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SalesForce.com (CRM) announces earnings after the close on Thursday, May 23, 2013. The company provides enterprise cloud computing solutions to various businesses and industries worldwide. Founded in 1999, it sports a market cap of $24 billion even though it has never showed a profit.

Not showing a profit makes it difficult to calculate a P/E ratio, forcing analysts to look at revenue as an alternative proxy to measure enterprise value. YOY revenue growth has been high, about 32%, which gives some justification for its forward P/E of 74. This compares to its competitors' forward multiples of 12 for Oracle (ORCL) and 20.5 for SAP (SAP). CRM seems pretty pricey, even if the company turns the corner to profitability.

Here are the results after the earnings announcement for the past four quarters, with the stock price change from the close on the day before the announcement until the closing price on Friday (when the weekly options expire):

(click to enlarge)

For each of the last four quarters, the company has exceeded estimates by such a large margin that you might wonder what the analysts were smoking when they made their analyses. Actual results were over ten times greater than estimates almost every time. They weren't even in the same ball park. How could they be so far off so consistently for four consecutive quarters? Something is fishy here.

A conspiracy believer might suggest that they low-balled estimates and whispered to their bosses to buy shares. This might get them a raise because after every announcement the stock has moved higher by an average of 6.6%.

The pattern of analysts not being close to reality seems to be continuing. The current estimate ($.11) is after the 4 - 1 stock split declared on April 18th, so it is essentially $.44 compared to the old numbers. But last quarter the company reported earnings of $.51 and this is not a seasonal business, and with sales reportedly growing at 32% YOY, you would expect that earnings would be much higher. So why are estimates so much less than last quarter's earnings?

Over the last several months, I have been testing the proposition that the level of expectations prior to an earnings announcement is a better indicator of what the stock price will do than the actual earnings themselves.

I have been using several indicators to determine whether expectations are unusually high (or low) leading up to an earnings announcement and what the stock price is likely to do after the announcement:

  1. Stock price action in the most recent weeks.

  2. Whisper numbers vs. analyst estimates.

  3. Recent post-earnings price changes compared to earnings results (is there a pattern for that company)?

  4. Current RSI levels.

  5. Overwhelming positive (or negative) comments on various blog posts.

If expectations are usually high, there is an excellent chance that the stock will be flat or fall after the announcement, regardless of how much the company might surpass estimates, and conversely, the stock is more likely to move higher when expectations are low, even if estimates are merely met.

In addition, I have checked out recent hedge fund activity (are hedge funds buying or selling the stock?) to get a better handle on whether the stock is likely to rise or fall after the announcement. While hedge funds are not always right, they can be counted on to have conducted some serious due-diligence work before making a decision to commit or divest, and they have far more resources at their disposals than any individual could hope to have.

I have had some serious success with this model, including eight consecutive winning pre-earnings calls without a loss - see results.

CRM presents a serious challenge to my model. By the measures I have used so successfully, the current level of expectations is seriously high. Check out the recent price action:

(click to enlarge)

The stock has picked up about 15% over the last six weeks and reached a new high last week while whisper numbers are $.13, or about 18% higher than estimates, and RSI is 94 (very overbought), all important indications that expectations are unusually high.

Institutions have added just over a million shares over the past quarter (an insignificant number for a company with 586 million shares outstanding), just about equal to the number of insider sales, so the hedge fund statistic is not much of an issue here.

People seem to either love or hate this company. In the week preceding the last earnings announcement, several articles were published on Seeking Alpha that panned them.

A sample, with a quote from each:

What's The Deal With Salesforce.com?

When viewed from the fundamentals, the current valuation of Salesforce is absurd.

Something Is Seriously Wrong With Salesforce

… at this dilutive speed, the Salesforce.com stock is little more than a Ponzi scheme.

Salesforce Earnings Preview: 7th Consecutive GAAP Loss Expected

What has occurred at Salesforce in recent years are efforts to maximize insider shareholder wealth with no regard to and to the exclusion of outside shareholders.

With comments like these, how could anyone expect the stock to move higher after the earnings announcement that came out after the close on February 28th? But it managed to go up by 7.6%.

Indeed, there is a lot to not like about CRM. Executive compensation, for one. Marc Benioff, co-founder and Chairman, collected $110 million in salary and options exercise last year (seems like an unreasonable compensation for running a company that chalked up an operating loss of about $270 million). Three other top managers earned an average of ten times their million dollar salaries in options exercise as well.

For some (unknown to most of the public), most analysts seem to love the company. Fourteen rate it a strong buy, 24 a buy, and continuing the love-'em-or-hate-'em theme, 5 rate it as underperform or sell and only 4 are neutral, calling it a hold.

Maybe the analysts are low-balling estimates to make the company look good, waiting for the stock to move higher after earnings because they beat earnings so badly, and justifying their "buy" or "strong buy" ratings so they get to keep their jobs for another quarter or so.

If I liked this company, I would buy shares before the announcement because of the remarkably consistent pattern of besting estimates and having the stock move higher after the announcement.

If I were bearish on CRM (or if I had total faith in my expectations hypothesis), I would take advantage of the escalated option prices for the May 4-13 weeklies which carry an implied volatility (IV) of 80 compared to 48 for the June-13 options. I would invest in 10 diagonal spreads, buying June-13 50 puts and selling May4-13 (expiring 5/24/13) 47.5 puts.

I would also buy 7 June-13 - May 4-13 call calendar spreads, paying about $.40 just in case the stock does manage to move about 6% higher, continuing the historical pattern. This is the risk profile graph if you bought this combination of spreads, assuming that IV of the June options would fall from 48 to 40 after the announcement, shelling out about $2500:

(click to enlarge)

These positions should make a gain if the stock moves as much as 6.6% higher (the average change for the past four quarters) after the announcement or falls by any amount. The maximum gain (about 50%) would come if the stock remained essentially flat. I think I will try this play with only a small investment because while my expectations hypothesis would predict a flat or lower stock price after earnings, there is a conflicting strong historical pattern of the stock moving higher after announcements. These spreads seem to cover both possibilities and should only lose if the stock moves up 7% or more.

The wonderful thing about options is that you can be wrong and still make a gain, just as long as you aren't terribly wrong. The CRM earnings announcement history makes it a particularly challenging earnings play, regardless of whether you prefer stock or options.

Source: How To Play The Salesforce.com Earnings Announcement

Additional disclosure: I plan to buy the CRM option spreads outlined in the article prior to the earnings announcement. I am also long an ORCL straddle.