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Why The CRM Short Thesis Is Somewhat Alarmist...(Pt. 1)

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

The CRM shorts on Seeking Alpha may get a little uneasy with this article, but right off the bat, let me say, I don't disagree with the premise of shorting CRM. I myself have a short position. But I believe that the most often stated premise for doing so, that the company is losing money every year, is incorrect.

The majority of Seeking Alpha posters that have a negative view on CRM are quick to point out how much money CRM is losing on GAAP basis. The argument may go something like (and now I'm taking serious liberties by paraphrasing, but I don't want to cite any particular individual's post):

"well they may be profitable on a non-GAAP basis, but stock comp is a real expense, and GAAP is the number you should be looking at. If you look at GAAP, and not the fictional non-GAAP number, which is just a distraction by management, then you'll clearly see losses, and not a profit."

I've seen several Seeking Alpha posters make this kind of argument. I've even seen one poster (who I think does pretty good analysis generally) insinuate that this type of activity (i.e pointing to Non-GAAP instead of GAAP) be considered "criminal", while a well-known hedge-fund manager (whom I greatly respect) has also said that he believes GAAP EPS is the correct measure to look at for this company due to the high levels of stock based comp.

But I believe this is very misguided. GAAP is ok in a pinch, it's the best we have, and there's probably no better accounting system, but GAAP almost never accurately reflects the underlying economics of a business. In the case of stock comp., which is of course a true expense, it is very hard to measure. In the case of CRM, the GAAP numbers are particularly whacky. Why? Salesforce.com uses the Black-Scholes option pricing model to value its stock-comp expenses as permitted by GAAP. The Black-Scholes formula does a reasonable job when the stock price is trading around fair value, but the results are loopy and unreliable when the stock price is very far from fair value which I believe is true in the case of CRM.

The reason that the B.S. model works well when the stock is close to fair value, is that the stock price is an input for the B.S model, and what it really does simplistically speaking of course, is to say that the value of an option is somewhat less than fair value of the underlying asset if its at-the-money or out-of-the money.

But this is contingent on the market reflecting a fair value for the asset under consideration (which I would argue it does a majority of the time).

However, when you have a stock such as CRM, which arguably has gotten so much higher than the underlying fair value of the business a premise I assume everyone who is short to begin with may agree with, (incidentally, the current valuation [2/28/2013] on a non-GAAP, ex-excess cash, fully diluted basis is ~80x FY14 EPS), then the black-Scholes model, using an extremely high input for stock-price relative to the operating results, is going to give you an outlandish looking GAAP SBC expense. And the faster the stock rises, relative to the underlying results, (and there is some serious stock promotion being done by Mr. Benioff), the more oppressive the SBC expense will look, even if it has nothing to do with the actual amount of value transfer of company ownership to employees.

In fact GAAP EPS divided by basic share count (dividing by diluted share count is double counting), then becomes a not great proxy for underlying profitability of the business, while Non-GAAP EPS ex-ing out SBC divided by a diluted share count tends to be a little more accurate.

Some of you may not be convinced. I suspect this argument is likely to cause of cognitive dissonance among other posters. I'll try to demonstrate the math is a few simple example in part 2...and then maybe depending on the feedback I get and time permitting, I'll get deeper into the CRM analysis itself.

Disclosure: I am short CRM.