One of the intriguing things about bubbles is how they sometimes prop up companies that could otherwise face very serious difficulties. And one of the most amazing things about the latest tech bubble lies precisely on how some of the stocks being promoted, like Salesforce.com (CRM), have deeply worsening earnings trends.
Obviously, this buying of these stocks is predicated on there being some point in the distant future where these companies will turn incredibly profitable. And in the short-term, such buying is also helped by cash flow generation which seems to speak of hidden value. Salesforce has this cash flow generation in spades, due to 2 sources:
- It gets paid a subscription by its customers before it renders the services;
- And it pays a significant amount of compensation in stock and stock options.
These sources of cash, while dilutive and temporary, are probably enough to keep Salesforce.com far from a liquidity crisis in spite of its huge spending ways. However, they're not enough to prevent what has been substantial earnings and balance sheet degradation.
So much degradation, in fact, that I have turned to the Altman Z-score to try and ascertain its risk of bankruptcy. This article is the result of that endeavor. And the conclusion is startling.
The Altman Z-Score is defined by Wikipedia as follows:
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).
The Z-score has 5 inputs:
- T1 = Working Capital / Total Assets.
- T2 = Retained Earnings / Total Assets.
- T3 = Earnings Before Interest and Taxes / Total Assets.
- T4 = Market Value of Equity / Book Value of Total Liabilities.
- T5 = Sales / Total Assets.
The inputs show above then come together using the following formula:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Calculation for Salesforce.com
The following data, obtained from CRM's latest 10-Q is necessary to calculate the Altman Z-score:
- Current assets: $1698 million.
- Current liabilities: $3063 million.
- Total assets: $7970 million.
- Retained earnings: -$102 million.
- EBIT: - $160 million.
- Market capitalization: $30200 million.
- Total liabilities: $5111 million.
- Revenues: $3470 million.
Using this data we get the following parcels:
- 1.2 * T1 = -0.206
- 1.4 * T2 = -0.018
- 3.3 * T3 = -0.066
- 0.6 * T4 = 3.545
- 0.999 * T5 = 0.435
This gives us an Altman Z-score of 3.69.
Interpretation and Conclusion
The Altman Z-score is interpreted according to the following ranges (Source: Creditworthy.com):
3.0 or more,
Most likely safe based on the financial data. Of course, mismanagement, fraud, economic downturns, and other factors may cause an unexpected reversal.
2.7 to 3.0,
Probably safe to predict survival, but this is a portion of the gray area and is below the threshold of relative safety.
1.8 to 2.7
Likely to be bankrupt within two years. This is the lower portion of the gray area and dramatic action may be required to effect survival.
Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a financial condition generating this or lower scores.
Going just from a straight Altman Z-score calculation, CRM seems very low risk. Nothing else would be expected from a company trading for such a massive valuation - CRM trades for 98 times consensus non-GAAP 2014 earnings estimates, and 450 times present EV/EBITDA.
But the story doesn't stop here. Salesforce.com gets this score essentially due to T4*0.6 at 3.545, that is, due to the Market Value of Equity / Book Value of Total Liabilities ratio. In other words, Salesforce.com has a massive market valuation, and that gives it very low risk. This makes sense - if CRM needed money it could quickly raise a lot of it simply by issuing equity. But what happens if CRM drops a lot, say to one fourth of its present quote, where it would still be trading at a premium to the overall stock market?
What happens is that its market capitalization would get cut to just $7.55 billion, and T4*0.6 would then be just 0.886 … bringing CRM's overall Z-score all the way down to 1.03! That is, if Salesforce.com ever saw its stock get cut to around $12.50, then the Z-score would drop all the way down to "highly likely headed for bankruptcy"!
Salesforce.com's bankruptcy risk might well be hidden by its massive valuation premium. Were Salesforce.com stock to drop, and amazingly its Altman Z-score would quickly fall all the way down to the riskiest category - a company which can be expected to go bankrupt on short notice.
This serves both for the investors to understand just how risky Salesforce.com has potentially gotten, and for the company to have the fortitude to issue enough equity now so as to mitigate this danger before it ever materializes.