Evaluating CRM's Q1 results
OK, I have liked Salesforce.com (NYSE:CRM) for a long time now and have been at pains to express my thoughts in this forum. So maybe some readers will want to correct me for what they might think is my prejudice. At this writing, the shares are trading up another 5% and have made an all-time high close to $83/share. I'm not going to try to suggest that I know what the shares are going to do for the rest of this week or in the next week.
I try to make sure to remember that I wasn't favored with a prescience gene, sad though that is. And I'm cognizant that the purpose of writing articles is to look at whether the companies about which I write can produce significant positive alpha for extended periods. Once upon a time, Josef Stalin wrote an article called "Giddy With Success." Needless to say, the article was not about CRM or computers - for those of you with an interest, it was about slowing the spread of collective farms.
But the point I'm trying to make here is that despite the string of exceptional quarters that the company has put together, it is well to try to stick to quantitative methods of trying to evaluate the company. The answer is the same. Investors looking for a large-cap growth story in IT can do no better than CRM and that's likely to persist for some time.
CRM as an investment is the closest thing there is in the IT space to a company that amply rewards long-term shareholders. I obviously have no idea as to the results the company will post in its fiscal Q2. After all, the quarter isn't over until 7/31. But I think the likelihood is that once again, the company will significantly beat what I regard as conservative guidance. And that's probably true for this year as well. Today, tomorrow or whenever - investors should bite the bullet and start to establish a position.
I'm hardly unaware that CRM shares are volatile and not defensive. They have a current beta of 1.2X. The shares were $54 as recently as February 9 of this year at the bottom of the tech panic. There have been many recent articles on this site prophesying that we are in for a sharp pullback in the SPY or other indexes. If you feel that there's a significant risk of a significant market pullback, you should not be buying shares in CRM or almost any other name in the IT segment. In such a scenario, CRM shares might produce positive alpha but a negative return on your investment.
I have said that my prescience gene is inactive. And ditto for my omniscience gene. But I will try to do an analysis that might suggest that far from being expensive, CRM shares are far cheaper than most observers imagine. I believe that some of the naysayers will have to find a different name on which to pick and that some of the more dubious observers might be disabused of their preconceptions by an analysis of this quarter's beat.
If investors want to put together a large-cap growth portfolio with an IT component, I really think there's nothing quite like this company. The only comparisons that I can recollect, perhaps ironically, would be Oracle (NYSE:ORCL) at the apogee of the tech bubble and SAP (NYSE:SAP) during the rise of its ERP platform, R3. How the mighty have fallen.
Let me say at the start that many readers refuse to accept that companies that have a business model in which they sell a variety of multi-year contracts and collect revenues ratably ought to be valued significantly differently than a company that collects all the money for its sale upfront. Investors who own REITs have seemingly made the adjustment to looking at operating cash flow rather than GAAP profits because the value of the REITs is in the ongoing cash flow as that is the source of the returns that these companies provide.
And in looking at the other part of the income statement, it seems rather perverse to want to compare the revenues reported by this company, which come in ratably over several years to other companies who take all of their revenues from the sale of a product upfront. The biggest beat for CRM this quarter wasn't in reported revenues although the company did beat a little in that metric to be sure but by the massive increases in deferred revenues and especially off-balance sheet unbilled revenues.
I think it's worth noting that the largest transaction CRM sold this quarter was another nine-figure deal with a major financial institution. Like the two prior nine-figure transactions, this deal provided the company with little revenue this quarter, some increase in deferred revenue and the most significant part of the transaction was reflected in the non-billed, off balance sheet deferred revenue. In looking at this company, that bucket is surely as important a metric to look at as are the other more traditional sales metrics.
I will try to use another real estate example. Two developers build identical buildings. One sells the apartments as condominiums and collects all the cash and goes home. The other developer rents out the apartments on lease terms of different durations. In some cases, the building owner gets paid for the lease up front. In other cases, the building owner signs a multi-year lease and bills for the initial year at the time the deal is made. Occasionally, tenants go month to month. How should I report the revenues and expenses for each developer? How should a financial institution evaluate the worth of the building?
I do not imagine anyone would suggest that I compare the results of selling out a condo development to the results of a rental building by taking all of the costs of the rental building when it is built even though the revenues will come in over a multi-year time span. While the headline numbers for CRM have a modicum of interest, the core numbers of any analysis of this company ought to be the growth in bookings and the generation of operating cash flow, which are far more indicative of the strength of the business than reported revenues and reported earnings - GAAP or non-GAAP.
