Often the stock market presents investors with stocks that are difficult to figure out. Not all companies can be as straightforward as P&G (PG) or UPS (UPS). Often, it takes a good deal of research to figure out what a stock is worth, and where it is going.
On November 3, we profiled Salesforce.com (CRM), and reccommended that readers simply avoid the stock altogether. But now that Salesforce has reported its fiscal 2012 third quarter results, we felt it was appropriate to follow up on the stock and determine what to do with it from here on out.
On November 17, the company posted a GAAP loss of 3 cents/share, and a non-GAAP profit of 34 cents/share. CEO Marc Benioff stated that the company expects to reach a $3 billion revenue run rate in 2013, becoming the first enterprise cloud computing company to do so. The company beat on EPS by 3 cents, and beat on revenue by $13 million, yet the stock was slammed, falling by over 10% on the back of deferred revenues that declined 2% from the prior quarter.
Lowered deferred revenues seem to stand in contrast with the record deals the company signed this quarter. On the conference call, CEO Marc Benioff noted that "for the Sales Cloud, we signed Maersk (AMKAF.PK), one of the world's largest shipping companies in the world based in Europe. And they swapped out Oracle and selected Salesforce to their entire global sales team. We also won deals against Oracle (ORCL) with Bayer (BAYZF.PK), Eli Lilly (LLY), Telstra (TLSYY.PK), Fuji Xerox (XRX), Japan Post, Unisys (UIS), PTC Parametric (PMTC) and Diebold Securities (DBD), all strong wins against Oracle. But in Q3, we also won against Microsoft (MSFT), closing major deals with Pfizer (PFE), AXA (AXAHF.PK), CenturyLink (CTL), American Teleconferencing Services, Gates Corp., Banca Civica, Orion, Vbimps [ph] M&G and Tripwire. Other newer add-on transactions for the Sales Cloud from the third quarter included Adobe, Avaya, Sompo and Kaspersky Labs." Growth was strong across all geographic regions. Revenues in the U.S. grew by 36%, 36% in Europe, and 39% in Asia. Japan also showed a strong recovery. So where did the weakness in the stock come from?
Simply put, the numbers did not appear to impress enough investors. New subscription billings growth increased only 12% over the prior year, and the company's deferred revenues appeared to be soft. This was brought up many times on the conference call, especially by John DiFucci of JPMorgan. He brought up a number of valid points, noting that even though off balance sheet revenue grew faster than deferred revenue, accounts receivable actually declined, which are a good indicator of deals signed at the end of the quarter. Furthermore, he pointedly asked whether or not these weak numbers indicated a problem with end-market demand, which Salesforce has long been immune from. Do these numbers mean the economy is finally starting to affect the company?
We do not think so. Salesforce.com's end businesses are as strong as ever, and the shortfall in deferred revenues can be explained. CFO Graham Smith explained that the company does not recognize revenue upfront from Heroku and Radian6, since they bill on a monthly basis. The company decreases days sales outstanding from 55 days to 49 and worked to deliver strong operating cash flow. CEO Marc Benioff also chimed in, stating that "we don't traditionally manage metrics associated with deferred revenue like invoice timing or invoice duration. Those are not things that we are in there trying to dial up with customers ... we broke through more than 100,000 core customers in the last quarter, what we really saw was we continue to see very, very strong revenue growth, and we are doing a good job of predicting how our business is performing, and we're going to be able to continue to do that. But we have to be a little bit cautious regards to -- this concept of quarter end deferred is still absolutely -- it's a function of invoicing, and it's also influenced by other factors that Graham has mentioned, including things like invoice timing, invoice duration, new business linearity within the quarter, annual seasonality, these acquisitions, compounding effects of renewals. And those are things that we as a -- certainly, I could speak in terms of the sales organization. We're focused on beating the competition and signing deals. And in terms of those specific metrics, that's not where our eyes are. And so you can see variations in deferred revenue over time, which is why at Dreamforce, Graham called that out in the Analyst Day, and he basically said to be aware of those types of fluctuations in the future." To us, the deferred revenue trends seen here are quarterly fluctuations that do not reflect the underlying fundamentals of the business. It is interesting to not that in his post-earnings review of the company, John DiFucci placed a $115 price target on the company, which is actually above the current market price. If the bearish DiFucci values Salesforce higher than the market, where do bullish analysts see the stock going?
