Salesforce.com (CRM) is a controversial stock, nosebleed high, heavily shorted, and bouncing around in the area of a 52 week high. After a discussion with a reader, I became interested in the situation as a potential short: I have since taken up a position, and this article discusses the thinking and strategy utilized.
Price to Sales
CRM is presently trading at a P/S of 12.5 - extremely high. Ken Fisher's first book, "Super Stocks," contains an extended discussion of price to sales as an analytical tool. His research and thought processes underlie much of my thinking on this situation, and for readers who haven't read the book, it is a classic.
Briefly, the larger a company's market cap, the more difficult it is to justify a high P/S ratio, and the more likely the situation is to end in shattering nosedive. At a market cap of 19 billion, CRM is in a size class where it is very difficult for it to grow fast enough and long enough to eventually achieve a more conventional P/S ratio without going through a reduction in share price. A P/S greater than 10 is cause for considerable analytical concern.
Net Income% of Revenue
CRM 5 years from now
The above table lists CRM and four very large competitors. The final item is a projection of what CRM might look like in five years, assuming the share price doubles. In order to justify current multiples, the shares would have to double: otherwise, why take the risk? The assumed P/E of 23 is consistent with double digit growth, and the P/S of 4 is consistent with its big league competitors. Net Income as a % of Revenue reflects the logical relationship between P/S and P/E.
How do we get there from here? 39 billion market cap divide by P/S of 4 implies revenue of 9.75 billion. To reach 9.75 from the current 1.55, annual growth in revenue would be 44.5%. Margin would have to increase 2.5% per year. Growth generally declines as size increases. CRM is growing at a rate of 30%, and margins are decreasing.
I find it difficult to believe CRM can get there from here.
CRM's business model is subscription based - typically customers sign 12- to 24-month non-cancelable agreements. The salesman's commission is paid up front, but is posted to an asset account and amortized over the life of the underlying agreement. That is the proper accounting for the situation, since expenses are matched with the corresponding revenue. A vast majority of contracts are signed during the 4th quarter, which ends January 31.
The balance sheets have two separate deferred commission items, a current and a non-current. The trend for the past 3 years has been that these two asset items increase an average of 34% in the 4th quarter over the 3rd quarter. That has in turn reflected itself in regular increases in quarterly revenue, approximately 30% per year. In fiscal 2010 (ending 1/31/2010) the 4th quarter deferred compensation was up 39.5%, impressive and not too far from the rate of growth required to support the current share price.
This line of analysis is clearer if one studies a table with the necessary information:
As noted previously, it is unlikely that CRM can grow at a 44.5% annualized rate, which this analysis suggests is necessary to support the current price level. Given the predictive power contained in the deferred compensation item, investors who have any doubts can resolve them by consulting the balance sheet contained in the press release announcing 4Q 2011 earnings and observing the quarter over quarter increase of deferred commission. That will be the moment of truth.
Strategic and Tactical Thinking
Most value investors, the author included, have learned by hard experience that it is not always a good idea to short stocks based on valuation. It ought to work, but it doesn't, or not fast enough. The market can stay insane longer than you can stay solvent.
The purchase of puts reduces the risk, by limiting the investor's losses to the premiums paid, but has the disadvantage of being expensive if a long time goes by without a major move downward. To reduce the time cost of maintaining an options position, some type of spread would be helpful, since the time value of the short leg partially offsets the time cost of the long leg.
In this case, I went with the following trade, as a research project. I've had good results using diagonal call spreads for bullish positions, and would like to try my hand using the same principles on puts to reflect a bearish opinion.
Buy to open 1 CRM May 21 2011 170.0 put @ 32.95
Sell to open 1 CRM Feb 19 2011 140.0 put @ 8.30
The premium received for the 140 put offsets the time value on the 170 put, so time is on the investor's side. The short put expires February 19th, while the 4th quarter earnings press release came out on February 24th this year. Very possibly the short put will be out of the way at the moment of truth.
Disclosure: I am short CRM.
Additional disclosure: I am net short CRM as described in the article. I have no intention of initiating a positon in the other stocks mentioned.