The headline numbers and a bit more
So far as it goes, CRM had a decent quarter in terms of traditional financial metrics, as I will detail below. But it really had a much better quarter in the metrics such as bookings and cash flow, which are far more appropriate metrics to arrive at an objective valuation for the shares.
CRM reported a revenue increase of 27% as reported and 28% in constant currency. That growth rate was actually an acceleration from the 25% as reported growth rate achieved in the fourth quarter of fiscal 2016 (ended 1/31/16). Non-GAAP diluted earnings per share grew by 50% year over year from $.16 to $.24. So far as it goes, GAAP net income rose more than nine-fold although it still was just 2% of revenues. Overall, GAAP R&D expense declined from 15% to 14% of revenues year on year while S&M expense showed some operating leverage falling from 49% of revenues in fiscal 2016 to 46% in the current fiscal year.
In terms of product lines, the sales cloud enjoyed exceptional growth for a product of its scale and longevity rising 14.6% year on year, significantly above the estimates of most observers. The success of the sales cloud was a principal driver in the company's over attainment. On the conference call in response to questions, the company CEO, Marc Benioff, suggested that the accelerating growth of sales cloud was the result of product refreshes and even, perhaps, the result of some excitement regarding the company's nascent AI offerings in the sales cloud. I really don't know if that is the entire explanation and I would suggest as an alternative or an adjunct that by this time, CRM's sales cloud is getting all the marketing/sales advantages that inure to category killers.
The Service Cloud grew by 33% year on year, the App Cloud grew 45% and the Marketing Cloud only grew by 29%. All of these numbers were great, but the apps cloud growth of 45% was most so. The exceptional performance of the apps cloud is indicative of the momentum that CRM is achieving in selling its platform and infrastructure as the foundation of choice for many other smaller application software vendors. While it is hard to say with any degree of confidence, it is my belief that the application cloud, over time, has the opportunity to become the largest revenue generator amongst CRM's current product lines and I believe its potential growth remains underappreciated by many investors.
I have seen some articles and reports on this company to the effect that its growth rate would inevitably slow down. Of course, the opposite has been the case thus far. What I think is misunderstood is that CRM's opportunities in the applications and the service cloud are probably greater than the opportunities have been in the company's sales cloud. As it happens, the company's allegedly mature product line, the sales cloud, has seen accelerating growth. CRM is likely to remain a growth company at rates significantly above those forecast despite the so-called law of large numbers or the concept of reverting to the mean.
While it's difficult to quantify, the company probably has filled barely over a third of the total potential application stack. There are almost certain to be other clouds that will continue to be layered on what this company has already done and which are likely to sustain growth rates for a significantly longer period than is appreciated by the critics of investing in the shares of CRM.
When the headline numbers actually mask the growth achievements of the business
While CRM achieved a reported revenue growth of 27% that actually understates the productivity of the company's sales operation. Not by all that much, to be sure, but the bookings metric which excludes the increase in the off-balance sheet unbilled contracts increased by 28% year on year. Overall, the company now has almost $12 billion of booked business on and off the balance sheet. In the quarter, overall bookings rose to $2.12 billion compared to $1.547 billion in fiscal 2016, which represents growth of no less than 37%, really a most remarkable statistic. (I calculate bookings by taking reported revenues and then adding or subtracting the change in on-balance sheet deferred revenues plus the increase in off-balance sheet deferred revenues.)
Some interesting comparisons of note: Oracle had product revenues last quarter of a bit less than $3 billion. Product bookings for CRM totaled $1.98 billion, or about two-thirds of the product bookings at Oracle. To get that $3 billion of product bookings, Oracle needed 135,000 employees while CRM had a workforce of but 21,000. Yes, Oracle has a large maintenance base and indeed maintenance is the largest stream of revenues and profits that Oracle has (52% of revenues and really more than all of the profit) but I think the differences in the relative efficiency of the revenue generating machines is simply remarkable.
These days the number of personnel required to provide maintenance support has decreased significantly as many automated tools are common. Perhaps another number that is yet more striking is that Oracle spent $1.9 billion on sales and marketing to sell $3 billion of product. CRM spent $900 million on a GAAP basis in sales and marketing to sell $1.775 billion of product. It is apparently a lot easier to sell CRM product these days than it is to sell Oracle products.
