Investors in Salesforce.com (CRM) are hitting the panic button Tuesday after the company announced an unexpected debt offering. According to the press release which came out after the close on Monday, CRM will be issuing $500 million worth of convertible senior notes to qualified institutional buyers. There is an option for purchasers to buy an additional $75 million if the demand is strong, so it is likely the deal will actually be valued at $575 million.
Shareholders are especially concerned because the notes will be convertible – meaning that over some period of time we can expect dilution to shareholders. Now management stated in the press release that they have entered into an agreement with a counterparty to hedge against the risk of dilution. Essentially this likely means that CRM will have an option to purchase shares which it will pull out of the market to offset the additional shares issued when the notes are converted to equity.
But the problem with this hedge is that the third party will likely hedge his own exposure. So if the third party is obligated to deliver CRM shares to the company at some particular price, this counterparty will enter into transactions today to make sure that he is not left with significant risk if CRM stock continues to rise and he is forced to deliver the stock at a discount. The bottom line is that the transaction certainly initiates downward pressure on the stock.
Right now the terms are not clear as to what the interest rate will be on the notes or what the conversion price will be. CRM simply says that pricing and conversion metrics will be determined through a negotiation process with the buyers. The use of proceeds is also sketchy as the company intends to use the cash to pay for the cost of the hedge, and for “general corporate purposes, including funding possible investments in, or acquisitions of, complementary businesses, joint ventures, services or technologies, working capital and capital expenditures.” In other words, the company can use the cash for whatever they like.
It certainly wouldn’t surprise me to see CRM use the cash to pay for an acquisition in the near future as the cloud computing area is certainly ripe for consolidation. CRM already had a very attractive balance sheet and ample cash-flow so it doesn’t seem necessary for the company to raise $500 million unless they have a very specific plan for the capital. It would not be customary for the firm to announce an acquisition before the terms were agreed upon because that would cause the market to bid up the target company and likely result in a higher purchase price.
So I expect CRM has its eye on an acquisition and will be announcing the purchase in the next few months. The problem is that most of the time when an acquirer announces a purchase agreement, the acquirer’s stock (CRM) will drop significantly as once again the shareholders worry about dilution and overpaying for the target. So it seems very possible that CRM could see another gap lower in the near future.
CRM operates on a January year end, so their 2011 year is just about to complete. Analysts expect the company to earn 63 cents for 2011 giving them a current PE of about 111. Looking at forward earnings (CRM is expected to grow EPS by 32% to 83 cents per share next year) the forward PE is a tiny bit more reasonable at 84. Keep in mind that these ratios are calculated after the stock has already dropped more than 5% on the day. So it’s hard to look at this stock as anything but expensive.
In today’s momentum based market, it has been difficult to make money on the short side as positive trends have persisted regardless of the fundamentals. However, with a significant break like this, it is likely that the trend has been broken and further downside is likely. I would recommend shorting the stock today with a tight stop at the most recent high (near $75) If we are wrong, our losses should be close to 10%. However, if this stock trades down to a still attractive forward PE of 35, the gains on our short position will be roughly 58%. This could be a great trade to get the profits rolling in 2010.
Full Disclosure: Author has a position in the Sound Counsel absolute performance model.