What more can one possibly write about CRM that hasn't already been written?
This article isn't going to be a forecast of how well Salesforce.com (NYSE:CRM) is doing or about all of the company's opportunities - well I confess, I did sneak a bit of speculation in about that. But CRM is a very well covered name with 40 analysts projecting revenues and earnings. And for what it is worth, most recently, several analysts have said positive things about the company's prospects both for this quarter that will end in a bit more than two weeks and for the intermediate term. There really is very little that I might add to that discussion.
There is a certain genre of typically "B" movies that are typically set in a high school in which the class bully picks on some nerdy guy and accuses him of being strange and nerdy. Most often, because that is the way of American films, somehow the nerdy guy finds friends and together they go and finish off the bully. Usually the nerdy guy winds up with the beautiful women... But not always.
I sometimes think that in reading some recent articles on SA with regards to CRM's accounting strategy as though I were witnessing that kind of phenomenon, although needless to say, CRM is not one of those weak, nerdy looking characters that was always getting picked on.
Let me specify from the start that I along with everyone else who owns or is thinking about owning CRM shares knows that the company derives a substantial component of its earnings from stock-based comp. It isn't all that hard to find the exact statistics and in case any of you might be wondering, stock-based comp for this company was $593 million gross or $534 million net of the excess tax benefit.
Now quite surprisingly compared to the thesis advanced by several SA contributors recently, net stock based comp declined last year by 4% or $23 million when compared to the net amount reported for the prior fiscal year. Looked at another way, stock-based comp was 8.1% of revenues in the past fiscal year, down from 10.3% in the year before. So, whatever else is true, in looking at stock-based comp on a comparative basis, it is declining and not increasing, not the hallmark of a company with a strategy of using creative accounting.
For the record, I think, and always have thought that stock-based comp is an expense and it can and often does dilute shareholders' equity. I suppose I could write about some of the issues with regards to the FASB rule covering stock-based comp. There are different academic points of view as to whether or not using a method, that method in which volatility enhances the value of an option grant is really measuring the right thing. There is much to read on the subject and I will not bore readers with any of it. I will accept that FASB 123 is the bible on the subject and it shouldn't be challenged.
But I would think that no one, really, and likely not even the FASB itself would think for a moment that their regulations cover all situations or are holy writ without reasonable expectations of change and modification or the right of challenge. Fact is, I think the job of developing a prudent investing strategy that can maximize alpha is to find areas in which conventional accounting rules simply do not reflect the economic situation of the company being analyzed. It is easy, for the most part, to point out the obvious. It is a bit harder to look at the obvious and the surface and then to try to penetrate below that which appears on the surface.
Software companies, like almost every other classification of enterprise, are constantly changing and evolving. As more and more software companies sell their products on a subscription basis, ultimately, I expect there will be calls for the FASB to develop new regulations that better portray the economic realities of such transactions. That is really the purpose of the FASB.
I will try to show in the balance of this article that far from Salesforce.com stretching the envelope or using creative accounting to present a distorted and positive view of its operations to investors and other stakeholders, the exact opposite is true. The company is creating a massive store of value that is not recognized in any traditional fashion. At some point, one assumes, the FASB will promulgate certain regulations that do a better job in trying to evaluate the economic impact of subscription bookings and revenues. There are actually proposals that will change how subscription revenues that arise over multi-year periods might be treated in the future. But for now, I will simply write about what is rather than what is likely to be.
I am not a shill for CRM or its share price. Like it says in the disclosure, I have no current position in the name and no plans to start a position in the next 72 hours. And regardless of anything else, CRM is covered by 40 analysts. There is nothing that my poor tongue might articulate that is going to change the price of CRM shares in one direction or the other noticeably. And having watched companies in the enterprise software space for more years than I am willing to recollect, I can guarantee all readers that at some point in the future CRM will run into some problems.
Enterprise software is the quintessential black swan space so I don't know what the company's problems might come to be. But the company's bookings growth will miss expectations, someday. And the company's margin expansion will stall someday. But that someday is far from now and will not be related to creative accounting. There are more than enough ways for software companies to mess up without having to raise old chestnuts regarding aggressive accounting.
