Back in October I posted a piece on Seeking Alpha looking at three potential short candidates, one of which was Salesforce.com (CRM). And, indeed a brutal three-day stretch to close last week -- in which the stock fell 17% from Tuesday's close to finish Friday at $113.43 -- has seemed to vindicate some of my skepticism on the stock.
The catalyst, of course, was the company's third quarter earnings release on Thursday afternoon. Ironically, CRM beat estimates on the headline numbers: sales of $584 million and adjusted profit of 34 cents per share were both ahead of Wall Street consensus. But the big number analysts noted was the company's billings, which rose only 29 percent in the quarter year-over-year, below the 33 to 35 percent expected by many analysts.
Because the company sells subscriptions to its software over extended periods (normally 12 to 24 months), the company cannot book the entire value of a contract immediately; it must spread the revenue derived over the length of the service provided. Therefore, deferred revenue in particular is seen as a forward indicator of sales, since the entire balance (some $918 million as of October 31) will be booked as sales over the next few quarters. The Street quite clearly is concerned that the astronomical valuation placed on the stock relative to earnings and cash flow may be jeopardized by any slowdown in growth.
What I found more troubling than the slowdown in billings was the company's reaction to this miss. On a variety of levels, management seemed intent on downplaying the slowdown, using some questionable tactics along the way.
CFO Graham Smith went first, during the company's presentation for the third quarter conference call, clearly aware that analysts would be disappointed in the deferred revenue figures:
I'd like to remind people the quarter end deferred revenue was a function of invoicing and is influenced by several factors, including invoice timing, invoice duration, new business linearity within the quarter, annual seasonality and the compounding effects of renewals. And as we discussed at the Dreamforce analyst session, some of our recent acquisitions such as Heroku and Radian6 bill monthly and don't contribute significantly to the deferred revenue balance at all.
Smith's response sounds like a bit of a smokescreen: long-winded and unclear. But investors should be even more skeptical about the CFO's explanation. Why? From the Salesforce.com release announcing the Heroku acquisition:
The company currently expects no material revenue contribution from the acquisition during its fiscal 2012.
And from the press release announcing the purchase of Radian6:
FY12: The acquisition is expected to increase revenues by approximately $45 to $50 million
How then, does the billing cycle at Heroku and Radian6 affect deferred revenue growth on a relative basis, if the additional growth from the acquisitions represents no more than 3% of the company's total sales? At most, Heroku and Radian6 can cause less than a point decrease in billings growth, year-over-year. They hardly explain the notable slowdown (which was seen last quarter, as well) that so concerns Wall Street.
CEO Benioff then took up the argument on the Q&A portion, responding to a follow-up question about the billings miss:
The best performance indicator of the performance of the company, of course, is the revenue and the best indicator of the future performance of the company is the guidance that we're giving on the call today.
Benioff, like Smith, failed to satisfactorily -- or directly -- answer an analyst question about the decrease in billings growth. Even worse, note the arrogance of the CEO's response: investors should trust in the future growth at salesforce.com. Why? Because they tell us so. Don't worry yourself with your silly little models or your questions about backlog or billing. Just have faith.
The question remains, however: how much faith should we have in the guidance? CFO Smith should have inadvertently given investors pause with his answer to the following, unrelated question:
And clearly at this point in the year, as you know from previous years, we don't give any other guidance than just the first blush revenue. We haven't finished our operating model for next year. We haven't finished a lot of the detailed plans and therefore clearly, haven't finished our cash flow guidance either. So I'm afraid I'm just going to pass on that for the moment.
How is the company so certain in its revenue projections for the next fifteen months? Well, it just is. Granted, it's not exactly sure what SG&A will be budgeted at, how big its sales force will be or of the size of its marketing spend. But, as Benioff repeatedly pointed out, in the earnings release, the conference call, and a post-earnings Q&A with CNBC's Jim Cramer, the company will reach a "$3 billion annual revenue run rate" in fiscal year 2013. Benioff seems awfully confident in his prediction, despite the fact that the company has not yet completed its own internal models. Granted, the company's subscription model gives it far more confidence in forward revenue projections than most other companies. But the deferred revenue figure of $918 million still represents less than one-third of guided FY2013 sales, meaning some $2 billion of new revenue must be generated. The question about billings is a critical one; investors paying nearly 7 times forward sales for a stock have reason to be concerned about revenue growth. Time and time again, high-flying stocks have been cut down by what at first seem to be relatively small misses on sales and earnings numbers. CRM's insistence that its own projections are the "best indicator" seems dismissive of those valid concerns.
Benioff's repeated reliance on that awkward turn of phrase -- "a $3 billion annual revenue run rate" -- shouldn't sit well, either. A $3 billion run rate simply means that the company projects that fourth quarter sales in fiscal 2013 will be at least $750 million. As it is, the midpoint of the company's guidance is for $2.9 billion in sales in fiscal 2013, which is impressive enough in its own right. Why the need for the round number? It seems somehow undignified. It smacks of a CEO who is as concerned -- or more concerned -- with the numbers than with the company. The difference between $2.9 billion and Benioff's touted $3 billion figure is 3.6%. That's it. There seems no need to focus so intently -- and repeatedly -- on the round number.
