Looking for a Cloud Computing Hedge? Consider CRM March Puts

by: The Strategist

Based on the F5 Networks (NASDAQ:FFIV) earnings announcement and reaction we think March puts in Salesforce.com (NYSE:CRM) are good trade to consider. While they are far from identical competing companies, they are both part of the generally accepted “cloud computing” sector that had shown superior relative strength until last week with the F5 Networks earnings. Our empirical evidence of this grouping is the effect of the F5 Networks earnings on CRM and other names such as Riverbed Technology (NASDAQ:RVBD) and Aruba Networks (NASDAQ:ARUN).

Despite the relative strength in CRM and the fact that we are primarily relative strength traders here, we have not been able to buy the stock for a fundamental reason – it’s the primary reason we originally chose F5 Networks over Salesforce.com when we were looking for cloud computing exposure back in November.

While F5 Networks has translated revenue growth into bottom line earnings growth, we have not seen the same from Salesforce.com. FFIV is expected to grow earnings by 32% over the next twelve months while CRM is expected to grow earnings by only 16.67%.

Despite a market capitalization 96% greater than FFIV, Salesforce.com, the forward 12 month P/E multiple on CRM is 93.57 versus 28.95 for FFIV (we used last Thursday closing prices and Citigroup estimates for this P/E calculation plus chose quarters aligned on a calendar basis (FFIV 12 months ending Dec 2011, CRM 12 months ending Jan 2012).

How can CRM deserve such a superior valuation multiple without superior earnings growth? In fact, if we assign CRM a 60x forward P/E we get a price of $83.40 and a market capitalization roughly in line with F5 Networks prior to its implosion after earnings.

Bottom line is this, if F5 Networks was priced to perfection, then it sure looks to us like Salesforce.com is also even more. Based on our analysis of the detailed financials available on the CRM investor relations web site, the primary reason for CRM not translating revenue growth into earnings growth is an increase in marketing and administrative costs (it does cost quite a bit of money to buy Wall Street Journal color ads for their Chatter service as CRM did in November).

Momentum names merit their premium valuation because of their growth, with CRM we see premium valuation but not the growth. We think the F5 Networks (FFIV) report should be taken as indicative of a potentially disappointing report from its peers in the cloud computing space.

As we told our newsletter readers in late November when we compare and contrasted F5 Networks and Salesforce.com, we are not comfortable going directly short Salesforce.com due to the dangerous nature of momentum stocks on the short side. Trying to catch the top in a stock is similar to trying to catch the proverbial falling knife – we like to say that if you are trying to catch the falling knife you better have the good sense to let go the moment you recognize you caught the blade and not the handle.

Furthermore, should Salesforce.com (CRM) somehow deliver an above expectations report in February, or someone chooses to initiate a takeover despite what we consider a shaky fundamental and growth picture, we do not like the theoretical infinite risk profile of a direct short sale of CRM.

We propose investors looking for a hedge on their cloud computing space exposure consider CRM March puts. Specifically we would look at the $120 puts which are currently trading for approximately $5.90/$6.10 (bid/ask).

The trade offers a limited downside short position to a name that has not supported its price momentum with comparable earnings per share growth and has had difficulty translating revenue growth into earnings per share growth.

We have seen many cases of value investors trying to call the tops in the relative strength stocks all the way along the uptrend (or as we affectionately call them, "the nosebleeds" for their high valuations), hence we prefer the limited downside offered via puts.

We will be watching the February earnings report from CRM very closely and think holding March puts going into the report would be a prudent trade. If CRM does not deliver the downside could be far worse than the fallout after F5 Networks (FFIV). If we are wrong, the lost premium is the equivalent to less than a 5% loss on a direct short position in CRM.

Disclosure: We sold our FFIV after the earnings announcement.

Disclaimer: The facts in this article are believed by the Strategist to be accurate, but the Strategist cannot guarantee that they are. Nothing in this article should be taken as a solicitation to purchase or sell securities. Principals, Editors, Writers, and Associates of The Strategist may have positions in securities mentioned in this article and you should take that into consideration before acting on any opinions in any content from The Strategist.