CRM does a relatively complete job in discussing the potential costs of the stock-based compensation that it grants. I'm really not too sure as to how it might do a better job than it does. For those so inclined, you can go to page 10 of the company's last financial presentation and see all that you might desire to see regarding stock-based comp and its excess tax benefits.
I'm really not so sure that GAAP results need to be "dug out" as SA contributor Vincent Groenewoud suggests in his recent article. I generally have the conception that "digging out" implies that the required metric is not easily visible. But my goodness, on the very first page of the earnings release, it says that Q4 GAAP loss per share was ($0.04) per share and for those who have tender vision, the GAAP caption leads the non-GAAP earnings caption just the way the FASB likes it. I suppose I might stop there and then this would be the shortest article I have ever written and spare a few tender eyeballs.
But the fact is CRM actually tries reasonably hard to present a realistic, as opposed to contrived, picture of its operations. Management was more than a bit giddy during its conference call discussing the results of its fiscal Q4 that ended 1/31/16. Is it possible that the presenters were all a bunch of thespians trying out for roles in some TV business corruption drama? Or might it be that management thought they had just achieved one of the best quarters at scale ever seen in the IT space?
Needless to say, I think it was the latter. Why? Pretty simple actually. CRM CEO Mark Benioff who is pictured as some facsimile of the devil minus his horn and tail in the recent article I cited has a long history in sales. Keith Block, who is the President and Chief Operating Officer of Salesforce is a rather well known sales executive with a lengthy background at Oracle (NYSE:ORCL). For better or worse, these men live, eat, breathe and talk about selling large deals at CRM.
I would think that their interests and those of the shareholders are very closely aligned. And interestingly, when someone else says that they aren't and that Mr. Benioff is earning too much from CRM at the expense of stakeholders, the company acts quite rapidly to assuage such criticism. Jason Aycock, SA News Editor, ran a piece on Mr. Benioff's compensation the other day in which he noted that the proxy statement recently issued by CRM disclosed that Mr. Benioff's pay declined last year and that for the current year, CRM's compensation committee decided to lock in Benioff's salary at $1.55 million and his cash bonus at $3.1 million.
Now as it happens, Mr. Benioff was said by Forbes to be worth $3.9 billion. Does someone actually think that a man worth $3.9 billion is fixated on his compensation, regardless of whether it is $39 million or $33 million or some other number? I'm going to address Mr. Benioff's sales of CRM shares below, but I will simply say that so far as I might be concerned, if Mr. Benioff was able to achieve the results that the company posted last year for $39 million, I would prefer to see him earn $78 million just to see what that might accomplish for a higher payout.
I realize that many readers will not agree, but at this point, Mr. Benioff is just not doing it for the money. He doesn't need all the money he has and he is in the process of giving what he does have to various charities. Not really the hallmark, I should think, of someone who might countenance using creative accounting to mask the actual stake of the business that he has created, but in the words of that quintessential New Yorker who has made a gift of his persona to the nation through his candidacy for our nation's highest office, "whatever."
When it all comes together as it did last quarter, the people who run CRM do not try to hide their light under a bushel basket. They shout their success from the rooftops. And yes, when they read their press release, they actually manage to tell any listeners who care that they had a GAAP loss and when one pursues the detailed financial reconciliation it starts with GAAP earnings.
Let's make a huge assumption and believe that neither Mr. Benioff or Mr. Block or CFO Mark Hawkins are neither fools or knaves. In point of fact, these are brilliant men, the best of the best so to speak. Mr. Benioff invented the concept of Software as a Service, more or less, and has built a company and has made himself terribly rich in the process. Mr. Block was the heart and soul of Oracle's North American Sales organization for many, many years when it really could and often did achieve stunning sales performance. And Mr. Hawkins, well he has been a leader in various financial organizations in the IT world for such companies as Autodesk, Logitech, Dell and HP.
