Institutional Investors Are Preventing The Short Thesis From Playing Out

| About:, Inc. (CRM)

From what we have seen, (CRM) is perhaps the most hated stock here on Seeking Alpha. Most articles about the company focus on reasons to short the stock, and any bullish article about the company is met with a barrage of criticism: how can anyone be foolish enough to think this stock is a good investment? How can any investor in their right mind own shares of Salesforce? That is the issue we wish to explore in this article, for Salesforce's current owners are among the most powerful investors in the market, and there must be a reason for them to hold the stock. Since going public, Salesforce has risen almost 800%, trouncing the S&P 500's 21% gain over the same time period. And given the fact that the only real reason to be long a stock is to expect it to keep rising, there must be something that the company's current owners see that makes them bullish.

For purposes of disclosure, we are one of those owners, albeit indirectly. We hold shares of Salesforce through the Fidelity Growth Company Fund, which happens to be the largest individual entity to own shares of Salesforce. Does that mean we are bullish on Salesforce? No it doesn't. We bought shares of this mutual fund because we liked its track record, its overall methodology, and its emphasis on companies that have secular tailwinds. Salesforce just happened to be a part of that portfolio, and should readers choose to look at their own equity mutual funds, they may be surprised to find that they too own shares of Salesforce, even if they think it is the worst public company in the world.

Why Has The Short Thesis Failed?

On the surface, the short thesis for Salesforce makes sense. Overvaluation, GAAP losses, endless stock-based expenditures, and debatable accounting all make a compelling case to short the stock. This view has been detailed in many articles here on Seeking Alpha. And yet, over the past year, Salesforce has declined just over 5%, compared to a rise of 2.56% for the S&P 500. That is hardly the performance that is to be expected from a company with such a short thesis. And compared to other high-beta technology stocks, such as VMware (VMW) (down over 8% over the past year), Salesforce has held up well over the past year. How has Salesforce not plunged in light of the short thesis against the company? The answer, in our opinion, lies in who just exactly who owns this company. We break down the company's key investors below. Ownership percentages will be based on the company's 138.15 million outstanding shares (as of the company's latest 10-Q). Data will be taken from Yahoo! Finance, unless otherwise noted (as a side note, we excluded Vanguard and State Street from this list because most of their stake in Salesforce is through passive index funds, and we want this list to represent the ownership stake of investors who actively chose to own Salesforce shares).

Salesforce Ownership
Investor Investor Type Shares Owned % of Shares Outstanding Owned
Fidelity Mutual Fund(s) 20,533,854 14.863%
Marc Benioff Founder, Chairman, and CEO 10,000,000* 7.239%
Sands Capital Management Mutual Fund(s) 9,906,804 7.171%
Jennisson Associates Asset Management 6,540,570 4.734%
T.Rowe Price Mutual Funds(s) 5,547,876 4.016%
Ballie Gifford & Company Asset Management (U.K.) 5,455,476 3.949%
Winslow Capital Management Asset Management 4,571,307 3.309%
BlackRock Asset Management 3,604,291 2.609%
Morgan Stanley Asset Management 3,575,709 2.588%
Ameriprise Asset Management 3,285,998** 2.379%
Total N/A 73,021,885 52.857%

*Taken from Marc Benioff's last Form 4 filing.

**Taken from the company's last 13-F filing.

As the chart above shows, the 10 largest active institutional investors in Salesforce control over half of the company, giving them enormous power over the share price. And based on the latest 13-F filings of all of Salesforce's major owners, those 13-F filers hold 133,745,506 of the company's shares, or 96.812%. There is little retail ownership of the stock, and as such, the price of Salesforce's stock is dictated almost entirely by what its institutional investors do. And theirein lies the reason as to why the short thesis against Salesforce has been unable to unfold. There is enormous vested interest in keeping the stock price where it is. We will use Fidelity, the company's largest investor, as a case study to illustrate this.

Fidelity is one of America's largest investors' with well over a trillion dollars of client assets under management. Fidelity is more than Salesforce's largest investor. It is also one of its oldest. The Fidelity Growth Company fund (the fund through which we own shares of Salesforce) has been an investor in Salesforce since August 2004, having invested just a few months after the company went public. And the fund has steadily built a position in the company, adding over 150,000 shares in just the last month alone. This fund alone holds over 7% of the company, and it is the fund's second largest position. Why has Fidelity held onto its stake in Salesforce for so long? Surely Fidelity's fund managers have seen how the company has slid to posting consistent GAAP losses. Surely Fidelity's fund managers are aware of what is going on with the company's stock-based compensation. Why then, does the company keep accumulating shares? There are 2 possible answers to this dilemma. The first is that Fidelity is seeing something that the company's critics are not. Perhaps Fidelity's fund managers believe that Salesforce will continue to grow, and eventually return to GAAP profitability. The second answer, however, lies in the fact that at this point, it is extremely difficult for Fidelity to sell any meaningful amount of its Salesforce stock. Because Fidelity alone holds almost 15% of the company, any meaningful sale will cause the stock price to fall, thus hurting the funds that choose to retain their shares. And it would be also nearly impossible for Fidelity's funds to sell off their entire stake, given that collectively, they own almost 15% of the company. The market could not absorb such volume. In effect, Fidelity is trapped. The same situation exists at other institutional holders, albeit to lesser degrees. Meaningful share sales are very difficult, because no one would be able to sell their stake fast enough. The Salesforce short thesis has not worked because the stock has enormous institutional support. And until that support breaks, it will be very difficult to see a meaningful fall in the stock price.

The Role of Analysts

The Wall Street analysts that cover Salesforce also have a role to play in all of this. Critics of Salesforce consistently argue that the company and the analysts that cover it are engaged in a massive pump and dump scheme designed to dupe and defraud retail investors into buying the stock. Frankly, we think that this is unlikely for several reasons.

