Growth at Any Price?

Includes: CRM, MSFT, ORCL
by: Fiver Capital
I must confess a poor first impression of (NYSE:CRM). It was discovered in its infancy by the bumbling sales team as an Internet start-up I once worked for who swore it would be just the thing to juice their poor performance. I found this rather funny since there were only two salesmen and they had no leads to track, but I digress. This was way before the cloud computing buzz and I best remember the product on offer was basically a glorified database hosted on the Internet instead of locally. It's true that as one of the original software as service providers, CRM can confidently claim first mover advantage in the secular shift away from the archaic license and install model. But will they be the ones to rule the cloud?
It's critical to settle on a definition of the cloud before assessing CRM's position within it. Though visionaries talk of the "intercloud," a globally connected cloud of clouds, the cloud as it exists now is not a singular place. Any company offering computational resources that can be accessed on-demand from an off-site location is technically operating in a cloud. Users of a cloud share resources much like public utility customers share water and electricity, and in the current model, pay a subscription fee for the services they desire.
In addition to the Sales Cloud, CRM now offers the Service Cloud for customer relation management and Chatter, a collaboration application that comes free with other services. Then there’s Heroku and Jigsaw, not super-villians but an app building and business data service, respectively., and Remedyforce round out the company's a-la-carte offerings. And in case there was any doubt what it all means, the company reminds: "did we mention that all of it runs in the cloud?"
Here's the rub: The current shared model raises privacy and security concerns. There's also the potential for service disruptions like those on display at (NASDAQ:AMZN) last week where many of its cloud clients suffered major downtime. Until there are standards in place, the space will continue to be fraught with risk. And then there's the matter of competition.
Microsoft (NASDAQ:MSFT) released its Dynamics product in 2003 and just announced an updated version that allows a client to host their own cloud on premises. This is the infrastructure as service model and though it offers less economic benefit to the client, it attempts to address the issues discussed above. Oracle (NASDAQ:ORCL) entered the space in 2005 with its acquisition of Siebel Systems and now offers the Fusion product. Microsoft and Oracle each hold nearly 10% of their market caps in cash giving them deep war chests to impact the race to the cloud.
Getting back to CRM, earnings per share at the company have grown at an average clip of 14% annually over the past five years on revenues of 40%. Strong top line, middling bottom line. The problem is, the company makes not even 4 cents for every dollar they invest with the main cost (63% of operating expenses) being the highly trained sales team needed to explain the myriad of service options they offer. So what happens as they expand their product line? One of two things will happen: strong product reputation and a rising learning curve will allow sales and support costs to fall while net margins rise, or the company will sink under its own weight.
Suppose you believe the former. What would you be willing to pay for earnings growth while you wait? Thirty times earnings? Or 50? A hundred?? Try 283! This puts the trailing PEG ratio at 20. Frankly valuations like this give me the heebie jeebies. Return on equity for the trailing 12 months comes in at 5.6, the lowest point since 2006 when ROE was .2.
To me, the fundamentals at CRM leave little room for error. Besides that, as a GARP investor, I look for growth at a reasonable price. CRM might just be the perfect example of the kind of stock I don’t own, and wouldn’t own, no matter how dazzling the story. It's purely a momentum play for traders with (hopefully) tight stops in place to get them out before the stock plunges to a sensible P/E somewhere much, much lower.
My advice: Buy Microsoft or Oracle. Even better, short CRM too and make it a pairs trade.
Disclosure: I am long MSFT.

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