CRM-Climbing a wall of worry in just a few bounds
Salesforce (NYSE:CRM) announced the results of its fiscal Q4 the evening of 2/28. The quarter was strong as had been well advertised in advance. In reality, the results that were announced were pretty much what most observers and shareholders might have reasonably anticipated and were congruent with what I had expected as forecast in the article I most recently wrote on the subject.
The company is doing very well in terms of revenue generation, very well in growing its cash flow and less well in growing reported profits. The shares are doing less well over the course of a year and a bit better over the course of the last few weeks. The shares ultimately reacted positively to the earnings release rising by about 3% on a day in which the market was strong as well with the IGV appreciating 1.7%.
Overall, the shares are up 17% in the past year, which is decent, but quite a bit less than the move in the tech software index, the IGV. The shares have worked better since the start of the year appreciating 20% versus the 14% appreciation for the IGV.
To come back to the article I most recently wrote, I had suggested that it would be difficult for CRM to satisfy investors. That obviously hasn't been accurate since the article was published, but to an extent, the same factors I referred to at that time continue to constrain the ability of the shares to produce meaningful positive alpha despite what many, myself included, would consider to be strong operational performance, particularly in terms of revenue generation in this past quarter.
In looking back at what I wrote at that time, I find little reason to change many of the points that I made. This company continues to dominate its space and to enjoy a strong competitive position in its newer areas. It is actually enjoying some recrudescence of growth in its traditional Sales Cloud, perhaps based on product refreshes. And it plans to make some giant product announcements next week that may move its needle, or are, more likely, already part of the company's guidance.
Unfortunately, all of that seems to be embodied in the current valuation. In total, 45 analysts report their ratings to First Call. Of that cohort, 42 rate the shares either a buy or a strong buy. One of the things that can lead to under or over-performance are changes in analyst ratings. The fact is that there are simply not many people to change their minds positively.
The average price target posted on First Call is $94, and from what I have seen this morning, it may drift up a $1-$2 in coming weeks. I will go through some of the valuation metrics later in this article, but as I have pointed out before, stock-based comp, forecast to be just less than $1 billion prior to tax effects, will be the primary driver of reported earnings.
This is a company firing on all revenue cylinders, but that may not be quite enough to produce positive alpha for investors. I think the shares are likely to perform in line with the IGV for the next six to 12 months although I also think there may be some potential for appreciation based on next week's product release
Some thoughts about the quarter
I will reprise a few of the headline numbers below. The company reported revenues of $2.3 billion and GAAP EPS loss of $.07 for the quarter. These numbers compare to revenues of $1.8 billion and GAAP EPS loss of $.04 in the prior year.
Non-GAAP net income was reported at $.28/share based on 711 million shares outstanding, which compares to non-GAAP EPS of $.19 based on 683 million outstanding shares the prior year. The growth in outstanding shares year on year was 3.5%.
Cash flow, on the back of strong bookings activity, rose 50% for the quarter to $706 million, with full-year operating cash flow of $2.16 billion, up 29%.
For most observers, the sales attainment of the company was considered to be outstanding considering the combination of decent headline numbers and more than decent results in terms of the increase in both recognized and unrecognized deferred revenues. To what extent the over-attainment in bookings is a function of the seasonality in terms of renewals and annual billings is a bit difficult to assess.
It was encouraging to see a significant re-acceleration in the pace of growth for the company's sales cloud, the company's largest and original product offering. Sales Cloud revenues grew by 13.5% in the quarter up a bit from the 12.5% growth reported in fiscal Q3. The other product areas grew at rates consistent with or better than growth in prior periods.
Overall, deferred revenue booked in the quarter was $2.04 billion and that increased by 41% from the level in Q4 of fiscal 2016. For the full year, the increase in deferred revenues was $1.21 billion, an increase of 25% from the dollar increase in deferred revenue in fiscal year 2016. It is just difficult to avoid acknowledging that level of increase in deferred revenue last quarter.
I had the occasion to write about the results of Workday (NYSE:WDAY) after their earnings release and to comment about the increase they had in the deferred revenue metric at the end of their fiscal quarter (15%). The CFO of WDAY spent a fair amount of time explaining why that really didn't matter and many analysts said the derived booking metric, which was 30% growth, was ahead of expectations. The derived bookings metric for CRM grew by almost 37% in the quarter, clearly, one of the more outstanding sales accomplishments seen in this space in the recent past.
A tiny component of the growth was inorganic as the company has bought several smaller businesses in the last 12 months. It is even more impressive given the fact that CRM is 5X the size of WDAY. Again, how much of that outsized increase is a function of renewals and annual bookings is not disclosed and we do not know if there was any material change between this just reported Q4 and the year ago period - there probably was some.
