Certain stocks tend to elicit more emotion from investors (and Seeking Alpha readers) than others. Stocks like Apple (AAPL), Amazon (AMZN) Netflix (NFLX), and Sirius XM (SIRI) tend to be defended or attacked not only on their business merits, but on the premises that they HAVE TO fail or succeed. Amazon trades at a high P/E, therefore the business must fail. Sirius XM is misunderstood by the market. Netflix will be bankrupt. And Apple will fall without Steve Jobs. These are just some of the emotionally charged statements we have seen on Seeking Alpha. And Salesforce.com (CRM), the subject of this article, has seen its fair share of charged statements. And the company released its fourth quarter and fiscal 2012 earnings after the markets closed on February 23. Below we provide a summary of Salesforce's financial results, as taken from the company's financial statements and press release. For the record, we hold a position in Salesforce through a mutual fund that assigns it a weighting of 2.69%. We have no direct position in the company and no plans to initiate one.
|Q4 2012||Q4 2011||Fiscal 2012||Fiscal 2011|
|Revenue||$631.913 Million||$456.857 Million||$2.266539 Billion||$1.657139 Billion|
|Operating Cash Flow||$240.347 Million||$165.762 Million||$591.507 Million||$459.081 Million|
Before we address the obvious issue in these results, the glaring discrepancy between GAAP and non-GAAP earnings, we must address several other operational metrics, as well as guidance, for that is what will be driving the stock in post-earnings trades.
As we write this article, Salesforce is up almost 10% in after hours trading. And while it is not certain where the stock will close on Friday, it is clear that the market, at least for now, liked what Salesforce delivered. Non-GAAP EPS of 43 cents beat the consensus estimate of 40 cents. Revenues beat as well, with Salesforce posting revenues of $6310.913 million, ahead of consensus estimates of $624 million. Furthermore, the company posted accelerated billings growth, a key metric. Billings are the amount the company invoices to its customers, and serve as a gauge of future sales. For the fourth quarter, Salesforce reported billings growth of 57%, an increase from the 29% growth rate in the fourth quarter.
Salesforce also provided guidance for the 2013 fiscal year, as well as the first quarter. Here, the company fell short.
While revenue guidance of $673 to $678 million was ahead of expectations for $663 million, the company's EPS guidance of 33 to 34 cents a share for the first quarter was below expectations of 40 cents a share. Investors may assume that for a company as richly valued as Salesforce is, any weakness in guidance would serve as a catalyst for a steep sell-off, But that is not the case. With such companies, earnings are often not the most important result that investors focus on, and that phenomenon is at play here. On the conference call, Salesforce stated that during the quarter, it won 100 7-figure deals, and 9 8-figure deals in the quarter. The 100 7-figure deals represented growth of 300% over a year ago. These two figures lend support to Salesforce's efforts to deploy its products on an enterprise-wide level, something that the company has long considered central to its future success. As such, it appears investors are willing to overlook soft guidance.
Now that we have addressed why Salesforce is rallying despite soft guidance, we can look deeper into what the guidance consists of. As always, stock-based expense is the biggest factor at play here. Technology companies as a whole tend to be much more liberal with stock-based compensation than non-tech companies. Salesforce, however, takes the practice to a whole new level. For fiscal 2013, the company expects to earn $1.58 to $1.62 per share. But it expects to pay out $2.47 per share in stock. That expense overwhelms any GAAP earnings the company has, and it forms a core thesis of the short argument for Salesforce. So how can a company post such sustained GAAP losses quarter after quarter and still trade at over $130 per share? That is something we explore below.
The Folly of Being Right
Salesforce shorts are entirely correct in their assumption that Salesforce should trade lower than where it is. Even when using non-GAAP EPS, the company trades at a P/E ratio of over 82 times 2013 earnings. When GAAP earnings are used, there isn't even a P/E ratio to calculate, since there is no E. Shorts seize on this point, arguing that the stock MUST fall, because it is simply too expensive to be at this level. The shorts are correct that in a rational market, Salesforce should not trade this high. But that is where the shorts make their mistake. They assume that the markets are rational, when in fact, they are anything but. Irrational markets have made investors untold billions in profits, just as they have caused untold billions in losses to others. Irrationality is how Netflix can trade at $300 in July and fall to $70 and below a few months later. (Netflix is being used here as an example, and this is not intended to be a front in the debate about Netflix). It is not enough for the shorts to be right. Part of what makes critics of Salesofrce so passionate is their deeply held belief that because they are right, Salesforce MUST fall, all while ignoring several other crucial factors, which we will be addressing shortly.
