- Significant confusion exists regarding CRM and its inability to generate GAAP profits.
- The company generates free cash flow, but from sources that require further examination.
- Does the company look any more attractive from a free cash flow perspective?
Salesforce.com (NYSE:CRM) is a heavily debated stock, and rightly so. Bulls point out that GAAP profit metrics are irrelevant, focusing on substantial revenue growth and visionary leadership in cloud computing. Bears point out that the company, now generating more than $4 billion in revenue, still loses money on a GAAP basis, has declining gross margins and revenue growth rates, and operates in a highly competitive industry with no network effects and large, entrenched competitors. I've certainly been a bear over the last year, but I want to focus on the facts here and let folks draw their own conclusions.
GAAP reporting is a major source of confusion related to CRM (and other enterprise SAAS companies). In CRM's case, GAAP confusion primarily centers on revenue recognition and stock compensation expenses. CRM generates a substantial proportion of their operating cash flow (OCF) from growth in deferred revenue (business the company has billed for, either receiving cash or booking a receivable, but not yet recognized as revenue) and the add-back of non-cash stock compensation expenses. I've argued in the past why I believe both are dubious OCF sources, but the point here is that although CRM is not profitable by GAAP standards, it has historically generated OCF.
Free cash flow (FCF) is the most important metric for me to evaluate historical and future cash generation, and will serve as the primary input in this analysis. Here, I assume FCF is simply OCF less capital expenditures (excluding $270 MM the company spent on raw land in 2009). I've also argued in the past why I believe acquisitions should be deducted against OCF in determining CRM's FCF, but this analysis excludes acquisitions. Thus, I've given bulls everything they could ask for in presenting a fair picture - using an FCF metric that excludes acquisitions and eliminates most of the accounting adjustments that result in GAAP losses.
Salesforce generates the majority of their free cash flow from sources other than net income. Quality earnings are often described as having persistence and predictability. For example, a company whose net income equaled FCF would require no add-backs or adjustments - subject to a wide range of assumptions and techniques to massage - to reconcile the two. CRM's net income, on the other hand, is negative. They rely on massive non-cash adjustments - stock compensation being a major one - and changes in working capital accounts. Working capital changes are not predictable - in fact, many prefer to use after-tax operating profit plus non-cash charges as an OCF proxy when calculating FCF. CRM's stock compensation add-backs grow predictably, but lack persistence if employees begin demanding cash compensation in lieu of equity. CRM's foundation of OCF and FCF is tenuous.
Let's turn to CRM's performance in generating FCF. As the chart below illustrates, FCF grew rather rapidly until 2012, when it began to stagnate. Remember, these figures exclude cash acquisitions, which certainly have contributed to FCF generation, but most certainly were not free to shareholders.
It is important to note we are looking at per share FCF, since the stock compensation add-backs discussed above have a seemingly benign but long-term deleterious impact on shareholders. For example, CRM's outstanding shares grew from 586 MM in January 2013 to 610 MM in January 2014. During that same period, annual FCF grew from $557 MM to $576 MM. Absolute FCF grew 3%, but the accompanying increase in shares outstanding resulted in a per share decrease in FCF of 6.3%.
Although CRM's FCF per share has been roughly flat since 2012, the stock rose substantially. Meanwhile, the company used its cash hoard and borrowed to finance acquisitions. The combination of higher stock prices with continuously increasing shares outstanding, increased debt, and decreased cash has driven enterprise value to approximately $40 billion. The resulting EV/FCF seen below is now the highest in the company's public history, approaching 70.
EV/FCF, of course, excludes growth, CRM's major selling point to shareholders. Just like the more familiar PEG ratio, EV/FCF/G adds a growth component to evaluate a company's value. Here, the combination of CRM's stagnant FCF growth and increasing EV creates a remarkable endpoint to the chart below. As seen, EV/FCF/G typically fluctuates between 0 and 5, even in the company's early days, when they were generating only a few hundred million dollars in revenue and had massive growth opportunities ahead of them.
CRM's position as a battleground stock has come to a head. Bears would be wise to acknowledge GAAP shortcomings in valuing the business. Meanwhile, bulls should appreciate the growth in FCF - what really matters - is waning, resulting in a stock price that absent further speculation appears unsustainable.