the cash burn would be significantly greater than it is, likely forcing the company to take on more debt. Acquisitions would be much more difficult to finance, and Salesforce's ambitious growth plans would be much more limited considering its $429MM R&D budget last year, is relatively meager compared to what the competition can spend. Salesforce.com is completely dependent on its stratospheric stock price to finance its operations in a rapidly changing technological landscape that requires rapid innovation. The biggest hope for shareholders is if the company can parlay its overpriced stock currency into acquiring, or developing an actual business that is capable of generating free cash flow without the benefits of absurd stock-based compensation expenses. In the last fiscal year, free cash flow excluding stock-based compensation was a paltry $178MM. Therefore, at approximately $175 per share, Salesforce.com trades at roughly 143 times trailing adjusted fee cash flow.
In the company's earnings release, Salesforce raised its FY 14 revenue and non-GAAP EPS guidance to $3.82-$3.87 billion, and $1.93-$1.97, respectively. Salesforce continues to forecast losses in the range of ($1.22) to ($1.18) for the full year. Of course the company would be profitable if it eliminates $503MM in stock-based compensation expenses, $85MM in amortization of purchased intangibles related to acquisitions, and $27MM in net non-cash interest expense related to the convertible notes. Using the high-end of Salesforce's revenue estimates, stock-based compensation will be the equivalent of 12.9% of revenue generation. For Q1 FY 14, Salesforce forecasts revenue to grow by 27-28% to $882-887M. Diluted non-GAAP EPS is expected to be in the range of $0.40-$0.42, while the GAAP loss per share is expected to be in the range of ($0.44) to ($0.42). The difference between the GAAP and non-GAAP forecasts are the $113MM of stock-based compensation expenses, $24MM of amortization of purchased intangibles related to acquisitions, and the $7MM in net non-cash interest expenses related to the convertible senior notes that the company excludes from the GAAP numbers.
Even if you take Benioff at his word and believe the company will get to $10 billion in sales, and if you extrapolate profit margins at 20%, you get a company with $2 billion in earnings power. That sounds wonderful but the current valuation would still be in excess of 10 times those lofty aspirations, providing limited upside and huge downside if the company cannot meet its goals. A shareholder today will likely own far less of the company 3-5 years out. There are also huge risks that competitors such as Microsoft, Oracle (NASDAQ:ORCL) and SAP (NYSE:SAP) will gain further headway into Salesforce's key markets. If Salesforce was in a less competitive business with more durable competitive advantages, I'd be far less concerned with the lack of profitability, but I can think of few things more unpredictable than the cloud. For these reasons I'd stay far away from this stock. For an extremely risk-tolerant, long-term investor, selling out of the money calls might be a profitable endeavor assuming one is willing to go short upon being exercised.
Disclosure: I am long CSCO, HPQ, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.