While the S&P 500 is not overly cheap at this point in time, it seems to me that businesses facing short-term headwinds such as Cisco Systems Inc. (CSCO) and Hewlett-Packard Co. (HPQ) trade at all-time low discounts to intrinsic value, while a market favorite such as Salesforce.com Inc. (CRM) can trade at valuations that remind this investor of the tech mania that was so pervasive in the late 90s. To be clear, Salesforce has an exciting business and is a leader in the "cloud" industry, which is likely to be one of the most attractive growth areas over the next 3-10 years; it seems to me that the current stock price offers no reflection of the intrinsic value of the business. As Warren Buffett said "You pay a very high price in the stock market for a cheery consensus."
Salesforce, at close to $150 a share, offers no margin of safety and a high likelihood of undesirable future investment returns. I'd imagine that most market participants involved with Salesforce at these prices are insiders or employees, who may have difficulty selling their stock depending on certain conditions, and speculators riding the momentum train thinking that they can jump off before it derails. For institutional investors such as hedge funds, Salesforce offers a compelling short opportunity, and an even better target for call-selling for the purposes of either generating income or initiating a short position at an even more favorable entry point.
To understand the expectations placed on Salesforce's future prospects, it is important to look at the raw data. The company currently trades at about 170 times the median 2013 EPS estimates, 11.1 times book value, 8.1 times sales, and 30 times cash flow. The market capitalization of $20.2 billion is greater than Dell Inc.'s (DELL) market capitalization of $19 billion, despite Dell having produced about $35 billion in net income over the last decade versus Salesforce's relatively paltry $223MM.
Now obviously stock prices should reflect the discounted value of future cash flows, but it is amazing how much credit Salesforce is given despite extremely low profitability. Salesforce hasn't posted a return on equity greater than 10% at any point in the last decade, and return on invested capital has been even worse. While the business model of Salesforce is geared towards reducing acquisition costs for customers to leverage sales and marketing by reaching a critical mass, it is troubling to see a business that, despite robust revenue growth and considerable money spent on acquisitions, has been unable to generate profits above its cost of capital. R&D expenditures have been extremely high averaging just over 9% over the last ten years, but where are the returns reflecting the fruits of this spending? Technology has quite arguably the highest rate of obsolescence, so there is a huge risk that technology developed now could become obsolete 3-5 years from now. Therefore, the window to generate profits on that spending must be shorter than say for a biotech concern, but even in that world, the rate of return on R&D has been poor.
In all fairness, Salesforce is a wonderful success story and is a true innovator in customer relationship management and enterprise cloud computing. Revenue has grown from $51MM in 2003 to nearly $2.5 billion over the last 12 months. Cloud computing offers an ample runway for growth, and Salesforce is as well positioned as any firm to be able to capitalize on that. Salesforce has astutely used its rich stock price as a currency to make acquisitions, which have dramatically broadened the solutions that the company can offer to clients. CEO and Chairman Marc Benioff has been a true visionary as a leader of Salesforce.com and has created a powerhouse, which has forced tech behemoths such as Oracle Corp. (ORCL) and Microsoft Corp. (MSFT) to radically adjust their business models. Salesforce has created an ecosystem which can be accessed with incredible ease, and quite affordably, to companies both large and small for many essential enterprise technological solutions. Previously, these solutions were only really accessible through software which was only customizable for companies with large IT budgets, and were often quite "buggy" for lack of a better term. Non-GAAP EPS has followed the upward trajectory of revenue, and for fiscal year 2013, the company expects Non-GAAP EPS to be in the range of $1.48-$1.51.
