3 Kinds Of Stocks To Short (Part 1): The Frauds

| About: Salesforce.com, Inc. (CRM)

I recently read that Dan Loeb, head of Third Point LLC, drills the concept of finding stocks to short based the criteria of them being "fads, frauds, or failures."

The benefit of finding stocks than can be successfully shorted is that the returns aren't correlated to the market, allowing the investor to achieve significant risk-adjusted Alpha; the primary goal of anyone managing their own portfolio.

For each category, I'll describe some historical examples and then some modern day ideas from which to begin your research.


In order to identify frauds, you must be exceptionally diligent and have a supreme ability to read between the lines of financial statements.

You can "mark" a company and do further research when you find:

  • You read through the annual report several times and are still unclear of how exactly the company makes money.
  • The quality of cash flows, i.e. if the company is using stock options as their main source of cash flow.
  • Mark to model, as opposed to fair value accounting: company-produced models often lack transparency and lead to aggressive accounting practices, reflective of the corporate culture.
  • Stated returns on equity, assets, capital etc. that fly in the face of normal industry ratios: this is a classic red-flag for many American-listed Chinese companies, where returns on equity might be something ridiculous like 48% compared to established competitor ROE of 17%.
  • Heavy usage of the "cash flows provided by financing activities" to boost total cash flows - especially sale purchase of stock.
  • Astonishingly consistent revenue growth that can't be traced back to an organic improvement in business operations.
  • Confusing merger activity.
  • Management that attacks short sellers and constantly pumps its company's stock.
  • Company has a no-name auditor.

Historical Examples: The most well-known example is probably Enron. The company, busted in 2001, fit much of the aforementioned criteria. For its trading operations, the firm used the merchant revenue recognition model, as opposed to the agent model that was used by most trading companies. The merchant model was known to be far more aggressive in how it recognized revenues.

Outstanding revenue growth in the order of almost 70% characterized the company's "success," while the energy sector grew at single-digit rate.

Here's an excerpt from Enron's 2000 Annual Report. I had to chuckle a little bit while reading it:

"Enron has built unique and strong businesses that have tremendous opportunities for growth. These businesses - wholesale services, retail energy services, broadband services and transportation services - can be significantly expanded within their very large existing markets and extended
to new markets with enormous growth potential. At a minimum, we see our market opportunities company-wide tripling over the next five years.

Enron is laser-focused on earnings per share, and we expect to continue strong earnings per- formance. We will leverage our extensive business networks, market knowledge and logistical exper- tise to produce high-value bundled products for an increasing number of global customers."

The buzz-words are the key giveaway. The terms "growth," and "potential" are constantly referenced all throughout the report. Furthermore, saying that "at minimum," you see your potential tripling over the next five years is incredibly unprofessional.

The focus on EPS is a red-flag as well; I'd prefer the management of companies are focused on quality, "owner" free cash flow.

Lastly, I still don't understand how Enron made its money. I've Googled, I've read the report, I just don't get it. The company didn't care to explain much in its SEC filings either.

Potential Fraud: Salesforce (NYSE:CRM): Throwing around the "f" word is dangerous, and oftentimes kills the credibility of those who accuse it. So rather than calling Salesforce.com a fraud, I can honestly say that company is simply very questionable.

The constant pumping of Salesforce on the behalf of Marc Benioff (the CEO) reeks of textbook salesmanship and is quite unprofessional.

From its 2012 Annual Report:

"This incredible growth, even as we approach $2 billion in annual revenue, resulted in FORTUNE magazine ranking salesforce.com #4 on its 2010 list of the world's fastest-growing companies."

Incredible. Amazing. Fast. Awesome. Everything about Salesforce's growth is out of the ordinary - "unbelievable" as Benioff has said on Cramer's Mad Money time and time again.

Since Benioff has been able to convince Wall Street that GAAP accounting principles aren't relevant for his company, let's take at the in-depth accounting and share issuance to see just how much shareholder value CRM has created.

In 2003, there were 26 million fully diluted shares outstanding for CRM. By 2007, that figure had grown 361% to over 120 million. Today, 138 million shares are outstanding.

As for CRM's cash flow, the overwhelming source of the "growth" has been from the exercise of employee, dilutive stock options.

For example: For the three months ending April 30th, 2011, FCF was $113 million; $47 million of which came from stock-based expenses.

For the same period ending in 2012, FCF was $169 million; $81 million coming from stock-based expenses.

With only $56 million in growth - $34 million being derived from an increase in stock-based expenses - the growth story begins to look very unattractive.

For fiscal 2012, FCF was a stated $440 million ($230 million, or about 50%, coming from SBE). In fiscal 2011, FCF was $369 million ($120 million, 33%, from SBE). Accounting for this gimmick, FCF growth was non-existent. In reality, even without delving into CRM's inflated deferred revenue policies, true free cash flow is about $200 million. This is a huge difference; CRM is really trading at an obscene 100 times FCF, with the growth story actually reliant on continued growth in SBE.

Also of note was a stunning $374 million recent write-down of its marketable securities. I'm assuming this came from a realized loss on a large holding of mortgage backed securities.

Over the last six months, 370,000 shares ($50 million at current prices) have been dumped by insiders, with no purchases to speak of. No purchases whatsoever? Why should you be buying if they're not?

After accounting for warrants, stock awards, and convertible senior notes, another 20 million shares will be added to the float for a grand total of about $160 million shares.


Fraudulent? I'm not sure. However, the incessant pumping on the part of Mr. Benioff, the focus on non-GAAP earnings, excessive share dilution, massive insider sales, and free cash flow growth that is 50% composed of the exercising of stock options is quite worrisome.

All in all, Salesforce is a fantastic example of a questionable company with many red-flags.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.