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Jacob Wolinsky
Jacob Wolinsky
Articles  | Author's Website |

Whitney Tilson Explains Why He Is Short SalesForce.com

February 25, 2011 | About:

Speaking of a stupid market, there’s a company that reported yesterday after the close. Before I tell you the name, let me give you some facts and let’s see what you think it’s worth:

It had Q4 net income of $11 million ($0.08/share, down 50% YOY) and 2010 net income of $64 million ($0.47, down 25%), and gave guidance for next quarter of a small loss ($0.01-$0.02) and for next 12 months of $0.08-$0.11, down another 75%+ from the last 12 months. Even using the company’s pro-forma earnings (which exclude massive “stock-based expense”), last year’s earnings were $1.22, up 6% YOY, and the forecast of the next 12 months is $1.35-$1.38.

On the plus side, the company’s customers love the product and it is growing rapidly: revenues were up 29% and 27% in the last quarter and year, respectively, with TTM revenues of $1.7 billion. Also, operating cash flow was $166 million last quarter and $459 million last year, vs. only $31 million and $91 million, respectively, in cap ex. Thus, free cash flow last quarter was $135 million, equal to 30% of revenues ($457M in Q4), so at least on this metric, it appears to have high margins. Finally, the company has $1.4 billion in cash, short-term marketable securities, and noncurrent (long-term) marketable securities (equal to $10/share), with no debt.

So how much might this rapidly growing, high-margin (maybe) company be worth? Before you answer that, you might want to know that the gorilla of the industry, with more than 40x this company’s sales, is making a big push with a directly competitive product which is now available in 40 markets and 41 languages at ½ to 1/3 of the price.

Also, the company gives out stock options by the bushel, such that the share count rose 7.3% YOY last quarter, and the CEO, through 12/31/10, had an automatic selling program in place and was selling stock every day the market was open valued at more than $1.3 million (more the double the company’s total profits per day). Overall, the company has the second-highest insider selling of ANY company in the U.S. market.

So what’s it worth? Call me old school, but I think GAAP earnings matter and I think ALL compensation is an expense, whether it’s in the form of cash or stock options. But the company basically has no GAAP earnings to speak of, nor is it expecting any this year, so let’s give the company every benefit of the doubt and use its pro-forma earnings: $1.22 trailing and $1.38 (the high end) for this year (up a mere 13%). What would be an appropriate multiple? 20x? 30x? Using 30x x $1.38 = $41.40 plus $10 in cash = $51.40. As I write this, the stock is nearly 3x this at $141.80, giving it a market cap of $20 BILLION and EV of $21.4B.

Let’s be even more generous and use free cash flow, and let’s annualize $135M of FCF in Q4, so that’s $540 million. Put a 20 multiple on this and that’s $10.8 billion, plus cash equals $12.2 billion, just over half of the current EV.

The company, of course, is Salesforce.com, which is one of the leading stocks in the cloud computing bubble. Ferris, in his newsletter, Extreme Value, summarizes it nicely:

Aside from the hypergrowth that has long since disappeared, Salesforce's irrationally exuberant price tag also seems to assume zero competition. But hypergrowth is gone precisely because competitors are eating into Salesforce's market share.

It's no mystery what's bringing the competition out of the woodwork: Salesforce's fat gross margins. The company gets 90%-plus of its revenue from subscriptions and support. That part of the business earns 85% gross margins. (Another revenue source, called professional services, is less than 10% of sales and loses a couple million dollars every year.) Everybody in the industry is after a piece of that recurring subscription revenue at 85% margins. Big margins attract large, well-financed competitors the way drug rehab centers attract celebrities. In fact, Salesforce has attracted the biggest, best-financed, most ruthless competitor in the industry… the 800-pound gorilla of global software. Microsoft just announced plans to eat Salesforce's lunch. A couple weeks ago, Microsoft said its CRM software, Dynamics CRM, was available in 40 markets and 41 languages. It also said it would offer Salesforce and Oracle CRM customers low promotional pricing for the first 12 months if they agreed to sign a one-year contract by June 30. Microsoft is charging $34 per employee per month, versus Salesforce's Professional edition at $65 per employee per month and Enterprise's edition at $125 per employee per month. Oracle's CRM on Demand starts at $75 per month. If someone told me I was being undercut by the makers of Microsoft Office, I'd need two things immediately: Plan B and a clean pair of shorts

Microsoft Dynamics CRM is integrated with Microsoft Outlook, the hugely popular email application, and Microsoft Office. The latest version of Office is the fastest-selling one ever, and there's now a cloud version called Office 365. And while Salesforce might have a lot of valuable applications, and might still have a more robust and popular CRM product than Microsoft, it doesn't have Microsoft Office.

