Salesfore.com Can't Float in the Cloud Forever: 3 Reasons Why It's Time to Short

| About: Salesforce.com, Inc. (CRM)

Salesforce.com's (NYSE:CRM) share price popped 9% on Wednesday. This price move pushed me over the edge, and I have joined the large group of investors who are short this stock. My rationale is below:

Background

The often stated reason for shorting CRM is valuation. Per Yahoo Finance on Wednesday, CRM's

  • Forward P/E is 298.21
  • Trailing P/E is “just” 75.76.

Can you say “dot.com” bubble?

Of course, CRM's P/E has been elevated for a long time. Many people have highlighted this stratospheric evaluation, and shorted the stock. It is one of the most shorted stocks in the market. Most of these shorts have probably lost money. So on the surface the stock seems to be a perfect example of the old axiom about shorting that “stocks can stay irrational longer than an investor can stay liquid”. However, these high valuations suggest the stock needs to pull back at some point.

3 Common Sense Reasons Why It's Time to Short CRM

1. All clouds are not the same. It appears the main driver for the bullish view of CRM yesterday was positive results from companies like VMware (NYSE:VMW), Intel (NASDAQ:INTC), IBM (NYSE:IBM), etc. These companies are key providers of cloud computing components. CRM uses the cloud to deliver great application functionality, cost effectively.

The growth cloud computing component companies are reporting is related to the build out and operation of the cloud. Demand for these components comes from many diverse sources. It almost seems insatiable, and is driving large revenue growth in these stock. CRM's growth is driven by an increase in people subscribing to their applications. That growth curve is also strong, but not the same thing. It is probably more cyclical, more one-dimensional, and has a lower barrier to entry than the growth seen by a cloud component provider.

Further, the business/cost models between cloud component companies and CRM are very different. The cloud component companies costs are front loaded driven by R&D investments and production costs. Since these costs are largely sunk, the risk of cost management issues are front loaded and excess revenue can drop right to the bottom line. CRM's business model is the reverse. Largely the costs to operate the application, and service the costumers come after the sale. CRM's deferred revenue recognition polices should align revenue and costs. However, costs increase as more users access the system and any cost management risk will not have appeared yet.

Zachery Scheidt provides a much more detailed review of the potential implications of this situation in this article.

So in summary, all clouds are not the same. The cloud computing component companies are the cloud, while CRM is floating in the cloud. It does not seem appropriate for the market to simply assume positive results from component companies will apply to CRM. CRM's earnings announcement on May 18 would be the time for these differences to come clearly to light, and it may be desirable to get short before that event

2. Panic equals opportunity. As mentioned above, CRM is highly shorted. Yesterday's positive cloud news probably means many of those holding a short position are scrambling to cover. This has likely created a classic short squeeze. Short squeezes usually only last for as long as it take to exhaust the panic of the short sellers. Today's 9% pop in the stock could represent the capitulation of the panicked short seller. Hopefully, a reversal will be coming, and now is the time to take advantage of the panic.

3. Technical analysis. Many of the current owners of this stock likely own the stock because of the momentum illustrated via charts, and not the fundamentals described above. Using approximate numbers, the stock peaked at $151 in q4 and $146 in Q1. CRM can rise to $146 without setting a “higher high”, and a simple trend line through these peaks implies the stock might loose momentum around $141. This very basic technical analysis indicates that if CRM stalls at current levels owners may see momentum waning and be more likely to sell. This could drive both the demand for shares and price down.

Trading Approach

Often options can offer a cost effect, lower risk way to represent short sentiment in a stock. However, with such a large gap up in yesterday's trading, and the relatively high implied volatility in CRM's options, it seems more appropriate to simply shorted the stock anywhere over $140. Hopefully, the stock will reverse, and fill at least a portion the gap on today's chart today relatively soon. If that does happen, it might be possible to take modest profits, and replace the short position with a short put spread to reduce the risk of the trade. The 200 dma is just over $122. If the stock does start to pull back, this level could be a possible trigger to exit the trade.

If the stock continues to soar, being short will be painful. However, many portfolios are usually net long. Hopefully if CRM continues to go up, the rest of the market and especially other tech stocks, will continue to rise as well. So this trade can be rationalized as a hedge against other technology stock positions.

Disclosure: I am short CRM.

Disclaimer: This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.