Investors should not be slaves to GAAP, which has tremendous limitations for various businesses, but Salesforce offers one of the more egregious examples, in my personal opinion, of a company misleading market participants through emphasizing distorted figures to provide an overly optimistic view of the business. Shareholders should be looked at as partners. While management and analysts cheerleading can seemingly be forgiven when the stock performs well, if things end badly for shareholders, current activities may turn out to be seen through the rear view mirror as being less than one would hope for from a fiduciary. Non-GAAP earnings exclude the effects of stock-based compensation, amortization of purchased intangibles related to acquisitions, and net non-cash interest expense related to convertible notes. This figure does accurately portray cash flow, but a lemonade stand that expands throughout the United States while paying employees and acquiring other stands using an immensely inflated stock as currency would also show explosive non-GAAP EPS and revenue growth. Many companies issue stock and buy back nearly the equivalent amount to offset dilution, but Salesforce.com has taken dilution to a whole new level. Between 2003 to July 2012, Salesforce's share count has grown from 26MM to 139.425MM, representing a 530% increase. While an investor who previously owned 10% of the company would now own less than 2% might forgive management based on the explosive returns in the common stock, the fact that management is not including what equates to be one of the largest recurring expenses of the company in how it is evaluating its own performance should be extremely concerning. GAAP earnings are rarely mentioned in earnings calls and clearly little effort has been made to reduce dilutive practices.
While software providers such as Microsoft and Oracle were initially reluctant to acknowledge the threat of cloud computing, the winds have changed and both companies along with a host of others are developing competitive solutions which could severely impact Salesforce's future profit potential. Most people that have used a CRM product know that they are fairly interchangeable, and while Salesforce has used that business to expand to being the leading innovator of other cloud technologies, anything less than Google-like growth and margin expansion would make the stock a loser at the current price. While many companies would love to buy Salesforce at an appropriate price, the $20 billion market cap is impossible to justify for well-informed perspective business buyers, which reduces the downside risks of making a bearish bet on the company. Former momentum favorites such as Cisco and Dell had businesses that performed exceptionally well over the last decade, but saw their stock prices decline by 80% or greater based upon their Salesforce-like valuations before the bubble burst in March of 2000. Those companies operated in industries with similar opportunities to what the cloud offers now, but they had less ridiculous accounting, a much better track record of profitability, and, in my opinion, more durable competitive advantages relative to Salesforce. Now my point is not to say that Salesforce can't eventually grow into its market cap, and if management uses its rich stock as a currency to invest successfully in profitable and undervalued companies, my thesis would change materially, but I thought it would be helpful to look at what type of growth Salesforce would need to achieve to warrant the current valuation.
In the table below, we took the median estimate for CRM's earnings which is $0.88 per share, and we showed what the EPS would be, assuming 10%, 20%, and 30% compounded EPS growth respectively.
Even if Salesforce compounded earnings at 30% a year, in year 10, EPS would only be $12.13. Assuming a 10 times earnings multiple, the stock at its present price would have offered no value whatsoever. While that multiple might seem extremely low in context with how Salesforce is currently viewed, all one has to do is look at the multiples of Apple Inc. (AAPL), Google, MSFT, CSCO, and Intel Corp. (INTC) to see that it is very possible. If somewhat heroic assumptions are needed over a ten-year period just to come close to justifying the current price, where is the actual profit potential for a long-term owner of the stock? At that point in time, the market will be worried about the future just like it is now and not the past, so past performance will only count for so much. For those that think 30% EPS growth is conservative, I'd encourage you to look at how few companies have achieved that type of growth, especially those that have little track record of profitability. Also it is important to note that dilution will likely continue at an aggressive rate making strong EPS growth an even larger hurdle to jump over. Salesforce is financially sound, but the more established technology heavyweights easily have the financial heft to acquire emerging technology concerns, which could increase the odds of competing successfully in Salesforce's key businesses.
To be clear we don't engage in a lot of short selling and I believe that there are ample long investment opportunities to keep an investor fully invested. With that said, Institutional Investors looking to hedge portfolios using a value oriented, long-term philosophy would do well to consider a bearish bet on Salesforce. One might look to sell the January 14 200 calls for about $1,300 per option. I'd only engage in doing this if I were willing to be short the stock upon potentially being exercised, and what is nice is that the short investment thesis would be that much greater at over 200 times 2013 median EPS estimates. This might seem to be a wimpier track than shorting the stock directly, but our philosophy is based on maximizing the margin of safety and avoiding permanent losses of capital. It is very possible that Salesforce can jump over the short-term due to a short squeeze, or in response to a general market rally, but a disciplined dollar cost averaging approach to shorting the stock seems quite attractive particularly given the relative overvaluation to other businesses.