I wrote an article a couple of days ago that talked briefly about Salesforce.com (CRM). The company recently posted their 10-Q, so I thought it would be a good exercise to work through it and see if we could find anything interesting:
The company ended the quarter with about $1.4 billion in cash/equivalents and marketable securities, down slightly from $1.45 billion at the start of this fiscal year; current assets have decreased by more than $400 million over that same period (to $1.25 billion), while total assets have increased by more than 11% to $4.6 billion – this is more than entirely due to the goodwill account, which doubled to $1.5 billion as Salesforce continued to purchase companies for significantly more than their net asset value (for example, GoInstant Inc. and Rypple, two recent acquisitions of more than $50 million, each had less than $1 million in net tangible assets). On the liabilities side of the balance sheet, the picture is essentially unchanged over the past nine months.
Looking at year-to-date figures on the income statement, total revenues have increased 35.5% to $2.2 billion; this was driven by the Americas, with both Europe and Asia/Pacific growing at less than 30% year over year. At the same time, cost of revenue has increased 42%, resulting in a comparatively slower increase in gross profit of 33.7% – and a decline in gross margin of 100 basis points.
Operating expenses also outpaced sales growth (up 37.7%), with marketing & sales expenses increasing 40% to $1.18 billion. As a result, the operating loss through the first nine months has more than tripled, reaching $90 million; after accounting for interest expense of more than $20 million and other income/expenses, the pre-tax loss for fiscal 2013 has eclipsed $100 million. After tax, the result was even worse, due to the following:
“The Company regularly assesses the need for a valuation allowance against its deferred tax assets. In making that assessment, the Company considers both positive and negative evidence related to the likelihood of realization of the deferred tax assets to determine, based on the weight of available evidence, whether it is more-likely-than-not that some or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, the Company considers its cumulative loss in recent years as a significant piece of negative evidence. As a result, in the third quarter the Company determined that the negative evidence outweighed the positive evidence as of October 31, 2012 and recorded a one-time, non-cash charge to income tax expense in the third quarter of fiscal 2013 in the amount of $149.1 million to establish a valuation allowance against a significant portion of its July 31, 2012 deferred tax assets balance.”
As expected, CRM shareholders continue to be diluted and hold a diminishing claim on the overall pie: Year over year, diluted shares outstanding have increased 4.7% to 142.2 million; this is up more than 15% from the start of calendar year 2009.
Moving to the cash flow statement, we start with a year-to-date net loss of $250 million. The key items as we work our way to cash flow from operations are depreciation and amortization (up $159 million), expenses related to employee stock plans (up $272 million; this is more than 3x the total for ALL of fiscal year 2010), and monetization of accounts receivable (up $271 million); collectively, net cash from operations comes in at $455 million. Looking at investing activities, the company has spent $575 million on M&A and $125 million on capital expenditures through the first six months of the year, a total outflow of $700 million. By the way, this isn’t out of the ordinary – M&A is a recurring piece of CRM’s capital allocation, and has averaged about $350 million per annum since fiscal 2010. The point is this: Even if we let Benioff & Co. lump stock-based comp expense into our measure of free cash flow, it’s still fighting to stay in the black after accounting for capex and normalized M&A spend.
Something interesting in the 10-Q that’s been previously reported is the company’s real estate purchase in California - in November 2010, the Company purchased approximately 14 acres of undeveloped real estate in San Francisco. The Company capitalized pre-construction activities related to the development of the land, including interest costs and property taxes, totaling $5.7 million. During the first quarter of fiscal 2013, the company suspended pre-construction activity, and “continues to evaluate its future needs for office facilities space and its options for the undeveloped real estate.” A spokesperson for CRM said the following at the time of the announcement: “"We have a great problem, which is that we're growing faster than we anticipated at the time we bought the land. We're going to need space sooner than we can build it."
One more noteworthy comment, this one from the conference call – here’s what was said on the second quarter call: “Nevertheless, with our strong Q2 and first half cash flow, we still expect full year operating cash flow growth in the low-20% range.” On the Q3 call, here’s what management had to say: “For the full year, we expect operating cash flow growth of approximately 20%.”
Obviously that’s a small change, but a change nonetheless. When asked by an analyst whether this had changed, CFO Graham Smith said, “Yes. I think we've got guidance for full year operating cash flow of around 20%. Obviously, we had a big $40 million boost in Q4 last year from the multiyear invoice. But we're comfortable with the 20% operating cash flow number for the full year.” In case you missed it, that’s called dodging the question; again, this is small – but for a company that sets public targets to the single-digit millions of dollars ($3.041 billion to $3.046 billion) and never fails to mention an increase in guidance, I doubt they actually forgot the figures they trotted out on the third quarter call (and the boost in last year’s fourth quarter was known about 90 days ago).
For most market participants, this is all irrelevant because Salesforce has the trinity of buzzwords – cloud computing, social and mobile. For those individuals looking for concrete signs of business progress, revenue continues to grow at a rapid clip – a necessity to justify anything near this valuation; whether or not this can continue for years to come, and eventually result in outsized profitability, is to be seen.
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As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.