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Salesforce.com’s (CRM) high valuation has been upheld for years by the company’s first-mover advantage and ability to increase its marketshare in the corporate migration to cloud-based information management software. This has enabled Salesforce to avoid cash expenses, by using their stock as a substitute.

On February 24, 2011, Salesforce.com released 4Q FY 2009 earnings and its 8-K [pdf] updating guidance for next year to GAAP earnings of $0.08 to $0.11 and non-GAAP earnings of $1.35 to $1.38. This is seemingly a large enough difference to warrant questioning during the earnings conference call.

Below is a word cloud from the questions and answers portion of the earnings call transcript.

Salesforce Earnings Call Q&A WordCloud

Figure 1 - February 24, 2011 CRM Earnings Call Q&A WordCloud

There was not one question regarding GAAP or non-GAAP earnings over the next year. The words GAAP, earnings, dilution, or margins were not even uttered in the Q&A portion of the call.

Most investors seem willing to ignore dilutive stock policies during this “early land-grab phase” for business-cloud market share. They believe once the market matures, Salesforce can fire all its staff, maintain market share, and cash in on 80% gross margins. I do not see that golden scenario playing out, but even if it does I am confident Salesforce will dilute away the benefits to current shareholders.

Issuing stock to raise cash for expenses has become engrained into Salesforce’s business model. Salesforce expects to accrue $1.57 per share in stock-based compensation expenses during this fiscal year. Built into Salesforce’s share price is the expectation of strong revenue growth for a number of years. Salesforce needs its sales team, consulting team, R&D team and their stock-incentives to acheive this growth. Below, is a chart of shares outstanding since 2005.

CRM Historical Shares Outstanding

Figure 2 - CRM Historical Shares Outstanding

The window through which current shareholders benefit from the golden scenario unfolding is quickly closing shut. Based on the stock’s performance post-earnings, some investors have read the 8-K and found the writing on the wall. After closing at $134.32 on February 24th, CRM jumped after hours and opened the next day near its highs for the day at $146 before selling off to close at $138.83. Since failing at this resistance level, CRM has struggled to find significant support.

CRM projects the weighted average diluted shares outstanding to equal 145 Million over the next year. That means about 150 million shares outstanding by Jan 31, 2012. I think CRM will underperform the market until CRM shows a decreasing rate of shareholder dilution and an increasing trend in GAAP earnings and net margins. I am short out-of-the money CRM LEAP calls.

Source: Dilution vs. Growth: Expecting Salesforce to Underperform