Few stocks are as controversial here on Seeking Alpha than Salesforce.com (CRM). Opinion seems to be universally set against the company, due to a host of well-known concerns. To us, the most prominent concern that investors have with the stock is the fact that while the company posts consistent non-GAAP profits, it posts consistent GAAP losses. It is that issue that we wish to explore. First, we will delve into Salesforce's results for the first quarter of fiscal 2013. For the record, we hold Salesforce shares via a mutual fund, but hold no direct position in the stock or underlying options. We do not mean for this article to be a recommendation to buy or sell Salesforce. Rather, it is meant to outline our view that the stock is unlikely to fall.
Results & Analyst Commentary Overview
After the markets closed on May 17, Salesforce posted its first quarter fiscal 2013 results. The company announced a GAAP loss of 14 cents per share on revenues of $695.467 million, which beat estimates by $17.3 million. On a non-GAAP basis, EPS came in at 37 cents, beating estimates by 3 cents a share. Deferred revenue, a key metric, rose 46% over the previous year to $1.33 billion, and unbilled deferred revenue grew to $2.7 billion, up from $2.2 billion in the prior quarter. Billings growth rose 34% in the quarter, a key metric for the company.
Salesforce also raised guidance, now projecting non-GAAP EPS of $0.38-$0.39 for the current quarter, compared to estimates of 38 cents per share. Revenue guidance of $724-$728 million was ahead of estimates of $713.8 million. For all of fiscal 2013, the company guided for revenue of$2.97-$3 billion, and non-GAAP EPS of $1.60-$1.63, ahead of estimates of $2.95 billion in revenue and $1.61 in EPS.
The market must have liked what it saw from Salesforce, as shares closed up 8.8% on Friday, May 18. Analysts offered plenty of bullish commentary as well, and we break it down below.
- UBS: The firm raised its price target from $180 to $190 and reiterated its buy rating. UBS cited the company's growing backlog, now at $4 billion and larger than even Oracle's (ORCL), as well as Salesforce's growing market share as reasons to remain bullish on the company. According to UBS, "23% sequential growth in contracted not billed backlog (up $500M) blew away even the most bullish call for 5-10% growth." UBS raised its 2013 estimates to $1.63 in non-GAAP EPS (from $1.60), and fiscal 2014 estimates from $2.14 to $2.16 in non-GAAP EPS.
- Needham: The firm maintained its buy rating and price target of $160. Needham argues that Salesforce is "the highest quality and largest scaled SaaS name in our universe, best leveraged to the rising strategic importance of SaaS and Enterprise Social trends." The firm raised its revenue estimates for fiscal 2013 to $3 billion and non-GAAP EPS estimates to $1.65, fom $1.63.
- Macquarie: The firm maintained its outperform rating and $170 price target for Salesforce. Macquarie argues that "results handily beat on all metrics and support our view of CRM as a long-term secular winner in the enterprise paradigm shift to cloud, social and mobile technologies." The firm raised its fiscal 2013 estimates to $2.994 billion in revenue (up from $2.944 billion) and non-GAAP EPS estimates from $1.60 to $1.62.
- Nomura: The firm raised its price target for Salesforce from $155 to $160. Nomura argues that the company's 34% growth in billings "a positive surprise that should be a welcomed by investors that had expected the potential for tougher growth metrics in the seasonally weaker 1Q." Nomura's target price represents a multiple of 23 times enterprise value to unlevered free cash flow, and 4.8 times 2013 revenues.
- Canaccord Genuity: The firm reiterates its price target of $180 and its buy rating. Canaccord believes that this "is a tough tape," and that Salesforce could decline. But, "once individual company fundamentals matter again, we are quite confident that CRM shares will quickly resume their upward trajectory. When you combine a solid 90-day report card that produced an always popular beat and raise, it seems pretty clear that CRM's fundamentals put them into the top 1% of software companies worldwide." Canaccord thinks that investors could buy in a bit at this level, and add more shares should the market drag Salesforce down.
There is one thing missing from all these analyst opinions and notes: GAAP earnings. Of the analysts we have seen that have provided post-earnings updates, not a single one commented on the company's GAAP losses. The same thing occurred on the company's earnings call. The word "GAAP" was not mentioned at all. And it is not as if Salesforce hides its GAAP losses. They are included in the company's earnings releases, and they are included in its filings with the SEC. What is going on here?
Paper Profits or Real Cash?
One of the central, if not the central theme of the short thesis against Salesforce is that not only is it richly valued on a non-GAAP earnings basis, it is overvalued on a GAAP basis, because the company has a share price of well over $100, with no GAAP earnings. And yet, the stock does not fall. What is going on? We believe that Salesforce has broken the GAAP model, and the stock is unlikely to fall, for the simple reason that none of the institutions or analysts that move the market actually care about GAAP EPS when it comes to Salesforce.
Critics charge that Salesforce.com is masking its true earnings. We disagree. Securites law requires a company to release its GAAP earnings. But there is no requirement that the company actively direct investors to look at those numbers. The assumption is that people who wish to invest in the stock market are able to interpret a company's GAAP results for themselves. And Salesforce publishes all relevant GAAP metrics. The question we wish to pose is this. When it comes to Salesforce, or any company for that matter, what metric is the best to judge performance?
Salesforce critics say that the company is hiding behind non-GAAP earnings to mask its weak financials and entice investors to buy the stock. Whether or not the company is a buy or sell is not what we wish to figure out here. We are not making a call on where Salesforce is going. We are only using the financial information the company has provided in its earnings release. But, just as Salesforce may be hiding behind non-GAAP earnings, a company can hide behind GAAP earnings as well.