Is it actually conceivable that these men know what they are doing and believe that GAAP metrics present a seriously flawed picture as to CRM's financial performance? Mr. Groenewoud suggests in his article that the heavy institutional ownership - 88% - in the last reporting period is a potential risk. Might it instead be that institutional investors and management and for the very limited difference that it makes, this writer as well, actually do not believe that CRM has a problem with creative accounting? Instead, the problem, at least so far as I see it, is slavish devotion to a set of rules from the FASB that were drawn up long before the emergence of companies in the IT world that sell their services very differently than all that has come before?
What is a sale?
No, that isn't really a joke or a trick question. For those of you old enough to remember President Clinton's trouble defining the word "it," here comes another one of those problems. Most of the time, defining a sale is not a particularly difficult undertaking. Your company sells another company something of value and your company sends the customer company both a product and then an invoice. That creates both a sale and an account receivable. Later, if it all works out, your customer pays for the product or the service extinguishing the A/R, which then becomes converted to cash. For many years, that is the way the software industry was - or was it really?
I'm not talking about the parlor games that malignant managers in the IT space have played in order to game the system. IT has relatively high values that can be created by the most gossamer of "real" facts and hence the space has attracted fraudsters and charlatans for as long as it has been around. I once had a conversation about Larry Ellison and Oracle's ingenious ways of stretching the last month of a quarter to 35 days. My client told me at the time that was what he expected Oracle to do, what he was paying Oracle to do and not to bother him by suggesting Oracle used aggressive accounting.
Speaking now as a long-time analyst, it was always fascinating to see how men and women would check their commonsense at the door and come up with schemes to baffle the unwary - including this writer from time to time. From a sheer entertainment point of view, the scam cooked up by Powersoft and Sybase probably was the most fun to watch - although I don't imagine it really was that entertaining for many investors. More than a few companies used to engage in end of the quarter barter transactions.
Since these companies had agreed to merge, it really didn't matter just how much Sybase "sold" to Powersoft and all of a sudden, Sybase seemed to need loads of PowerBuilder licenses. In other cases, "sales" were made to companies who everyone knew could never pay. The "sale" was recorded in the quarter in which it was needed and then when the "customer" couldn't pay, it was written off as a bad debt. Informix made a regular practice of selling its software to Russian banks at the time of the 1998 financial crisis. Needless to say, that ended badly.
My favorite experience in watching a sale that wasn't had to do with Peregrine who would religiously send software to IBM (NYSE:IBM) at the end of the quarter, then take it back and send even more of it out again the following quarter. For that trick more than a few people went to jail but it was great fun watching from the sideline. To a certain extent, Sarbanes-Oxley has actually done what was intended and there are fewer outright frauds in the IT space these days, but one must be ceaselessly diligent.
And now we come to Salesforce. Salesforce reported revenues in Q4 of $1.81 billion and for the full year, its revenues were $6.67 billion. Is that really the economic worth of what Salesforce shipped? Of course not! Why, well Salesforce only gets to record the monthly invoices that it generates for its service even if the contract it signs with its customers is for multiple years. The reason CRM broadcasts its changes in deferred revenue and its changes in unbilled deferred revenue is not to confuse things but so that investors and anyone else who might be interested can observe what the company actually sold during a particular quarter.
CRM could report a quarter of excellent sales and poor bookings and that would be far more disturbing than if it reported a quarter with poor sales and excellent bookings. And almost everyone who follows the company or owns the shares knows that and believes that and it is the fatal flaw at the heart of Mr. Groenewoud's arguments. The performance metrics that CRM publicizes are not misleading but are the exact and the only exact way to understand the economic health of this company or any other company that uses a subscription model to sell.
Philanthropic donations are really not nefarious devices to enrich donors at the expense of shareholders.
Many contributors and investment advisory services have commented about insider sales at CRM. It's a popular topic for disclosure. Of course, the sales have happened, but in this case, the question is why? For the most part, Mr. Benioff's sales of CRM shares are to fund his donations to charities. Since 2010, he and his wife have contributed $250 million to local children's hospitals in the Bay Area.