The SAP comparisons are equally, if not more invidious, for that company. SAP had product revenues during its first quarter of $1.32 billion. The company has 75,000 employees. Sales and marketing costs were $1.44 billion for the quarter. I think the numbers make further commentary about the SAP/CRM comparison superfluous. I think that the economics of spending more on sales and marketing than is being produced in product revenue absent some outsize build up in deferred revenue is really very questionable.
It is just very hard to maintain looking at these types of comparisons to maintain that CRM has an unprofitable business model or alternatively that Oracle or SAP are somehow more efficient than CRM. What is even more remarkable is the fact that CRM has a much narrower product line than either SAP or Oracle. CRM doesn't sell ERP, it doesn't sell HCM and it really doesn't sell standalone BI. In the categories in which it does compete, it is dramatically outselling its two major competitors by some significant amount although absolute statistics are hard to come by. It appears that CRM is taking market share from both Oracle and from SAP at an accelerating pace.
I'm going to go out on a limb and suggest that much of the reason for the dramatic differences in sales efficiency is that the business models of SAP and Oracle oblige them to try to cover the waterfront with application software solutions that have to have some degree of integration. That's going to have to be true as historic SAP and Oracle users migrate to the cloud.
Integration is the largest single factor in trying to sell complete application stacks. And so, the basic inefficiencies of trying to be all things to all people will continue into the cloud environment for these companies to say nothing of the expense and effort of trying to support a multiplicity of disparate code bases that are apparently not yet completely integrated. While many observers both on and off Seeking Alpha maintain that CRM has a flawed and unprofitable business model, considered a bit more analytically, the exact opposite is true.
Parenthetically, SAP's deferred revenue declined by about $60 million in its quarter that ended 3/31 while Oracle's deferred revenues in the quarter that ended 2/28 rose by $24 billion. CRM's deferred revenues rose by $207 million in its quarter that ended 4/30.
Is cash king or is it the flawed accounting conventions that rule?
There are no prizes available for guessing how I come down on that question. Now there are those investors who will say, "I understand the analysis that you have done and even though it is quite unconventional, I will accept the fact that CRM actually has the far more preferable and profitable business model when compared to its legacy competitors." But still, it barely reports profits and somehow that just doesn't feel right.
As I have tried to mention the reason that CRM doesn't report profits is not because there are no profits to report but that the accounting system that CRM uses is deeply flawed and sadly misrepresents the real profitability of the company's business. A much better way to evaluate CRM is to consider both the growth and the sources of the company cash flow and free cash flow metrics.
Operating cash flow for the quarter reached $1.05 billion, up from $735 million in the year earlier period. That is a growth of no less than 43%. Before anyone asks, part of that increase is the ongoing switch to annual buildings that occur at the start of the calendar year. But that was a negligible factor last quarter. By far the largest component of the $300 million year over year increase in operating cash flow was the decline in A/R balances, which remarkably fell by no less than 50% in fiscal Q1 when compared to the end of Q4.
Quarterly revenues in Q4 were $1.81 billion and were $1.92 billion in this just reported quarter. Now it is a remarkable accomplishment to be sure and one that begs for a theory as to how revenues go up sequentially while receivables drop by 50%. In the real world, the only way that happens is when the quarter in question is exceptionally linear and there is no pressure to close deals at the end of the quarter.
Of course, there is some seasonality reflected in the numbers that is dependent on when the company does its billings, now 79% of revenues, but not enough to account for a 50% drop in receivables. The inference that I might draw is that the company is very well set up indeed for a strong Q2 than will handily beat expectations and likely let the pipeline grow in what is historically the smallest quarter of the year.
The company has forecast an increase in operating cash flow growth of between 25%-26%. That would bring that metric to $2 billion for all of fiscal 2017. Free cash flow in fiscal 2016 was $1.38 billion. (I'm excluding the purchase of the company's new headquarters in the calculation.)
The company does not forecast free cash flow but based on Q1 capex of $83 million, my estimate for that metric would be about $1.65 billion or up 24% from the prior year. That too is likely to prove conservative although needless to say, the benefit in cash flow that was derived from the drop in receivables cannot be repeated in the balance of the fiscal year and is likely to go the other way. I think it is significant that a company that has top line growth of close to 30% with all the cash consuming demands that such growth brings can achieve a cash flow margin of just less than 25%. It suggests just how great is the cash generating capacity of this business model whenever growth moderates.
