Salesforce.com (CRM) has been a company that has continually increased its investment in the cloud computing space to increase its revenue and its operating cash flow. In this article, I will show that the marginal efficiency of those investments have been decreasing and that the metrics of revenue and operating cash flow have masked a business model that is increasingly becoming broken.
What Salesforce Wants You to Know
Salesforce.com wants you to focus on two things: revenue growth and non-GAAP earnings measures. Salesforce.com is showing growth in both of these measures and they want you to think that because of this, they are doing a good job with their shareholders investment.
(Fiscal Year ended January 31) | F2010 | F2011 | F2012 | |
Revenue | 1,305,583 | 1,657,139 | 2,230,539 | |
(percent increase) | 26.9% | 34.6% | ||
Operating Cash Flow | 270,911 | 459,081 | 591,507 | |
(percent increase) | 69.5% | 28.8% | ||
(Source: All figures in this article sourced from Salesforce.com)
In the most recent quarterly conference call, these were the two metrics that flamboyant CEO Marc Benioff talked about. GAAP earnings were not discussed.
What You Really Need to Know
What you really need to know falls in two categories: how Salesforce.com is performing on other metrics and how their investments in their business are starting to show diminishing marginal returns.
What are those other metrics to look at, and how have they performed?
First, GAAP earnings must be looked at. Say what you want about how other metrics provide information about the business (and I think they do), but you simply cannot overlook the most important of them all: GAAP earnings.
(Fiscal Year ended January 31) | F2010 | F2011 | F2012 | |
Net Income | 80,719 | 64,474 | (11,572) | |
(percent increase) | -20.1% | -117.9% | ||
This obviously tells a much different story. Why is that? First, Salesforce.com's use of the Operating Cash Flow metric is not uncommon and while not "according to GAAP," it is not a bogus metric either. It is basically GAAP earnings that have been adjusted for non-cash items. This is done to demonstrate the cash-generating power of the company. Fair enough, cash generation is certainly important. But what Salesforce.com is not telling you by reporting Operating Cash Flow as they do is that two items contribute to that number that are not directly to do with how well their core operations are doing. Those two items are changes in working capital and stock-based compensation expense.
Cash generated from working capital is simply the net change in current assets and current liabilities. These changes can generate cash by collecting receivables and by dragging payables. They are not strict functions of profitability. Those changes are included in Salesforce.com's Operating Cash Flow numbers and should be backed out in order to get a truer picture as to cash generated by operating their core business. Further, Salesforce.com uses issuance of its shares to employees as a part of their compensation. Since the issuance of those shares does not consume cash (a share certificate is issued as opposed to a company check), that expense is backed out when Salesforce.com computes Operating Cash Flow. Again this distorts the true picture on the profitability of operations. Sunil Shah covered this point in his SA article and quoted legendary investor Warren Buffet who is absolutely on point: "If stock options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world do they go?" When one adjusts for these two items in Operating Cash Flow, a much less rosy picture emerges.
(Fiscal Year ended January 31) | F2010 | F2011 | F2012 | |
Operating Cash Flow | 270,911 | 459,081 | 591,507 | |
Stock Expense, after tax | 37,353 | 62,884 | 223,240 | |
Changes in working cap | 31,070 | 129,420 | 105,011 | |
Adjusted Operating Cash Flow | 202,488 | 266,777 | 263,256 | |
(percent increase) | 31.7% | -1.3% | ||
This startling figure shows that real operating cash flow (as adjusted above) has in fact declined in 2012.
But what I find even more of a concern is a look at some of the return metrics at Salesforce.com. They reveal a trend toward a broken business model.
The Salesforce.com business model is to invest in its core business of offering a suite of cloud computing services to its worldwide base of customers. They do that through investing in their own research and development, through investing in an ever-expanding group of employees and through acquisitions of complementary businesses. Those investments used to pay off handsomely and allowed Salesforce.com to grow and become profitable. But those investments in R&D, headcount and acquisitions are not paying off today as they once did. Investments in their business are now generating diminishing marginal returns as shown by a look at the following return metrics. Despite management crowing about incredible returns and delivering awesome results, a sober look at the numbers reveals that these investments in their business are delivering less return.
In the table below, I look at Return on Capital Employed (ROCE) in two different ways, the GAAP return and the Adjusted Operating Cash Flow return. Both metrics show that capital employed in the business is now showing declining returns. Their absolute level is nothing to brag about, and certainly not the stuff to create a lofty valuation.
(Fiscal Year ended January 31) | F2010 | F2011 | F2012 | |
Revenue per Employee | 328,945 | 312,314 | 286,518 | |
(percent increase) | -5.1% | -8.3% | ||
Adjusted Operating C.F./Employee | 51,017 | 50,278 | 33,816 | |
(percent increase) | -1.4% | -32.7% | ||
Operating Expense Ratio | 71.42% | 74.58% | 81.27% | |
(percent increase) | 4.4% | 9.0% | ||
Investing in more employees is increasing revenues and increasing adjusted operating cash flow at a diminishing rate. Increasing spending on operations is also demonstrating diminishing marginal returns as that ratio has been rising.
Salesforce.com's business model appears to be breaking down. Investments in their people, in their operations and in newly acquired assets are generating less return than they used to. The growth machine is consuming more resources to grow at the same rate, and increasing investment in the core business is therefore showing diminishing marginal returns. If Salesforce.com's investments in its own business are showing declining returns, what is an investment in their stock likely to show? Salesforce.com's lofty valuation of 7.86 times sales, 10.98 times book value, 170.25 times EBITDA and PEG of 3.61 (source: Yahoo Finance) are not justified by these diminishing returns.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in CRM over the next 72 hours.