He has also focused his contributions on other Bay Area charities including UC San Francisco, the Exploratorium museum of Science and Human Perception and the Campaign for Hope SF. For those readers who listen to Salesforce conference calls, almost unique amongst the companies that I follow, anyway, there is always commentary about the company's 1/1/1 plan. Recently Mr. Benioff and his wife pledged another $100 million to a new $1.5 billion children's hospital at UC San Francisco.
I really have no particular idea as to the man's personality. Maybe he is mean to his animals or neglects his kids - I don't think so, really, but maybe. But if someone wants to understand why the man sells Salesforce stock, the first place to look would be to consider how he is able to fund his rather significant charitable contributions. I will leave you with Mr. Benioff's commentary regarding philanthropy: "Those fortunate enough to become rich should give their money away now rather than to wait until they're finished making money to figure out what to do with it."
I'm sure that not all of the readers of this article will be persuaded that Mr. Benioff's sales of Salesforce stock are motivated by his adherence to such a goal, and I'm equally sure that the man is not wearing a hair shirt or living in a hovel or driving a nasty car. (Although maybe he is - in one article, I read he says that he eschews fancy hotels for Airbnb (Private:AIRB) accommodations to save money for shareholders.) But I confess that I do find it a bit off-putting to see a decent entrepreneur chastised for making contributions in accordance with his personal philosophy.
OK - enough of the moralizing, let's get back to the main point here and explore the intricacies of how Salesforce does their business and whether it presents some misshapen picture of its success?
Almost 40 years ago now, I worked for a company that sold computer terminals that would work with IBM systems to a large variety of blue-chip clients. We would sell hundreds of thousands of these terminals to substantial and less substantial users who mainly wanted to lease the terminals, associated printers and their controllers from us. Needless to say, the company I worked for was not a bank and lacked the financial resources to provide lease financing to all of our clients. And so, we would take the leases to different banks and see how much we could raise by assigning the future payments.
Of course, that was one of my jobs, which is why I know about what happened. There was, to be sure, an education process in terms of getting the financial institutions comfortable with the life of the product, but it really didn't matter all that much since the contracts we sold were ironclad. In the event, the credit losses were minimal and by the end of my time in Oklahoma, we had more offers from financial institutions to buy the leases than we had leases to sell.
Now why am I spending so much time and space writing about something that happened almost 40 years ago? Pretty simple. Our company took the transaction with the financial institution as a sale and got to report all of it in the period in which the terminal was shipped to the customer and in which he signed an acceptance certificate. There were times when users were unwilling to sign four-year leases - the standard term of the contract in those years - there were all kinds of reasons for that. Then I had to work harder and get the financial institution to advance us more money than the discounted present value of the actual lease. And when that happened, we couldn't take revenue, despite having received the cash, for anything beyond the guaranteed term of the lease.
Fast forward a few years and system integrators sprung up both in terms of funding federal sales and in terms of funding sales to commercial clients. It is still the case today, that most sales to US government agencies are done on paper from large SI's and leasing companies. The government contracts for several years of fixed payments, the SI essentially finances the lease and usually finds a third party to fund the entire transaction so the vendors in the consortium can get paid upfront. Needless to say, the vendors in the consortium take the payment from either the SI or the leasing company and record it as a sale. It is a sale, really.
Now let's take a look at what CRM - and for that matter every other subscription revenue company - actually does. Just to make this as simple as possible, I will take one of the nine-figure transactions that Salesforce booked last quarter. This particular transaction was a seven-year lease with guaranteed payments in excess of $400 million. It is with one of the most creditworthy institutions in this country, an absolute rock solid credit and a household name. How much revenue did Salesforce recognize for that transaction in the period it took place?
I really don't know precisely since I don't know the day on which the contract was executed, but Salesforce charges for its service agreements by the day and that is all the revenue it can recognize in a particular period. But given the nature of things in terms of determining the size and longevity of the arrangement, it probably took place within the last 10 days of the quarter. In that case, Salesforce probably got to recognize something less than $2 million of revenue in the period the customer signed the contract and accepted the product. Somehow I think most readers intuitively understand that when a company has to defer 98% of the revenue that it has sold on a specific agreement with the best credit in the nation, the accounting system that mandates this treatment is profoundly misrepresenting the profitability and the scale of CRM's business.