It is not enough to be right in your convictions. To profit from them, others must be convinced. And that is where the issue with shorting Salesforce arises. For all the volatility in the stock (it currently has a beta of 1.41), Salesforce shares have gone almost nowhere in the past year.
With Salesforce forecasting a huge rise in GAAP loses, from a 9 cent loss in fiscal 2012 to a 53 cent loss in fiscal 2013 (using the midpoint of guidance), shouldn't the stock be in freefall? Rational logic suggests that it should. And yet, rational logic also says that for the foreseeable future, such a frefall will not occur. The reason why is deceptively simple. Salesforce will not crash from where it presently trades because the market and the media do not care about what the shorts and critics are saying.
In researching this article, we did not come across a single news story or analyst quote that made any deep analysis of the company's GAAP losses, or its valuation. Bloomberg's story on Salesforce's earnings made mention of its net loss of 3 cents per share, but spoke of "higher marketing and research spending" as being the culprit. No mention of the company's creative accounting or enormous stock-based compensation expense was made. Nor was its valuation called into question. The very fact that analyst estimates for this quarter used non-GAAP figures highlights the fallacy of arguing to short Salesforce at this point in time. No one seems to care about using GAAP earnings figures when it comes to valuing Salesforce. Nor does anyone seem to care that its P/E ratio, as per Google Finance, currently sits at over 6,300. The fact that the market is choosing to ignore the GAAP losses at Salesforce is but one of the problems with shorting this stock.
Insider Sales: An Inevitability
Most, if not all of the bearish articles discussing Salesforce on Seeking Alpha have touched on the massive insider sales that occur at this company on a regular basis. Executives sell stock and cash in options like clockwork.
Many investors have an aversion to seeing insider sales, haunted by the memories of Enron executives cashing out by the millions as the company was on its march to bankruptcy. Investors and short sellers equate insider sales with there being something amiss at the company. Yet this is not necessarily true. Netlfix provides for a great case study. For years, company executives from Reed Hastings on down sold stock like clockwork. They sold no matter what the stock did. If it was going up, they sold. If it was going down, they sold. Critics of the company seized on this, arguing that something was amiss. Then came the price increase in the summer of 2011. It is important to note that Netflix shares initially rallied sharply on news of the price hike. The price hike, on its own, did not upend Netflix. The subsequent PR blunders and terrible communications the company had with its customers are what was most responsible. Netflix began their freefall when the company issued downbeat guidance, realizing too late that the price hike, and later Qwikster, was a PR disaster that was costing it customers. Bears seize on this point, arguing that greedy management cashed out ahead of ordinary shareholders. But how could Netflix management have known their moves would be received this way? However poorly Netflix executed in 2011, it is doubtful that the company's executives knew that things would play out the way they did. We may be long shares of Netflix, but we do not bring up Netflix here to defend what happened in 2011. Nor are we recommending shares of Netflix one way or another. Rather, we highlight Netflix to show that insider sales are not always indicative of a ticking time bomb in a company.
Frankly speaking, it is much more worrisome to see a company with no history of large insider sells begin to report large sales of stock by company executives. That is much more indicative of trouble than consistent insider sells. Furthermore, if one is to believe that insider sales at Salesforce are due to a lack of faith in the company or "skeletons in the closet," then this most recent earnings report disproves that. If company executives knew throughout the fourth quarter that it was going to be a great one, wouldn't they have waited until the earnings were released, the trading halts lifted, and then cash out at a much higher price? A rational person would wait to cash out at the highest possible share price. However, the Salesforce culture proves that constant insider sales are INEVITABLE.
Salesforce issues stock like candy. Stock-based expense is a huge component of Salesforce's expenses, and it is what overwhelms the company's non-GAAP income. Critics of the company equate the constant insider sales as management having a lack of faith in the company, or with there being something wrong. But, it is crucial to remember that the executives of this company are human. They respond to incentives. And when you know that you will be issued more stock next month, next quarter, and next year, why would you ever bother holding your stock options until the very last minute? Salesfoce.com executives are not selling stock on such a consistent basis because they do not believe in the company. They are selling because they are human. Ask yourself this. If you were given stock options in Salesforce, and knew that you would be given more stock options regularly for the entire duration of your employment, would you choose to hold on to them, or cash them in as fast as possible? The desire to receive money as fast as possible is very powerful. The insider selling at Salesforce is not due to a lack of belief in the company. It is due to a flaw in the company's culture. Apple, for example, treats every stock option like it is sacred, and executives are barred from cashing in for years. Tim Cook, for example, must wait 10 years before he can realize the full value of the shares granted to him upon becoming CEO. Furthermore, insider sales are usually seen as a sign that management is not confident in the ability to create long-term value for shareholders. Insider sales have been going on at Salesforce for years, yet no one can argue that the company has not created shareholder value since its IPO in 2004. Interestingly enough, founder Marc Benioff has not sold stock since the end of 2010. If insider sales are due to some sort of skeleton in the Salesforce, the founder does not see it.