We will use Company X as an example. Company X just reported its annual earnings, and had GAAP income of $1 billion. The company actively proclaimed on its conference call that it is in great shape. But, a closer look at the company's earnings shows that the company had an unrealized gain of $1.5 billion on its investments, which was included in its net income. Without it, the company would have lost $500 million. Worse, the company is cash flow negative. You dig a little deeper and see that in fact, Company X is consistently cash flow negative, and its income comes from those periods where it decides to shift some of its declining cash balance to investments, which you realize are very risky in nature upon reading the company's SEC filings. Under GAAP, things look great at Company X, with GAAP income of $1 billion for the year. But underneath the surface, you see that Company X is hiding behind GAAP earnings to mask its weak operating performance.
Salesforce's GAAP losses grew this quarter relative to last year. But so did its non-GAAP income. And the company's cash & investments balance, arguably the true measure of a company's success (after all, there is no successful company that does not grow its cash & investments balance), is growing. Year-over-year, Salesforce grew its total cash & investments balance from $1.447174 billion to $1.657089 billion. Debt rose slightly, from $496.149 million in the previous year to $502.326 million in this most recent quarter.
Cash flow at Salesforce is growing. Whatever debate may exist about GAAP vs. non-GAAP earnings, there is no way to cloud cash flow. There is no such thing as GAAP or non-GAAP cash flow. Whatever the difference between cash balances between 2 reporting periods is the amount of cash that went in or out of the company. And at Salesforce, cash flow is growing. In the first quarter of fiscal 2013, the company posted operating cash flow of $213.212 million, versus operating cash flow of $135.918 million in the previous year. Free cash flow grew as well, from $112.204 million to $168.491 million.
When discussing Salesforce's cash flows, it is inevitable that the issue of stock-based compensation arises. It is here that our argument over whether or not Salesforce has broken the GAAP model arrives at. Issuing stock as compensation has been a fact of life for Salesforce since the company began. And under GAAP, the issue is largely a wash. If you pay an employee $100,000 annually, there will be a compensation expense of $100,00 on your annual GAAP income statement. It will not matter if they are paid in stock or cash. Salesforce has made a conscious decision to issue stock like candy to its employees as compensation instead of cash. It is now firmly embedded into the company's cost structure.
Therein lies a dilemma for Salesforce's investors. Per GAAP, the company's stock-based compensation expense overwhelms any GAAP income every quarter, and every year. However, the company is steadily growing its cash & investments pile, owing in part to the fact that it issues shares to employees instead of cash. Alternatively, the company could simply pay its employees in cash. The GAAP losses would still exist (or perhaps lessened a bit), because arguably you have to pay your employees the same $ amount, be it in stock or cash. But in that case, Salesforce would be sending valuable cash out the door. In this most recent quarter, over 38% of the company's operating cash flow came from the adding back of stock-based expenses. And yet, it is impossible to deny that the company's cash is growing.
Perhaps the most interesting argument for why we believe that Salesforce has broken the GAAP model is the consideration of a Salesforce dividend. Arguably, dividends (especially rising dividends) are a sign of health at a company, and consistent GAAP losses are a sign of weakness. Assume, for a moment, that Salesforce instituted a policy of paying out 100% of free cash flow as dividends. In the first quarter of fiscal 2012, that meant the company would have paid out $112.204 million in dividends. Had that amount been distributed across the company's 141.062 million diluted outstanding shares that quarter, an investor would have received 79 cents per share in dividends. And in this most recent quarter, the company would have distributed $168.491 million in cash across 146.051 million diluted outstanding shares, giving each investor a dividend of $1.15 per share. In this scenario, Salesforce grew its dividend per share by over 45% in one year, and grew its share count by just 3.53%. All this without posting a penny of GAAP net income. What does this mean? It means that in theory, as long as Salesforce simply grows its free cash flow and share count at historical norms, the company can increase its dividends every year, without having to ever post a GAAP profit. For all the fears raised over the dilutive effects stock options have on Salesforce's investors, in this scenario, it is those very stock options that allow the company to keep expanding its dividends.
Are we saying that GAAP EPS has no relevance? No. What we are saying, what we wish to show with the financial figures and scenarios above is that Salesforce is showing financial health on many fronts. Cash flow is growing, and the company is steadily accumulating cash & investments on the balance sheet. And stockholder's equity is growing. Even when goodwill is completely removed from equity, Salesforce grew stockholder's equity from $801.979 million in the previous year to $978.765 million in the most recent quarter. How can a company be growing its equity and cash if it does not post GAAP profits? This is an interesting contradiction. None of the analysts that track Salesforce seem to care about the company's GAAP losses. Nor do any of the institutional investors that have billions invested in the company. The GAAP losses are not hidden from them. They are included in both the company's earnings releases and its SEC filings. So why does the stock not fall, in light of such obvious GAAP losses? The answer is simple. Until the analysts and institutional investors that move the stock begin to actually care about GAAP EPS as a relevant metric with which to judge Salesforce, the stock will not fall.
We are not making a call on Salesforce.com in this article. Rather, we are pointing out that until market movers actually begin to care about GAAP losses, the stock is unlikely to fall. By many other measures of corporate health, the company is thriving. Its cash & investments are growing, and its stockholder's equity is growing as well, even when you take goodwill completely out of the equation. And yet, the company's GAAP losses show no sign of ending. The contradiction this presents is a very interesting one, not only within the scope of Salesforce.com, but the markets as a whole? Which financial metrics are truly the most important? When it comes to Salesforce.com, the market has, for the time being, voted that GAAP earnings are not an important metric. And until the market votes otherwise, we think is unlikely that the stock will fall.
Additional disclosure: We are long shares of Salesforce.com via a mutual fund that gives the stock a weighting of 3.61%.