Understanding The Bull Case For Salesforce.com

Nov. 4.11 | About: Salesforce.com, Inc. (CRM)

First of all, I should say I am short Salesforce (NYSE:CRM) because of the extreme overvaluation, the lack of earnings growth and the non-GAAP shenanigans that allow it to claim a profit while posting GAAP losses, due to the way it ignores compensation costs paid in stock.

However, it is critically important to understand what the bull thesis is, lest it be right and overwhelm any kind of overvaluation or lack of growth.

The bull thesis in CRM rests mainly upon 2 vectors:

The cash flow CRM generates

Because of its nature as a subscription-based service, CRM gets to collect cash from customers well before it renders its services and recognizes revenues from rendering those services. This allows CRM to post a large operating cash flow even though, given that the revenues are not all recognized upfront, the earnings lag.

One can check the latest 10-K or the most recent 10-Q to observe this in action. CRM posted $459 million in operating cash flow during 2010, and $222 million during the first 6 months of FY 2012.

Obviously, the cash flow numbers being much larger than earnings makes for an opportunity to calculate valuation multiples for CRM that are a lot less outlandish than Price-to-Earnings, even if non-GAAP based.

A P/CF multiple using $459 million in operating cash flow, 141 million shares and $133 per share comes in at 41.5. Not cheap by any measure, but not 10-40 times higher than the market, either, as would be the case when using P/E. Also, contrary to EPS (GAAP or non-GAAP), one can argue that operating cash flow is still growing as long as revenues continue to grow.

My problem with this argument? Well, a large part of the operating cash flow, 18% in 2010 (CY), but trending towards 50% in 2011 (CY) is coming from paying employees with stock, hardly a high-quality source of cash, if it can even be called “operating cash flow”. This means that any cash flow based multiples should probably be corrects upwards by a factor of 2, and then they become as supportive of CRM’s share price as the P/E.

My position regarding cash flow being generated from paying employees with stock can be understood if one imagines a company selling something for $10 (net) and paying $20 to its employees in stock to sell it. Such a company would show non-GAAP earnings like CRM and cash flow like CRM yet would obviously not be worth much.

The subscription model

Perhaps even more salient than the cash flow, the main point in the bull’s thesis is that if and when CRM stops growing so fast, it will be a huge money-maker, even earnings-wise.

Central to this theory is the notion that most of the costs to get a customer are up-front, and there’s not much in costs for CRM to keep and service such customers. This is borne out by the fact that CRM is now spending at much as 53.7% of their revenues in “Marketing and sales”, and much of that theoretically needs not be spent to service or keep existing customers after year 1.

Part of this theory is certainly right, it IS much cheaper to keep a customer than acquire one. So, earnings from existing customers should be much higher than those from newly acquired ones.

What is my problem with this? First, it is very hard to know how much of the marketing and sales is needed to service present customers. Then, a part of the costs to service clients, including long term commissions, is capitalized or exists even if the customer is not new. Also, and most important, a large percentage of CRM’s customers, 70% or more, are already beyond the first year of their contracts, have already renewed, and the huge profitability kick-in has not been observed. It is hard to believe that revenue growth at just 30% per year can have costs so high that they are able to eat up all that increased profitability that was sure to arrive but never did, and keeps getting pushed back, to the point where CRM has shown no increased profits, even in non-GAAP terms, for almost 2 years (7 quarters).

Finally, if keeping the existing customers is so costless, then a much increased marketing spend should produce much faster growth – because most of it would go to capture new customers. Such is not observed; the absolute growth from 2008 FY to 2009 FY, 2009 FY to 2010 FY or 2010 FY to 2011 FY is in the same ballpark ($250 - $350 million in absolute increase in revenues) even though marketing spend in 2011 FY was more than twice what it was during 2008 FY. Either finding new customers is getting a lot harder, or there really is a large component of marketing and sales that goes to service existing customers, going directly against this thesis.


It helps investors and traders to know what the other side is thinking. In fundamental terms, the above 2 theories are what the other side is thinking in CRM. Obviously there are also a few other components regarding momentum, the “cloud” story and, I believe, a huge stock promotion, in play.

As I believe I have shown above, these arguments can have some validity, but are far from being clear cut. At some point, even if one believes the model the company follows has delayed profitability, profitability HAS to make an appearance, which it hasn’t.

Add to this the questionable nature of a company that switches from GAAP to non-GAAP clearly to paint a better picture and you have what looks to be an obvious stock promotion far departed from reality.

Disclosure: I am short CRM.