Since its IPO, Salesforce has dramatically outperformed the S&P 500, rising over 730%, as the S&P 500 rose just over 20%. This occurred even as insiders sold millions in stock. It is important to remember that at this company, insider sales are an inevitable result of the corporate culture. That is a flaw that the market has chosen to ignore, and just like with the company's consistent GAAP losses, it is something that must be recognized by a much wider audience before Salesforce can fall.
Pump and Dump: A Look at Who Owns the Company
Another charge that we have seen surrounding Salesforce is the accusation that this stock is part of a wide-ranging pump and dump scheme where analysts and hedge funds tout the stock, all while they dump their shares on unsuspecting retail investors. Yet, a look at the shareholder base of the company reveals that such a scheme is unlikely.
Fidelity is the single largest investor in Salesforce, owning over 20 million shares, or almost 15% of the company. Founder Marc Benioff owns 10 million shares, and unlike his subordinates, he has not sold stock since the end of 2010. Those 10 million shares are equal to a stake of around 7.35%. Other large shareholders include Vanguard, with a 3.81% stake, Sands Capital Management with a 6.84% stake, and Jennison Associates, with a stake of 6.08%. Both Sands and Jennison manage institutional investments for mutual funds, corporations, public funds, and endowments. They are not hedge funds who trade in and out of the stock. Together, these firms, along with founder Marc Benioff control nearly 40% of Salesforce stock. Furthermore, the rest of the other major investors in Salesforce are almost all mutual fund companies such as T.Rowe Price or BlackRock. The only investment bank on the list is Morgan Stanley, which holds a 2.8% stake in Salesforce. Frankly, we think it is a stretch to assume that these mutual fund and asset management investors are engaged in a pump and dump scheme. They are long-term holders, and unlikely to be constantly trading in and out of the stock at the expense of ordinary investors.
Whatever accounting and valuation issues may be present at Salesforce, it is difficult to deny that the company is executing well at the operational level. Billings are growing, and revenue is as well. The cloud computing landscape may be competitive, but at least for now, Salesforce is holding its own against a variety of competitors in the market it helped create.
If you are a bullish on Salesforce, this earnings report confirmed the bullish story. Billings were strong, revenue guidance was good, and the company's goal of having its products adopted and used at an enterprise-wide level is gaining traction. And if you are bearish, this earnings report has done nothing to alleviate the concerns outlined above. Salesforce is still posting GAAP losses. Insiders are still selling stock. The valuation is astronomical (or non-existent for 2013 on a GAAP basis) and the company's accounting practices are still very aggressive. However, all of these factors must be reconciled with one crucial element, and that is the point of this article. Very few people in the broad investing world care about the issues brought up time and time again on Seeking Alpha. The valuation is ignored. GAAP earnings are ignored. Insider selling is ignored. And the massive stock-based compensation is ignored. Simply put, we think it is unwise to tie up capital in shorting Salesforce until these issues are addressed in a much wider setting and gain broader acceptance. There are many more compelling investments out there, from both a short and long perspective than being short Salesforce. This article is not meant to argue for a long position in the stock. Rather, it is meant to serve as a cautionary tale to those who insist that Salesforce must fall, simply because they are correct in their assessment that the stock is overvalued. It does not matter if these critics of the company are correct. The market has shown time and time again that when it comes to Salesforce, it simply does not care about these issues. Markets can remain irrational longer than you can stay solvent. Will Salesforce stock succumb to these factors someday? It is difficult to predict that here. We believe that rather than hoping the market will recognize the issues surrounding this company, it is simply better to move on to other trades and investments. Salesforce.com has changed the world of technology in many dramatic and permanent ways, and it has made itself indispensable to many companies by involving itself in their daily operations However, we think that at this time, this stock is one that investors need not involve themselves in.