  1. Investment banks aren't major owners: With the exception of Morgan Stanley (MS), the investment banks that cover Salesforce have never been major holders of the stock, thus diluting the argument that they are trying to dump the stock. You cannot dump stock onto unsuspecting retail investors if you never owned it in the first place. And Morgan Stanley, which is bullish on Salesforce like the rest of Wall Street, has held onto its stake for some time.
  2. Retail investors are not the target audience (or owners): It is important to remember just who the targets of these Wall Street research reports are. They are institutional clients of each investment bank, not retail investors. You might think that Merrill Lynch's buy rating and $200 price target on Salesforce are garbage, but the firm's institutional clients do not think so. For better or worse, they believe in the research that Wall Street analysts are doing on Salesforce, and that thinking has helped support the stock price. Furthermore, as we showed above, retail investors own almost none of the company. For Salesforce and its analysts to be engaging in a pump and dump scheme, retail investors actually have to buy the shares, which is something that they have not been doing.

Analysts play a large role, in our view, in keeping Salesforce's stock price where it is. On the company's last earnings call, not a single analyst asked about the company's GAAP losses, or its stock-based compensation. And research reports, at least those that we have seen, make no mention of GAAP earnings, focusing only on non-GAAP EPS (which measure more accurately measures a company's performance has been a debate that has been going on for years, and is not unique to Salesforce). Because the institutional clients of these investors buy into their research, the stock is essentially unable to fall to where it would trade without institutional support. Wall Street is ignoring the issues with Salesforce, and it seems that even Morningstar (MORN) has been caught up in this.

Morningstar is considered by many to be more objective and impartial in its stock research, given that it is focused on research, and not generating investment banking business. On the surface, that commitment to integrity comes through in the company's rating on Salesforce. Morningstar rates Salesforce a sell, and has assigned it its lowest star rating (1 out of 5) and a fair value estimate of $81, well below where the stock currently trades. And yet, Morningstar's report makes no mention of the company's GAAP losses, or its stock-based compensation, or its accounting practices. In fact, Morningstar praises CEO Marc Benioff, writing that, "Marc Benioff cofounded and is CEO as well as chairman of the board. He owns nearly 8% of the company's outstanding equity and received total compensation of about $21 million in fiscal 2011. We appreciate Benioff's commitment to creating shareholder value, demonstrated by his high stock ownership and prior refusal of peer-level compensation for his stewardship of the company." That statement is tantamount to blasphemy for Salesforce shorts, who view Benioff as a used car salesman presiding over a huge accounting fraud (although, to be fair, Salesforce shares have risen almost 800% under his tenure). Morningstar does criticize Salesforce for creating a misalignment between management and investor interests. But their criticism stems not from insider selling (the most obvious reason), but from the company's poison pill and staggered board, which make it more difficult for the company to be taken over. It seems that not even Morningstar sees the reasons for shorting Salesforce as being reasons the company should be rated a sell.

When Will The Short Thesis Finally Work?

We have written about Salesforce several times before, and regularly receive messages asking about when we think that the company's stock price will crack. Just over 10% of the company's float is sold short, and short-sellers often think that each quarterly earnings report will be the one that finally breaks the stock and sends it into a downward spiral from which it will not recover. We do not see it that way. The real owners of the company, its institutional investors, have demonstrated that so far, they do not care about GAAP losses, or any other aspect of the short thesis for Salesforce. And the analysts that cover the company make no mention of those short arguments in their research reports. In our opinion, for Salesforce to truly begin to fall, at least one of two things must happen.

  1. Specific analyst downgrade(s): For the short thesis to begin to really work, we believe that Salesforce needs to see downgrades from the analysts that cover it. But these must not be downgrades based on valuation (meaning "the stock has run through our target, so we are downgrading to neutral"). These downgrades need to be based on things such as GAAP losses, or the company's accounting, and analysts needs to explicitly state that these are issues that investors need to consider when it comes to evaluation Salesforce. That will mean that institutional money managers will at least see these issues brought up before them, and consider what they mean.
  2. Meaningful institutional sales: Given that institutional investors own almost all of Salesforce, it is not enough for panicky retail investors to sell their shares. Their holdings are not large enough to cause a meaningful drop in the company's stock price. Meaningful sales by institutional investors, when and if they begin, would drive the stock price down. Based on Q1 2012 13-F filings, institutional investors sold 2.813% of their Salesforce stock in the first quarter of 2012 (Salesforce stock rallied over 52% during the first quarter of 2012, recovering its losses of the second half of 2011). A drop of 2.813% in institutional holdings is not enough. There must be a large drop of at least 10-15% in the holdings of Salesforce's institutional investors for the stock to begin dropping by meaningful amounts and staying there.

Short-sellers and critics of the company believe that it is each earnings release that will mark the beginning of Salesforce's collapse. However, earnings releases and 10-Q filings are not the right things to analyze in order to determine when the short thesis will begin to work. Rather, investors should look to analyst reports and 13-F filings, to see that sentiment has changed. Only when institutional investors begin selling in large amounts, and analysts begin downgrading the company will the short thesis be able to truly play out.

Conclusions is a company that serves as proof that our markets are never as simple or clear as we would like them to be. The short-thesis for the company seems clear, yet it has not played out because there is enormous vested interest among major investors to keep the stock from falling. And analysts seem to ignore all aspects of the short thesis, making no mention of it in their research. Until sentiment surrounding this company changes, we do not think that the stock can plunge (and stay at those levels). While the company's future stock price may be uncertain, one thing is not: that will continue to remain a controversial company.

Disclosure: I am long CRM.

Additional disclosure: We hold shares of CRM through the Fidelity Growth Company Fund, which gives the company a weighting of 3.61%.