Salesforce: Valuations in the cloud
Tarun is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Salesforce (NYSE: CRM) is a leader in the cloud-based customer relationship management (CRM) area. The company is expected to grow via the network effects of software applications built by independent software vendors on its cloud platform offering (Force.com). Investors like the stock because of the large growth potential of cloud computing and Salesforce’s pioneering work in the area, especially in S-a-a-S and P-a-a-S. But digging deeper, Salesforce’s stock might be on shaky ground due to:
- Increasing competition: Larger well-capitalized players such as Oracle (NASDAQ: ORCL) and Microsoft (NASDAQ: MSFT) have entered the cloud CRM market and are aggressively under-cutting on prices. For example, Microsoft’s Dynamics CRM is being offered at a ~30% discount to Salesforce’s product.
- Due to the nature of cloud computing, customer switching costs are low (especially at the small-to-medium business level). A study by Nucleus Research indicated that it took a medium-sized business about 2 days to transition 100k customer accounts from Salesforce to a competitor.
- Lower than expected sales growth: Sales growth has not kept up with marketing cost growth. This could be because there is little operating leverage to take advantage of and/or the company is spending money on customer retention rather than acquisition. Also as they acquire larger customers, margins should decrease (competitive pricing pressure combined with larger service and acquisition costs).
- Aggressive Accounting: Salesforce has been aggressively transferring a lot of expenses onto the balance sheet (BS) in the hope that as revenues grow they can slowly amortize those expenses over time. The stock option based compensation policy also seems dilutive to shareholders.
- Salesforce might be hiding true costs by accruing large portions of sales commissions on the BS.
- Share dilution could happen based on outstanding convertible debt and employee stock options (the vast majority of these are in-the-money and are being cashed out by top management).
- While non-GAAP results look decent, GAAP results have declined. These non-GAAP results exclude a lot of “capitalized” expenses and are conveniently used as executive compensation metrics. Interestingly, the CEO had touted the company’s GAAP earnings a couple of years ago (when it was positive) but has since decided to concentrate on non-GAAP metrics (as GAAP metrics declined).
Salesforce has grown bookings and revenue at a very fast rate, but there are little earnings to show. Larger well-capitalized competitors have entered the market and challenged Salesforce’s place in the value chain. Meanwhile, management continues to dole out stock options to employees at the expense of shareholders.
Investors have remained optimistic about the stock’s prospects based on the long-term secular growth of cloud computing and Salesforce’s growth in the P-a-a-s market. Investors might also be wrongly assuming that Salesforce has become the dominant cloud platform (this is still undecided). Trading at absurdly high valuation multiples (40x EV/FCF! At this rate if you bought the entire company today it would take you 40 years to recoup your investment, assuming you continued spending on infrastructure maintenance) and negative earnings (2012E eps is -$0.12) means that the stock is priced for perfection. In the current uncertain macro environment, it will take one miss on Salesforce’s part for valuations to fall.
Unfortunately, the market can remain irrational for a long time before CRM’s price corrects downwards. Hence shorting the stock is not recommended at this time. I suggest buying long-dated out-of-the-money put options (which are cheap) and waiting for their price to appreciate based on the stock’s decline. As financials begin to reflect a clear deterioration in company fundamentals, I would short the stock.
Fool blogger tarunp does not own shares in any of the companies mentioned in this entry.
