This Decade's Most Profitable Short Opportunity

by: Convex Strategies

With the risk of beating a dead horse, the first (but not nearly the most important) interesting aspect of's (NYSE:CRM) shares is the P/E ratio. On Tuesday, October 18, Salesforce's stock traded at 631.90 times trailing earnings. What that truly means, in Peter Lynch parlance, is that if earnings stay steady, it will take 600 years to make your initial investment back. In other words, given the $.21 EPS over the past 12 months, it will take 631 years to receive your initial investment of $129.54 per share.

Obviously investors have poured into CRM because they believe in the growth story that has been fluffed, pumped, and hyped for the last few years. Granted, 2010 was a good year for GAAP (bolded for reasons coming) EPS was $.65 a fantastic 81% from 2009's GAAP earnings of $.36. The issue, of course, is that 81% growth doesn't meet the requirements of a P/E ratio well over 500. In order to come into some equilibrium of paying that much for earnings, growth should be relatively close to the P/E ratio; If I'm paying 600 times earnings for a stock, those earnings better be growing at torrid, historic rates.

They're not.

Actually, they're not growing at all. Despite the free information out there available to investors, mainstream media has neglected the story.

From May 19, 2011:

"For the full fiscal year 2012, the company expects to report a GAAP net loss per share of approximately ($0.03) to ($0.01), while diluted non-GAAP EPS is expected to be approximately $1.30 to $1.32. All EPS estimates include a one-time tax benefit of $0.04, associated with the acquisition of Radian6. The non-GAAP estimate excludes the effects of stock-based compensation expense, expected to be approximately $238 million, amortization of purchased intangibles related to acquisitions, expected to be approximately $60 million, and non-cash interest expense related to the convertible senior notes, expected to be approximately $11 million. EPS estimates assume a GAAP tax rate of 113%, and a non-GAAP tax rate of 33%. For the purpose of the EPS calculation, assume an average basic share count of approximately 136 million shares, and an average diluted share count of approximately 145 million shares. completed its previously announced acquisition of Radian6 on May 2, 2011, and these estimates include the forecasted operating results for Radian6 from that date forward. Radian6 estimates incorporate a preliminary purchase price allocation, and are therefore subject to change."

When eager investors get a look at CRM's annual 10-K in early 2012 (Salesforce's 2012 fiscal years ends on January 31st, 2012) they will likely be a bit surprised to see negative earnings in the filing. In the glossy, animated first few pages of the report, however, they'll likely read an upbeat, excited tone from CRM'S CEO, Mr. Marc Benioff. The reality is that CRM's real P/E ratio will no longer be in that ridiculous 600 range, but rather "N/A." On a comical note, as fellow Seeking Alpha contributor, Todd Johnson (who has shed a significant amount of light on this subject, and deserves much credit) points out, $.01 in EPS for fiscal 2011, at current prices, would result in a P/E ratio around 13,000.

The reasoning? The company feels that their stock-option executive compensation, charges for convertible senior notes, and amortization of certain intangibles assumed from takeovers are not good indicators of their true success as a business. Well, that's fantastic, but if you lose true money, the shareholder's money nonetheless, and construe it as a gain of millions of dollars, you're lying. You're gaming the accounting system, and the massive institutional ownership is fine with it (or unaware), for now.

I can possibly understand neglecting the charges related to the amortization of intangible assets and non-cash interest charges for convertibles, since they're one-time, non-cash charges (yet they are still asset reducing, value removing expenses).

Explained in Buffett terms, if Salesforce used stock options to pay their rent, would you consider this to be free rent? Of course not. The landlord's get their value, and value doesn't come from nowhere; it's exchanged. In the real-life case, it has been transferred from Salesforce to their employers, who will eventually exercise their options. In effect, Salesforce sold pieces of their businesses to pay their executives handsomely, as opposed to forking over the cash. Also, executive pay is not a one-time charge. Executives need to paid, usually around the holidays, handsome bonuses rich with stock-options every year to stick around. This is a real charge, and it's a travesty that CRM does this every year.