If CRM took the lease to a bank and sold it on a non-recourse basis, it could recognize all of the revenue upfront. That later transaction is self evidently less profitable to CRM than signing a lease and retaining all the benefits of ownership after the expiration of the initial term of the lease. CRM's lease retention rate since it has reported such things has been significantly above 90% and most of the churn is really the result of the company's customers downsizing or merging. Very few people throw CRM systems away after one year or three years or even after seven years unless the organization gets smaller or no longer exists.
There is a very simple exercise that I invite readers to do and see if it works out in terms of their own understanding. CRM for fiscal 2015 had reported revenues of $6.67 billion and a GAAP loss of $47 million. But I think we have determined that the revenue number presented seriously misrepresents the value of what CRM sold. In point of fact, the actual value of what CRM sold was not $6.67 billion, it was actually something like $8.1 billion, which represents both the monthly billings that CRM sent to its customers plus the amount of contracts signed that either have been paid for upfront or contracts for which the service will be paid for over time. Again, according to what I know, these are ironclad contracts - no outs, no contingencies, no future deliverable - you pay, we supply the service. CRM sales management is said to be very clear on what it will and what it will not accept as a long-term contract.
Let's take the exercise a little further and see where that gets us in terms of "real" earnings. This company had a gross margin on subscriptions last year of 81%. For the sake of this exercise, let's assume that the gross margins on the additional revenues were the same, surely a very, very conservative estimate. The company recorded a marketing expense of $3.239 million, which was 52% of subscription revenues. Much of that expense is really not variable, it is salaries and administrative costs, advertising and promotion and the like. The only variable part of S&M is sales commissions. I'm going to get wild and woolly here and suggest that incremental sales and marketing costs are going to be 20% of incremental revenues, which is about $480 million.
So, trying to look at this in a fashion that is similar to what would happen if the Salesforce solutions were sold and not leased would add $2.4 billion to revenue and perhaps as much as $940 million to cost. That would bring pre-tax GAAP profits to more than $1.5 billion for fiscal 2015. I'm not sure what the tax rate would have been on that, but for the sake of this discussion, let's use a 35% tax rate. And that leaves a bit over $1 billion in after tax GAAP earnings, or about $1.50-plus in EPS.
I'm sure some readers will feel uncomfortable with such an exercise, but really even that calculation is too conservative as it allows for no recognition of residual value at the end of any lease period which is almost certainly measured in the billions of dollars overall due to the stickiness of what Salesforce and every other subscription company is selling. The truth is, we really do not know yet just how profitable these companies will be. But I think that far from CRM using creative accounting to mask a deteriorating situation, it is using accounting methodology that masks just how profitable this company already is. One may think that a P/E of 50X is still high for this kind of a company. And that brings me to the penultimate section of my little tale.
Is it inevitable that the growth rate of large subscription companies must slow down?
Mr. Groenewoud's article states that "growth is slowing with little hope for it to return to previous levels." At one level, that seems a reasonable contention. The amount of "service" that a company like this has to ship in order to sustain a constant level of revenue growth obviously has to rise at greater and greater rates simply to keep the same growth rate. Simple math. And indeed, that is exactly what the consensus revenue forecast says. It uses something like company guidance to forecast a 22% growth rate in the current fiscal year and then diminishes the growth rate in the following year to 20%, which is actually a little bit higher in dollars than the revenue growth rate forecast this year. Almost every analyst alive would use that kind of methodology to avoid unnecessary explanations of how a company at scale can continue to grow at similar growth rates year after year.
I have no urgent desire to attempt an in-depth analysis of how this company can keep growing at rates of higher than 20%. But unlike Mr. Groenewoud, I think I at least have to look at how growth happens for a company like this. Regardless of what the CEO of Oracle has to say on the subject, it is almost certainly true that this company has dominated and will continue to dominate the market for cloud-based sales automation solutions.