And ironically, some observers were unhappy that the forecast for Q1 reflected to a degree the significant level of bookings recorded in Q4. But the least that can be said is that there were no ambiguities about the company's revenue performance in the quarter - the beer for the CRM sales organization was as cold as it is ever going to get.
As a result of the powerful increase in deferred revenues, cash flow from operations (CFFO) increased by no less than 50% for the quarter and 29% for the year. Again, there were seasonal factors at work in that performance which will not likely be repeated in future years. While the company doesn't forecast quarterly cash flow numbers, the strong performance in Q4 is almost certain to produce a far smaller growth in cash flow in Q1.
Just looking at the company's forecast for its deferred revenue balance, which is for growth of 22%-23%, brings that metric to $4.87 billion. That is down by almost $650 million from the results of the quarter just reported and will constrain quarterly cash flow. In Q1 fiscal 2017, the decline in deferred revenues was only $293 million. It is likely, therefore, that CFFO will contract somewhat in the current fiscal quarter although full-year guidance is for cash flow growth of 20%-21%, which would take CFFO to about $2.55 billion for the current fiscal year.
It also means that there is a strong probability that the derived bookings growth proxy will be below the number that had been expected by investors. As mentioned earlier, the bookings growth proxy was 37% this past quarter and with the forecast the company has provided for cash flow in Q1, it seems likely that the bookings growth proxy will be more in the range of 15%-20$ for that period. It really is just enhanced seasonality that will eventually settle out.
Despite the strong revenue performance, there was no leverage at scale in CRM's quarterly results and that has and is likely to continue to put a cap on its valuation and its ability to produce meaningful alpha for investors. While some of the margin weakness is a product of the Demandware acquisition and headwinds from FX, I think it is fair to say that looked at holistically, the company has yet to lay out any clear path to consistent progress in terms of GAAP profitability.
All of the following expense ratios are GAAP and they really aren't pretty, given the company's revenue performance. Gross margins declined by 200 basis points to 73% during the year partially due to a very modest mix shift, which saw service revenues grow a bit faster than subscription revenues. More important was the loss of deferred recognition due to purchase accounting conventions.
Research and development costs rose by 100 basis points, although compared to the level of such costs at other application vendors such as Workday, they are very modest at 15% of revenues. Sales and marketing costs are still at very extended levels and their improvement in percentage terms of 100 bps was smaller in Q4 than in the earlier quarters of the year.
General and administrative expense of 11% is rather high for a company of this scale. In general, application vendors with their complex contracts and large IP portfolios tend to have high general and administrative expense; this one is high enough to be an outlier.
Overall, GAAP operating margins went from a minor positive number in fiscal Q4 2016 to a minor negative in this latest fiscal quarter; the company managed to post a $51 million loss after tax this past period compared to a $25 million loss in Q4 the prior year. In stepping back and considering the quarter as a whole, I think that the revenue performance was fantastic while the earnings performance was mediocre. I am still looking for the leverage at scale, which I think is necessary for the next leg up in the shares.
The company is forecasting stronger performance for non-GAAP margins mainly because the stock-based comp metric is continuing its growth. Last year, non-GAAP margins rose by 78 bps, despite the fall in non-GAAP gross margins, which were constrained by the revenue adjustments required by purchase accounting. The company is forecasting that it will increase non-GAAP margins by 125-150 basis points. Quite a bit of that will be the absence of the revenue recognition adjustment in the second half of the year, which is why earnings are forecast to be more back-end loaded than has been typical.
It also has forecast that operating cash flow will rise more slowly than revenues while deferred revenue growth will be greater than revenue growth. While not explicitly forecast, it is almost certain that stock-based comp is forecast to grow. Overall, the difference between GAAP and non-GAAP earnings is forecast to be $885 million. Last year the difference was $680 million. It is, I think, reasonable to assume that most of that increase will be coming from stock-based expenses.
That slowing growth syndrome - how does CRM avoid the perils of becoming a middle-aged software vendor?
Despite claims to the contrary by Oracle (NASDAQ:ORCL), CRM remains, basically unchallenged, as the world's largest vendor of applications delivered through the cloud. There is no sign that it is going to be knocked off its perch anytime soon, either by Oracle or anyone else.
There are two basic strategies that the company is following in trying to maintain its growth rate with annual sales forecast to exceed $10 billion. One of them is a strategy of significant product enhancement featuring both AI and analytics. That part of the strategy is one of the elements that will be on display with some level of specificity during the March 7th announcement.