Benioff, of course, has been criticized in the past for his focus on numbers. Of late, CRM bears have been pointing out the company's earnings -- or more accurately, the company's former earnings. CRM managed a breakeven performance for fiscal year 2008, then posted GAAP earnings for each of the next four years. However, FY2012 will result in a GAAP loss of 11 to 12 cents per share, as the company has ramped up hiring (head count was up 46% year-over-year in the recent quarter) and investment to gain market share and expand its business.
The company, however, seems loath to discuss this. In the earnings release and conference call, it prefers a non-GAAP measure, which excludes stock-based compensation, amortization, and other charges. (Senior VP of Investor Relations noted upfront in the conference call that "our commentary will be primarily in non-GAAP terms.") By this accounting, the company will actually earn $1.32 per share in the current fiscal year. But this method of accounting, for fiscal year 2012, will simply ignore over $200 million in stock-based compensation, for which CRM investors will pay, through share dilution. (The chart here shows the steady rise in shares outstanding; a $575 million convertible debt offering means another 6.7 million shares can potentially be added, given that the stock trades well above the conversion price of $85.36.) It is one thing for a company to ignore one-time charges for acquisitions or non-cash goodwill impairment; yet the company's repeated dismissal of substantial, material and dilutive employee compensation programs as they relate to earnings is troubling. The company's disinterest in the GAAP figures is shown by the fact that at no point in the earnings release or the conference call did any company representative (or analyst, for that matter) broach the fact that a formerly profitable company was now losing money, at least according to traditional accounting standards.
In Benioff's defense, he is likely not hiding the loss -- he simply doesn't care, at least not right now. From his interview with Jim Cramer:
Well, what we're doing, Jim, is trying to build one of the great new technology companies...Instead of buying the complex hardware and software from companies like Microsoft (MSFT), Oracle (ORCL), and SAP (SAP), you're seeing [our customers] acquire our technology at record rates to deploy a whole new infrastructure based on the cloud. So this is a time for us where we're trying to aggregate market share, we're trying to aggregate revenue, and we're totally focused on top-line growth. If we were a company only focused on earnings, we would not be growing our market share and revenue, which would be the wrong thing to be doing at this time in our life cycle.
This attitude meshes with his answers on the conference call. Note in his earlier answer that Benioff said the "best indicator" of the company's performance was "the revenue." Not the earnings -- the sales. And, in fairness, Benioff's strategy may be wise. Fellow high-flyer Amazon.com (AMZN) is following a similar strategy, investing now at a cost of present earnings with the hopes of boosting market share and cash flow down the line. CRM is spending money to build as much market share as it can before offerings from larger, more well-financed competitors -- including Oracle (ORCL), SAP, and Microsoft (MSFT) -- are able to challenge their dominance.
And indeed, even Benioff's critics often point out that he is a solid salesman and an excellent spokesman for CRM stock. While reading the Q&A, Benioff's enthusiasm comes through, as he talks about reaching $10 billion in revenue (an impressive goal, though there's another of those "round numbers"), or jabs at Oracle and SAP, dismissing their offerings as inferior. The man clearly believes in Salesforce.com, and its stock.
The question, however, is how good a manager is he? Let me be clear that I do not think for a second that anything criminal -- or even unethical -- is going on at Salesforce.com. It's not Enron; nor, for that matter, do I believe CRM will go the way of Netflix (NFLX), where its very business model will be called into question. But Benioff's cheerleading tone, the company's reliance on non-GAAP figures, the evasive answers on deferred revenue: these should be red flags for investors.
The irony is that the CRM story is strong enough to stand on its own. While I share the value investor's natural bias against high-multiple growth stocks, Salesforce.com remains an interesting and potentially profitable investment. The company is generating cash and showing impressive top-line growth. If Benioff's strategy of swapping margins for market share in the short term is correct, the company can see significant earnings leverage down the line.
Of course, the question is: what kind of earnings? No matter how strong the story, the company's seeming emphasis on embellishment -- non-GAAP earnings, revenue "run rates," PR battles with Oracle -- should concern investors. A good CEO can be good for a stock; but it is absolutely essential for a company. Is Benioff that CEO? Will his focus on long-term investments pay off?
In the meantime, CRM stock looks to be approaching a key inflection point (click to enlarge):
chart courtesy finviz.com
The stock is on the tail end of a classic bearish head-and-shoulders pattern, and at the same time heading toward a repeated level of support around $110 per share. One can easily see a small bounce during light trading this week, but there seems little doubt that $110 will remain a key level. Should the stock break that level, the short-sale bandwagon will fill up quickly.
Wall Street -- and the business world -- seem to always find a way to punish hubris. Yes, Marc Benioff has done a great job for his shareholders -- so far. Yet his focus on round numbers, his insistence on taking jabs at the competition, and his endlessly positive cheerleading for CRM stock should make investors wary. It's not that the business model is a failure, or the company's current numbers a sham. But growing companies hit bumps in the road, and need a good driver. Benioff's relentless optimism should cause investors to wonder whether he is the right man for the job.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
