Wall Street history is littered with highly promotional and misleading salesmen preying on the greed of short-term speculators to benefit their own interests. Salesforce.com's (CRM) CEO Marc Benioff has parlayed a robust personality, a sheep-herd of an analyst community, and a momentum-based investor base to expand his company and personal fortune. The company boasts commodity-like products, abysmal profitability and atrocious capital allocation, yet trades at one of the highest multiples in the market on non-existent earnings. While market participants' willingness to value the company at astonishingly high levels has unquestionably helped Salesforce.com's competitive position, the laws of fundamental finance will eventually kick in, and it will be the company's shareholders who are left holding the bag. I've written about Salesforce.com's overvaluation before so this article will touch more on the recent acquisition and the absurdity that I consider Salesforce.com's accounting to be.
On June 4th, Salesforce.com agreed to acquire ExactTarget (ET) in a transaction valued at approximately $2.5 billion. With Salesforce.com selling at 9.1 times book value, you'd think Benioff would utilize stock to acquire the company but instead he is paying all cash. Considering the fact that Salesforce issues stock like it is going out of style, I would speculate that ExactTarget's management was wary of what obviously is an overvalued currency and chose to wisely opt for cash. For $2.5 billion, Salesforce.com shareholders got a company with 2012 revenue of $292MM, operating losses of $20MM and net losses of $21MM. In fact, this company has been a consistent money loser in every year since it went public in 2009. Perhaps you are thinking that this business is blessed with tremendous proprietary advantages and that the value is masked behind short-term losses that will likely lead to long-term financial success. Just Google email marketing companies, which is what ExactTarget, is and you'll see that this is just another commodity offering with terrible margins. Marc Benioff said that this acquisition was the most important in its history, which it may well be, but I believe future write-offs of intangible assets are a likely probability.
Salesforce.com has a stated goal of being the number 1 cloud company in the world and it is doing everything in its power to achieve that goal. Attaining size without regards to the cost of doing is the hallmark of an entrenched management concerned with their own interests, as opposed to those of shareholders. These acquisitions are great for management because they are able to command a higher salary, issue more super-cheap stock options below market value and improve a below-average competitive position through adding additional products and services that can be cross-sold to customers. Shareholders would be much better served if Salesforce.com used its inflated currency to buy profitable and undervalued businesses, even if they are unrelated to the cloud. Salesforce.com boasts a very effective and highly paid sales force, so there is tremendous logic in leveraging it to further their cross-sell efforts. The problem arises when Salesforce.com's highly promoted accounting metrics disregard the true costs of its acquisitions and the salaries for the sales team, which have directly negative implications for long-term shareholders' interests.
The key to understanding the charade that Salesforce.com's management promotes to boost the share price is to understand what constitutes the company's non-GAAP earnings, and then looking at the business strategy that takes advantage of the bogus accounting. Salesforce.com defines non-GAAP net income as its total income excluding the following components, which the company believes are not reflective of its ongoing operational expenses. These components are the following: Stock-Based Expenses, Amortization of Purchased Intangibles, Amortization of Debt Discount, One-Time Tax Charges and Income Tax Effects and Adjustments. So let's think about things clearly to really grasp what is going on. Salesforce.com is a growth story only based on revenue growth because there is no earnings to speak of whatsoever. Acquisitions will certainly boost revenue growth while the conscientious decision to ignore amortization costs clearly hides the impact of the excessive prices paid to acquire this in-organic growth. Other companies use similar metrics and often we see large write-offs at some points such as with Hewlett-Packard's (HPQ) disastrous Autonomy acquisition and Microsoft's (MSFT) aQuantive purchase. The fact that Salesforce.com hasn't reported substantial write-offs despite a clear lack of profitability is alarming to me and I'd be very curious to understand their accountant's justification of this.
The second phase of the charade is what truly bothers me in relation to the stock-related compensation being excluded from consideration as an operating expense. Stock-related compensation has averaged close to 10% of total revenue over the last three years. This is a huge expense and is a major reason why shareholders have been diluted dramatically over the years. Think if the New York Yankees or LA Lakers paid the majority of their players with stock options instead of cash and used Salesforce.com's absurd accounting standards. The profit margins would be stupendous but of course the owners would be diluted. As a private business, shareholders would be irate believing that their long-term profit potential is being hurt by these actions, as would sensible shareholders if the teams were traded publicly. It takes a complicit Wall Street to ensure that this type of charade can continue and all you need to do is read the transcripts of the Salesforce.com conference calls to see the different atmosphere that pervades them. It works even better when an inflated currency is used to acquire real assets, albeit at inflated prices, and then the only accounting metric (amortization of goodwill) that measures the disconnect between price paid and measurable value, (outside of profitability attained through synergies which are non-existent thus far) are excluded from non-GAAP earnings. All of these actions serve management and the company itself, as it is easier to justify exorbitant salaries due to the increased size of the enterprise.
There has been a long running debate in regards to stock options, as to whether they are an expense or not and how to value them if they are deemed so. Often the argument is examined only in the context of one interest group, but it is important to break it down to the various interest groups involved in a publicly traded security. For shareholders, stock options are unquestionably an expense due to the dilution that they cause to shareholders' existing equity stakes in the company. For creditors, stock options are a tremendous asset in that cash is preserved, which means that interest and principal payments are more likely to be made than if stock options weren't used. For management, stock options often are granted at super-cheap prices below market values, and give the recipients huge upside with virtually no downside. For the average employee, stock options can be a benefit if the stock performs well, but when compensation is skewed towards equity options it can also have disastrous consequences when that stock comes out of favor, negating the value of years of hard work. It is laughable to me that the technology industry is the only real industry where there is a widespread promotion of adjusted earnings excluding stock options. This might be appropriate in a fixed income presentation, but it is a promotional concept driven by many of the same constituencies that drove the excessive speculation in the late 1990s. Valuing the options is exceptionally difficult but I believe the current model using Black-Scholes is as good as any other that can be reasonably used.
In summary, I'm very surprised that there has not been more activist involvement in Salesforce.com. I personally don't like taking the short side of an investment, but I will from time to time sell deep out of the money calls with the willingness to go short if the odds are stacked in my favor, and I have done so successfully in the past with CRM. Because I don't currently have a stake in the company in either direction, I find myself objecting to the misleading tactics of management and what I rightly or wrongly believe to be incompetence by the majority of analysts covering the stock. It is interesting how when Bill Ackman's presentation against Herbalife (HLF) made headlines implicating the company as a pyramid scheme, market commentators jumped on the story but very little is said about something, that in my estimation, seems far more ill-conceived and misleading. The key is differentiating between constituencies as opposed to looking at a company, management, creditors and shareholders as all having the same interests. Salesforce.com is maximizing the company and management's interests and shareholders are in the worst position. The stock market can make a rational person look like a fool over reasonably long periods of time, which is why I'm not short, but I openly encourage a discussion with Salesforce bulls or analysts on why my argument is wrong.