Valuing unicorns is never easy. By their nature, unicorns are unique. On conventional metrics, the company has an EV/S of 6.4X, a P/E of 82 times non-GAAP EPS estimates and its free cash flow yield is 2.9%. Many readers will ask how long does CRM's over-performance have to last to justify its current valuation? As I have suggested before, it is not that the valuation is too high but that the accounting system that is used is far off-base.
I have a modest proposal to see if we can make better sense of this company's current valuation and why that valuation is well warranted. As some readers may be aware, Jonathan Swift of Gulliver's Travel fame was the first author to title one of his essays "A Modest Proposal." The title has been used many times since. After all, most observers think it is the best satirical essay ever written in the English language. Obviously, it is not about computers or the arcane world of accounting conventions. In 1729, when Dean Swift wrote the piece there were no computers and misbegotten accounting such as the South Sea bubble was just emerging.
For those of you with the interest, A Modest Proposal was a plea for the government of that day to alleviate the suffering of the native Irish and to provide them with a modicum of justice and rights. The essay was fantastic but its policy proposals lay dormant for almost 200 years until the Easter uprising.
My proposal has nothing whatsoever with the Protestant Ascendancy of the treatment of the Irish in Ireland. My proposal is that we add back stock-based comp to expenses and use overall bookings in lieu of revenues. In the just reported quarter that would have added $200 million to revenues and added $189 million to operating expenses. But as most observers realize this is a very seasonal company and bookings are at their lowest point in Q1 and ramp through the year.
Last year bookings - bookings for on-balance sheet items were about $7.7 billion and overall bookings for the year, including the increase in non-billed off balance sheet bookings came to a bit over $9.7 billion. CRM doesn't provide all of the figures that would be needed to most accurately forecast total bookings but with the results of Q1 in hand along with some guidance, overall bookings for this company during its fiscal year 2017 will probably reach to between $12-$12.5 billion and that is a conservative estimate I believe.
In any event, using bookings instead of revenues will add about $4 billion to the revenue calculation. Just to be fair, it would probably add about $400 million to commissions. On the other side of the ledger, the stock-based compensation expense for the year might total over $800 million. It was $593 million last year and it was $189 million in the April quarter. Overall, making those changes would increase pre-tax profits by $2.8 billion. The company estimates a normalized tax rate of 35% so net income would be $1.8 billion greater than the current forecast. The company has 687 million shares outstanding. That works out to an additional $2.62 of earnings to add to the current estimate of $1.01.
Such a change in the company's financial reporting would bring the EV/S from 6.4X to 4.65X and it would bring the P/E down to 29.7X. Those are still not bargain basement numbers but the company is still growing at almost 30% and just raised guidance.
There are going to be readers who question the methodology used in deriving the numbers or who question the relevance of the numbers that I used overall. OK, my proposal was not all that modest, but then again neither was that of Dean Swift. It isn't going to happen any time soon. And I confess that the numbers are broad estimates and are not meant to be precise. For me, it is just a way of looking at this company and providing far more accurate estimates of key valuation estimates than are otherwise available.
The preponderance of new price targets from those analysts who have changed them so far today is in the range of $100/share. That's conservative as it should be. I think a 30X multiple on the earnings adjusted as I have suggested is as reasonable as any other price target and that yields $108/share.
CRM reported another blow-out quarter last evening that showed revenues above estimates. The company chose to raise revenue guidance minimally and to leave EPS forecasts alone. The company had a very strong cash flow quarter and management raised its forecast for that metric as well.
But beyond just the headline numbers, the company had a spectacular growth in bookings. The way I calculate that metric, including the increase in off balance sheet deferred revenues, bookings growth was 37%.
The company's line of business numbers proved to be very encouraging as well. Its initial product, sales cloud, showed accelerating growth at 14% and its Apps Cloud line of business grew by 45%. I think many investors and observers still underestimate the potential for the Apps Cloud and other emerging new products for this company.
The company did achieve a 300 bps increase in reported GAAP margins and much of that growth was in the context of rising sales productivity. I think the trend of rising operating margins will continue now for the foreseeable future.
I realize that traditional valuation metrics still portray CRM shares to be a very expensive investment. I have proposed another way of looking at the company's operating results that takes account of the company's mismatch between when it records revenues and expenses. Overall, such an exercise leads reported profits to more than treble. While still not a value name, even when using my proposed way of looking at the company's adjusted valuation metrics, I think that even GARP investors might want to think of making commitments in the name. CRM shares continue to be my strongest recommendation in the large cap IT space.
Disclosure: I am/we are long CRM.
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.