The analyst bulls on Salesforce did not change their views on the company after the earnings release and conference call. Jefferies placed a $156 target on the stock and kept its buy rating, noting that "CRM disappointed by missing F3Q12 Street billings expectations for the first time in 10 quarters. Management said that they exceeded their own new business expectations in the Q and implied F4Q12 billings would re-accelerate. Also, FY13 rev growth was above prior Street ests (adj. for assumed Model Metrics contribution)" Management said that growth would re-accelerrate in the fourth quarter back to a range of 32-33%. Goldman Sachs also remained bullish, keeping a buy rating at $150 price target on the stock. In its report, the firm noted that cash flow of $129 million easily beat the consensus estimate of $109 million. Putting a damper on things, S&P and Credit Suisse both lowered the price targets from $145 an $140 respectively, to $135. S&P is concerned that revenue growth is slowing, and Credit Suisse is concerned about the impact of continued investment on margins, but the firm is impressed with the continued traction of the company's products as well as its cash flows. However, Deutsche Bank counters with a bullish stance. The firm is very impressed, saying that "In our opinion, despite the optics of billings, business momentum continued and actual bookings grew faster than revenue's 36%. As a result, we are reiterating our Buy rating and raising PT for $205.” The firm agrees with management that the lapse in deferred revenue does not reflect fundamental weakness at the company and is confident in Salesforce's future prospects. Overall, analysts are bullish, and their blended price targets leave a fair amount of upside to the stock. Of these 5 firms, the average price target is $156.02, representing upside of over 37%. The Reuters average price target is just below that, at $154.06. But is the analyst community correct here? And perhaps more importantly, can Salesforce overcome the accounting issues we highlighted in our previous article?
We are changing our view on Salesforce after this quarter, but only to a limited extent. Previously, we recommended all investors stay away from the stock. Now, we are slightly more comfortable, and are willing to recommend it to investors with a high tolerance for risk. The stock has come down by a fair amount, and the balance sheet is improving. We do not wish to have this article turn into a Netflix-style debate over accounting issues, and as such we recommend this stock ONLY to investors comfortable with the company's continued use of creative accounting practices. Investors who wish to short the stock due to accounting and overvaluation are welcome to continue doing so. But for investors looking to get long the stock, now is a good time to do so, but ONLY if they are fully aware of the company's accounting practices and valuation. A quick recap of these practices is as follows.
- Stock based compensation: Salesforce hands out stock to its employees in huge quantities, and as of now, these expenses overwhelm any non-GAAP earnings the company posts. They will most likely continue for the foreseeable future.
- Goodwill: A large majority of the company's balance sheet is supported by goodwill, which increased this quarter from $671.57 million to $732.06 million, due to the company's continued acquisition spree.
- Depreciating sales commissions over time: Unlike many companies, Salesforce does not expense the commissions to its salespeople upfront. Rather, it books them as an asset and depreciates them over time to coincide with the revenues brought in over time from its software contracts. This has been approved by the SEC, but may still unnerve some investors
- Valuation: The company's valuation is stratospheric, and many investors will be put off by it, including us. We recommend this stock only to those investors who are not deterred by such a valuation. It is perfectly understandable if many investors cannot stomach the company's valuation.
The company increased cash on hand from $449.794 million to $502.987 million, and marketable securities rose from $127.582 million to $142.861 million. Days sales outstanding declined to 49 days, and operating cash flow improved.
These metrics make Salesforce.com seem more compelling to some investors, while others are just as skeptical of the company as ever. And that is perfectly understandable. Not every stock can be free of controversy. Salesforce.com certainly isn't, and that makes it all the more compelling to examine.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.