Many red flags caused me to short Salesforce.com (CRM)

In my previous article on Salesforce.com, I analyzed the heavy insider selling activity since the start of this year.


Total shares sold by all insiders: 3,027,237 at an average price of $84.

• Every single insider transaction since Jan 2010 is a Sell.
• Shares outstanding has increased year over year due to dilution via stock options. Shares outstanding stood at 107 million in 2005. Currently, there are 134 million shares outstanding on a diluted basis.
• Several of these transactions must be due to exercising stock options. I looked at the ‘shares owned after trade’ in the export from GuruFocus and it contained the same share count even after several transactions for Graham Smith.

In this article, I am going to look at some of the valuation metrics and look at GAAP vs/ non-GAAP earnings. Lets see if the company has high ROE and FCF growth to justify the high valuation placed on the company.


1) Lets start with some valuation metrics for CRM

• P/E = 220
  
  
  
• EV / Sales = 10.8
  
  
  
• EV / EBIT = 100
  
  
  
• EV / EBITDA = 74
  
  
  
• P / Cashflow = 46
• P / FCF = 56
  
  
  

· The closing price for CRM on Sept 20, 2010 was $123.14. (46% higher than the average selling price of insiders since January 2010)


· The diluted GAAP EPS (for the last 12 months) for CRM is $0.56 per share.( you read that right )


· That gives you a P/E of 220. ( Anyone remember 1999-2000 dot com boom )


· Earnings yield (the inverse of Earnings to Price) is a good way to compare stocks to bonds. Computing this for CRM, we get an earnings yield of 0.45%.


· As a comparison, the yield on 10 year Treasury is about 2.7%.


· CRM trades at 10x sales. ( value investors like to buy companies trading at 10x post-tax earnings! What a contrast.)


2) Lets look at the results of last few quarters ( the numbers are presented on a diluted GAAP EPS basis)


· Q1: $0.13


· Q2: $0.11 ( in may the forecast was 7-8 cents)


· Q3: $0.14 - $0.15 ( this is forecasted by the management)


· Full year forecast for the year: $0.43 - $0.45 (on a diluted GAAP basis) (forecasted $0.58- $0.60 in feb 2010)


If i subtract the earnings of the q1 and q2 and projected earnings of q3 from the forecasted earnings for the year,


· Q4: $0.06 ( 45 cents – 24 – 15 = 6) Sounds low. Is Management purposely giving a low number for the full year?


3) Lets look at GAAP v/s non-GAAP numbers


· Full year forecast: $0.43 - $0.45 (on a diluted GAAP basis) (forecasted 0.58- 0.60 in feb 2010)


· On a diluted Non-GAAP basis, EPS forecast is $1.15 - 1.17 ( Forecasted 1.25-1.27 in feb 2010)


Wow, that’s a big difference between the GAAP and non-GAAP numbers. Looking at page 3 of the Q2 earnings announcement, I see that $0.85 is stock based compensation expense. GAAP considers this an expense where as the non-GAAP number ignores this expense. That means the stock based compensation expense is almost 2 times of what the common share holders will earn this year.


That makes me wonder why do managements report non-GAAP numbers? Is it meant to help shareholders see the true results of the business and ignore the effects of one-time non-recurring charges or is it meant to make the numbers look better than they really are? FYI, CRM started reporting non-GAAP numbers from this financial year.


In the previous year, they were happy to report GAAP eps of $0.63 cents. ( which rose 82% year over year)


4) Lets also compare the results with the results of the prior year (on a diluted basis).


· Diluted net EPS in Q2 2010: $0.11 ( compared to $0.17 in 2009 ) down 35%


· Diluted net EPS for six months in 2010 : $0.24 ( compared to $0.31 in 2009) down 22.5%


As you can see, even the most commonly used number by Wall St analysts has been falling significantly. Well, lets give CRM the benefit of doubt and maybe check the non-GAAP numbers.


· Diluted non-GAAP net EPS in Q2 2010: $0.29 ( compared to $0.29 in 2009 ) Flat


· Diluted net EPS for six months in 2010 : $0.59 ( compared to $0.57 in 2009) up 3.5%


Weird!! Even the non-GAAP numbers have been flat or slightly above 2009 number. I wonder how despite such results the share price of CRM continues to march ahead.


· Share price day before release on Aug 19: $96.41.


· Share price after earnings announcement on Aug 20: $112.75. (increase of 17%)


· Share price on 20^th September: $123.14 (increase of 28%)


5) Finally, lets look at ROE, Sales growth, operating cash flow growth.


ROE - FY 2010 : 7.7% ; FY 2009 : 6.5%; FY 2008: 4.1% ;


OCF growth in 2009 : 12.4% (versus NI growth of 136%); OCF growth in 2010: 18% (versus NI growth of 86%)


Sales growth in 2009 : 44% ; Sales growth in 2010: 21%

• For a company with ROE less than 10%, the market has assigned a P/E multiple of over 200.
• Sales growth seems to have slowed to 20% (and possibly slower this year to 15-17%). The market has assigned a Price / Sales multiple of 10x.
• Not many analysts seem concerned with the faster growth in Net Income compared to Operating Cash Flow. ( The Operating cash flow is greater than Net Income which is good. However the pace of growth in OCF is much slower than the growth in Net Income).
• Management likes to report Deferred Revenue in earnings announcements off late rather than the EPS number. Deferred Revenue of $683 million, up 24% Year-Over-Year

Conclusion: Shares of Salesforce.com appear to be significantly overvalued. Along with that there are several other red flags that I have presented above. Salesforce.com may well be the best thing since slice bread and it may well have one of the best technologies in the modern era of ‘Cloud Computing’. However, a good company is not necessarily a good investment. I like to believe that long term returns in the stock market are determined by the price you pay for an investment. If you over-pay for any investment, then you are likely to be disappointed with your returns or you may have to adhere to the greater fool theory.


Shorting on valuation alone is a tough one. However, I think there are more red flags than just high valuation. I welcome comments and feedback. Disclosure: I am short CRM.