Management during the course of the call said that the Einstein capability already was having a noticeable impact on the company's ability to close large transactions and was a factor that drove Q4 performance overall and in the Sales Cloud in particular. Basically, at this point, analytics and Einstein are the company's growth strategy and its strategy for differentiation. The company made a dozen acquisitions last year and most of them had something to do with enhancing the capabilities in those areas that could be used across the different clouds.
An article like this is not probably the best place to address the question of how successful the strategy can be or will be or how it serves to differentiate the products. I do my own anecdotal checks on things like product performance and user interest. At a worm's eye level, the people who sell Einstein and analytics and have to make the strategy work are pumped. That is to say the strategy is being well received and it is helping salesmen to close large deals and is even adding a sense of urgency to procurement discussions.
I may feel that the company's share price will be constrained until there is palpable progress in terms of GAAP margins, but this company has done as good a job of remaking itself at scale as any I have seen. The positive case for the shares is that the growth rate seen at the end of the last fiscal year can be sustained because of the introduction of new products, including those that will be shown next Thursday.
The other strategy is acquisition. Acquisitions accounted for about 10% of the company's reported growth last year - 250 basis points of revenue in total. As most investors recollect, the shares were pummeled in the wake of an aborted deal to buy Twitter (NYSE:TWTR). The on-boarding of acquisitions appears to have gone smoothly and in particular, the Demandware acquisition is producing more revenue than had been targeted.
The conference call that was held didn't speak about acquisitions and it didn't touch on the new positions that have been established by two groups of activist shareholders. The company ended the year with $2.2 billion of gross cash and $1.1 billion of net cash, even after paying for 12 acquisitions. It is forecasting that CFFO for the year will reach about $2.6 billion and that free cash flow will be $2.1 billion. So, it has a substantial level of cash resources available with which to do acquisitions and it would be very surprising to me if that isn't the strategy it continues to pursue.
The acquisitions it might make are going to continue to pressure margins given that most of the companies being bought will be loss making. I think that the activist investor groups are highly unlikely to see this company adopt a capital return program in the next year - and most probably longer. Investors who buy these shares are looking for the best large-cap growth name in the enterprise software business. They are not likely to find this management acquiescing in either a capital return program or endorsing a strategy that would lead to rapidly rising profitability metrics.
From time to time, contributors to Seeking Alpha suggest that CRM shares need to be sold because they are too highly valued and because the company's growth is slowing and it doesn't make money. I have appreciation for some but not all of the points. There is, what might be called a scarcity value in this name as there just aren't other large cap, high growth names in the IT space and there are plenty of funds that need to fulfill their mandates.
Writing Thursday morning, the shares are priced at $83.06. The latest financial statement shows a fully diluted share count of 700 million, an increase of 4.6% from the year earlier level. That yields a market cap of $58.1 billion. Net cash on the balance sheet was about $1.1 billion, which yields an enterprise value of $57 billion. The company is forecasting revenues of $10.15-$10.2 billion and that yields an EV/S of 5.8X. That is probably a bit less than average for top line growth that is estimated to be 22%, with a significant probability of upside.
The P/E based on the company's non-GAAP forecast for the current fiscal year is 65X. I think it is fair to say that investors really aren't buying the shares because they have a bargain P/E. They do not and will not for some time to come.
As mentioned, the company is forecasting that its operating cash flow is forecast to grow by 205-21% for the year and that would bring it to $2.6 billion. Capex last year was $464 million. The company is forecasting about $500 million of cash flow this year producing a free cash flow estimate of $2.1 billion. That produces a free cash flow yield of 3.7%, perhaps a bit better on a relative basis than other free cash flow yields in the space.
The company is doing better in terms of revenue growth than some observers have allowed for. It has a reasonable strategy to defer falling revenue growth rates. If I were just grading it on the revenue and growth, it would surely get an "A."
It has yet to focus on improving costs and while non-GAAP margins are rising, GAAP margins seem trapped within a narrow band. It simply spends lots of money to sell its products and while it has forged some impressive relationships with many large users, it has done so at significant cost. Part of the issue is the rapid growth in both on-balance sheet and off-balance sheet deferred revenues, which are rising very rapidly and significantly distort the analysis of sales efficiency.
The overall increase in deferred revenue, billed and unbilled of $14.5 billion for a company that reported total revenues of $8.4 billion is extraordinary. Sales employees of this company are getting paid, for the most part, on the creation of annual contract value (ACV), which tracks the proxy bookings numbers. It is one, although not the only reason, why sales expense ratios are high and GAAP profits are non-existent. Absent a more rapid cadence of profitability growth, I think the shares of Salesforce are unlikely to produce significant positive alpha going forward. Still a strong hold for me.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.