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George Hu, the VP of marketing for CRM, is probably the number two at CRM in promoting the new ‘cloud’ paradigm. He comes after the CEO, Benioff, PR extraordinaire.

This is his recent option activity, disclosed on March 2. George Hu had a tranche of his options mature, making them eligible for sale (each year employee options mature, about 25% per year of a remuneration package).

For Hu, 4,585 shares were vested in the company, and guess what? He sold the entire lot (sold at $128, granted at average price of $45) immediately, making a sweet profit of $380K. That is perfectly acceptable, but I believe this is far more galling:

His remuneration package in calendar 2010 amounted to $6.0 million. Of the total remuneration, his salary (ie, cash wages) was 670K. In other words, 90% of his total remuneration was (shares via options) received and sold.

This leads to the crux of the problem:

In the non-GAAP earnings-per-share that CRM chooses to focus exclusively upon, they only account for wages, not options. Thus, the non-GAAP earnings-per-share excluded 90% of the VP’s remuneration.

In this (possibly extreme case), 90% of his total staff cost was not reflected in the wages' cost line, and personnel costs must be the biggest line item in the company’s P&L account. This is the main factor causing an enormous difference in the GAAP and non-GAAP earnings-per-share. Case in point for the next fiscal year to Jan 2012 is the relevant extract from their recent 10K filing.

The following is a per share reconciliation of GAAP diluted EPS to non-GAAP diluted EPS Guidance for the first quarter and full fiscal year:

Fiscal 2012

Q1

FY2012

GAAP EPS Range*

$

(0.01) - $(0.02)

$

0.08-$0.11

Plus

Amortization of purchased intangibles

$

0.08

$

0.28

Stock-based expense

$

0.33

$

1.57

Amortization of debt discount

$

0.02

$

0.08

Less

Income tax effect of certain Non-GAAP items

$

(0.15)

$

(0.66)

Non-GAAP diluted EPS

$0.26-$0.27

$

1.35-$1.38

Shares used in computing basic net income per share (millions)

134

Shares used in computing diluted net income per share (millions)

142

145

*

For Q1 GAAP EPS loss, basic number of shares used for calculation

As seen above, stock based expenses are by far the biggest variance between the two - net of tax, they represent 71% of the variance.

As for the controversy, whether options are a legitimate expense or not when calculating a company’s profit, no one has expressed it better than Warren Buffett in 1992:

If stock options are not a form of compensation what are they? If compensation is not an expense what is it? And if expenses should not go in the income statement, where in the world should they go?

One could extend the logic employed above further. Let’s leave out 90% of the rent and utility bills too. After all, we are in the clouds.

Disclosure: I am short CRM.

Source: Salesforce.com: Hu's Controversial Option Activity