In the wake of AAPL and IBM’s beats Tuesday afternoon (see Apple's earnings call transcript here, and IBM's earnings call transcript here), I thought I’d take a look at four of the key stocks in the tech sector. Admittedly, I’m no expert on tech, and I prefer more value oriented names that are easier to project. However, I continue to be confounded by the dynamics inside the sector.
On the one hand, you have proven titans like Microsoft (MSFT), Apple, and IBM trading for cheap to reasonable valuations. All three companies have great ROIC and ROEs, fortress balance sheets (both AAPL and MSFT have huge net cash positions, and IBM could easily pay off all of their debt with about 1 year's worth of FCF), a history of extremely profitable growth, and huge potential growth opportunities.
Despite this, all three companies trade for reasonable valuations (IBM and MSFT at below market P/Es, and AAPL at around a market P/E after factoring in their net cash position). Plus, IBM and AAPL beat estimates in their quarterly reports, proving the street continues to underestimate these best of breed companies. In the case of IBM, they even break out their long term earnings estimate (EPS = at least $20 per share in 2015, driven by a huge growth in software), giving a road map to what they think the company will look like (and earn) in 2015. Very few companies have the vision and confidence to even project earnings two years out, much less five, which makes it all the more impressive that IBM can.
On the other hand, you have a company like Salesforce.com (CRM). While its recent growth history has been impressive, it trades at nose bleed valuations (over 260x trailing earnings, 100x forward earnings, and 106x EV/EBITDA) and both its ROE and ROIC metrics aren’t very impressive. While some of this comes from the company expensing its huge R+D costs, the fact is that it must continue to invest in those R+D costs or fall behind, and its larger rivals do the exact same thing and still report great ROE numbers. That’s the advantage of being an established big cap: it gives them the economy of scale to make huge R+D investments and still be profitable. Here’s another fun fact: both MSFT and IBM have huge share buyback programs and constantly reduce share count outstanding while continuing to invest in R+D and growing the business. CRM, in contrast, is a huge share issuer, raising huge amounts of equity over the past few years in order to fund continued growth. In addition, insiders have continued to unload on CRM shares.
Clearly, investors are paying a huge premium for CRM growth (though it looks like CRM insiders would rather have the cash than pay the premium). So, just for fun, let’s try to look out to 2015 and project what these companies are going to look like. CRM increased revenues 4.21x and op income 5.73x, MSFT 1.41 and 1.46x, IBM 1.05 and 1.81, and AAPL 3.37x and 7.49x.
While CRM and AAPL’s growth will likely slow in the coming years (if Apple grew at the same rate for the next five years, its operating income would be 10x bigger than the average S+P 500 company and about the same size as Citigroup (C) and Bank of America (BAC)), even this aggressive projection will highlight just how high CRM’s valuation is. If AAPL grows at the same rate, it would have 2015 operating income of 138 billion dollars, and would trade at a current EV / 2015 EBIT of 2.1x. If MSFT grows at its historical rate, it would earn just over 35B and would trade for just less than 6x EV / 2015 EBIT. (Note: if you assume Apple will slow down to say, IBM’s rate, for the next five years, it would trade at 8.8x EV / 2015 EBIT.) IBM would earn just under 31B and trade for 6.5x EV / 2015 EBIT. CRM, if it grew at the same rate for the next five years and increased earnings 570%+, would earn $661mm in 2015 and trade at an EV / 2015 EBIT of 28.75x.
In other words, if the company grew at the same torrid pace they have for the past five years, they would still trade at a huge premium to the tech bellwethers. As a matter of fact, if CRM grows at the same torrid pace for the next seven years, its current EV / 7 years out EBIT would be the same as Apple’s EV / EBIT today. It would take 8 years of growth to trade for around IBM’s current multiple, and 9 years of growth to trade for about MSFT’s multiple. That’s a lot of growth projection, and the company would still have to keep growing at a torrid pace then to justify its valuation.
In sum, even with the rosiest of projections, I don’t see how an investment in CRM at today’s prices works out well for a long term investor. Maybe a strategic buyer gets crazy and pays a 3Par like multiple for the company, but it looks like even that type of craziness has already been baked into the stock price. While the market can do anything short term, longer term investors would be wise to look to the tech bellwethers, which offer growth at a still reasonable price, and follow CRM’s insiders' lead: avoid the stock until the market prices in a less rosy forecast.