I just want to call out some numbers from the earnings conference call that might illuminate a couple of points. This company divides its revenue into several buckets. The core business, Sales Cloud, had 12% growth in the quarter and that is up a few hundred bps from the prior quarter. Service Cloud grew at 35%, marketing Cloud grew at 31% and Apps Cloud and other grew at 43%. So, CRM's secret sauce is that it introduces new products year after year after year. If it were still just selling sales cloud no one would even consider this a growth story. I think most analysts today think that CRM competes for less than 40% of the available enterprise stack. But that doesn't mean that this lion won't continue to grow.
Right now, from what I have heard, marketing cloud is the easiest application to sell and the one driving the ultra-large deals. Mr. Benioff may have an ugly beard but he has a very, very shrewd brain. I think it really isn't a stretch to imagine that this company will steadily increase its product footprint and try to sell its installed base on new clouds and sell new clouds to new customers. I can't and won't tell you that everything this company does will turn out successfully. Indeed, if it did, I would feel that it wasn't making adequate use of its franchise. The company is now entering the AI space where it will have to develop a strategy to be successful in what appears to be a very hyped market space with very high expectations.
But I think that Mr. Benioff, and the rest of this management team have some idea about what it will take to insure that growth does not tail off and that the company will develop new clouds on a consistent basis. Right now, the big new thing for this company is analytics, which shows up in "other" - 43% growth, albeit from a de minimis number. I really wouldn't bet that there won't be a HR cloud or a payroll cloud or even a Supply Chain Planning cloud. I'm not quite sure as to what kind of product is intended for AI other than to imagine it will be some other type of cloud. That is, at the end of the day, the DNA of this company. Like the announcer says in the Geico ad, it is what they do.
Some final thoughts
I have seen more than a few recent articles on SA that prognosticate CRM is going to blow up and that it is misleading investors by use of creative accounting. I think the accounting is the opposite of creative, it unfairly and arbitrarily reflects a much less accurate picture of this company's economic strength than is warranted by the facts. Yes, stock-based comp is a cost and everyone knows it. And yes, this company's non-GAAP presentation benefits from the exclusion of stock-based comp as a cost.
But many commentators simply refuse to understand that the nature of this company's business, by which I mean its subscription model, dramatically understates both the scale and the profitability of what this company has achieved. In fact, even at this point, no one really knows just how profitable this company can be, since no one has yet to determine the real economic life of the service the company sells. Selling the same service to the same customers again and again and again over many years is outrageously profitable.
I have tried to go through an exercise to determine just how large and profitable this company already is, or perhaps better said would be if it used accounting treatment that is standard in many other areas of the IT industry. The results will, perhaps, excite some disdain, I suppose, but also may surprise some readers as well.
The best of Mr. Groenewoud's argument is about the potential for CRM to suffer from slowing growth. That could certainly happen and if company guidance is to be believed, it is already happening. But in the real world, that simply isn't a typical evolution of how hyper-growth companies evolve. Many software companies will use their cash flow to fund inorganic growth. That hasn't happened to any degree at Salesforce but it surely might.
But regardless of CRM's potential for inorganic growth, the company will find new worlds to conquer and indeed it already has. Not everything that Salesforce does in that regard is going to work just as not every quarter that Salesforce prints is going to be a blowout. But along the way, CRM has made one very successful acquisition on which its Marketing Cloud is based and has mainly avoided quarterly accidents.
Like all IT companies, CRM is going to have some quarters that are better than others. I wrote in the wake of earnings last quarter that the beer for CRM would never be colder and so by extension I must think that this quarter which will end in a couple of weeks will be less of an upside than last quarter. That might concern some analysts and investors. But there have been suggestions of late that maybe there is some super chiller for beer out there and the quarter will actually be a significant upside.
But I do believe that a quarter will come that significantly misses the company's targets and forecasts. That will be the time to consider the growth prospects for this company. CRM valuations will not fall because people think that its accounting is aggressive. The shares will fall when someone builds a better mousetrap and sells it at a lower price. Thus far, and for the most part, it is CRM that is selling the better mousetrap. And I have seen no evidence that suggests to me that anyone is even close to disrupting the opportunities of CRM.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.