Fortunately this is a marketplace, and stocks, over the long-term, approach their real intrinsic value.

It's sad joke how razor thin even CRM's reported profits and margins are. 0.84% operating margin? How about an ugly .33% return on assets. Seriously? And this thing is trading at over 600 times earnings? Once again, you better be seeing the most historic growth ever if you're buying CRM. Even 81% from 2009-2010 isn't enough to meet expectations over the long-term. Let's use Peter Lynch's example (page 171, One up on Wall Street), "Electronic Data Systems ... earnings and sales grew dramatically...stock price declined from $40 to $3 in 1974 because it was simply overpriced."

So what if investors keep believing that the company is growing, using the non-GAAP earnings (not likely at all, since GAAP is used for TTM P/E metrics)? CRM will still be an excellent short. They're not growing fast enough, they have endless competition from companies that are, quite simply, more profitable on a relative basis (like RNOW, LPSN, ORCL) and are better managed.

The reasoning for these horrible predicted GAAP numbers is even more hysterical.

From their 2011 Annual Report:

"Additionally, we plan to: expand our domestic and international selling and marketing activities; continue to develop our brands; add additional distribution channels; increase our research and development activities to upgrade and extend our service offerings; develop new services and technologies and integrate acquired technologies; and add to our global infrastructure to support our growth. We also regularly evaluate acquisitions or investment opportunities in complementary businesses, joint ventures, services and technologies in an effort to expand our service offerings. We expect to continue to make such investments and acquisitions in the future. As such, we plan to reinvest a significant portion of our incremental revenue in fiscal 2012 to grow our business and continue our leadership role in the cloud computing industry. We expect diluted earnings per share for fiscal 2012 to be significantly lower than diluted earnings per share for fiscal 2011."

You're kidding, right? How is this trading for more than 600 times earnings?

When a reinvestment of a "significant portion of revenues" results in negative REAL earnings, after several years of, as analysts have said, "unprecedented," or "top of the line" growth, you've got yourself a loser.

Also, let's consider the fact that CRM has a current ratio of .62 (which has been worsening in past quarters, as assets remain relatively constant while liabilities increase), and has $530,000,000 in debt compared to $572,000,000 in cash and cash equivalents.

And finally, let's say this reinvestment is a good thing; it is still going to result in "significantly lower diluted earnings." All the while, they are going to degrade the balance sheet even more by shoving cash flows into reinvestments, likely taking on more debt in the process.

Imagine what is going to happen to this stock, trading at more than 600 times earnings? The daily price increases are based not on fundamentals, but on the idea that the stock is going to go up even more than it already has. CRM literally defines an investment bubble.

How about our beloved Jim Cramer, regarding Salesforce? "'Just because a stock has had an incredible run, that doesn't mean it won't go higher still,' Cramer said Thursday."

Yes, Jim. Incredible insights. Who cares if it goes higher. How much are you going to make in a best case scenario, knowing what you know about upcoming fiscal earnings? Whatever that number is, it's definitely not worth the risk you are incurring.

For those who still doubt the logic behind slandering outrageously high P/E ratios, this one in particular, ask yourself how much you'd like to sell your shares of CRM for. $200? That would require GAAP earnings of roughly $.32 per share, assuming the same P/E ratio of approximately 630. As we've seen, the company is predicting a loss for 2012. Assuming the same P/E ratio, a $.01 profit for 2012 would make your stock worth...$6.30. (Is CRM really worth $6.30? Probably not. The company has shown significant growth, and its products are loved by customers. Fair value is likely in the $10-$30 per share range). is likely to turn out as one of the greatest individual stock collapses of this decade, and if you have the resources, take advantage of that. Shorting can get expensive, and who knows how long the shenanigans are going to last, so maybe buy yourself some long-dated puts. At the very least, it goes without saying: don't buy any shares of CRM.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I will likely buy put options on CRM shares, not including the next 72 hours.