In addition to Dynamics CRM, Microsoft has done several cloud computing deals lately. It recently signed a five-year, $100 million cloud computing deal with the New York state government. The contract covers 120 departments and 100,000 personal computers. Microsoft did a similar agreement with the California state government, covering 200,000 employees. It signed a deal with the Minnesota state government covering 33,000 employees, and another with DuPont.

Other large firms are in cloud computing, too… …If you still like Salesforce, know this: its management hates it. Salesforce CEO Marc Benioff sold 10,000-plus shares of stock every trading day in 2010. He's not the only one selling, either. According to market research firm Vickers Weekly Insider, Salesforce is the second most actively sold stock by insiders. In the past 90 days, insiders dumped over 583,000 Salesforce shares in 128 separate transactions (exceeded only by cell phone provider MetroPCS Communications, with 350 insider sell transactions).

We are short this stock, and we have been wrong so far (though not nearly as painfully as NFLX, as we started shorting it more recently and it’s not one of our largest shorts today because we’re waiting for the fundamentals to crack). If we’re wrong on this, we REALLY want to know it, so please email me if you can make a reasoned case that this stock is a bad short.

Disclosure: None

About the author:

Jacob Wolinsky
My investment ideas have been inspired by many of value investors including Benjamin Graham, Charles Royce, John Neff, Joel Greenblatt, Peter Lynch, Seth Klarman,Martin Whitman and Bruce Greenwald. .I live with my wife and daughter in Monsey, NY. I can be contacted jacobwolinsky(AT)gmail.com and my blog is www.valuewalk.com

Visit Jacob Wolinsky's Website


Rating: 3.4/5 (16 votes)

Comments

Adib Motiwala
Adib Motiwala - 7 years ago    Report SPAM
Jacob,

I had written two articles covering CRM as a short idea in depth.

http://www.gurufocus.com/news.php?id=107633

http://www.gurufocus.com/news.php?id=107724

I agree with everything Mr Tilson states. However, as we have seen with NFLX, just because a stock is over valued and insiders are selling and profits are down, does not mean it will correct any time soon.

I closed my short position with a tiny gain and am focusing my energies on the long side instead.

Alex Morris
Alex Morris - 7 years ago    Report SPAM
Jacob,

Thanks for posting. Did he say this on the conference call? Do you have a link by chance? Thanks!

"Salesforce CEO Marc Benioff sold 10,000-plus shares of stock every trading day in 2010."

All I can say: WOW
Adib Motiwala
Adib Motiwala - 7 years ago    Report SPAM
Well, he does own a lot of stock (maybe 8-9 million shares) and it would take him 3 more years of selling 10,000 shares a day to sell out.. Atleast that is what I remember from my prior research.
yswolinsky
Yswolinsky - 7 years ago    Report SPAM
Thanks Alex, I got it from his email. I know he does not mind it being reposted, and figured the readers would enjoy.

Thanks Adib, one important lesson I learned (although thankfully not through personal experience!) is never short a stock based on valuation alone. I do not short, but if I did I would be looking for companies that seem to be inflating earnings assets etc. or committing outright fraud, I would never short a stock with a high PE. If you shorted based on valuation anytime in the mid to late 90s you likely got crushed.
Jess1ca4
Jess1ca4 - 7 years ago    Report SPAM
Jacob,

Have you actually seen or tried either Salesforce's or Microsofts' solution? Or, have you asked the customers of these two respective companies how they compare? Better yet, have you asked any one at Salesforce why there is so much insider trading?

Salesforce customers pay the upfront "premium" because it is that much better. At the end of the day, if you have low user adoption or huge back end costs like you do with the other applications, I don't think it matters how inexpensive something appears upfront.

I was once a customer and now I work for Salesforce and I can tell you that management LOVES it. In fact, we all do. And we use our own product - the reason we are growing so quickly. I have worked at other software companies like Microsoft and this is just a better product. It is easy to sell, easy to integrate into your other solutions (Microsoft or not), easy to use, easy to build new applications on the force.com platform.

11 years ago we actually took Microsofts' lunch. They are now just realizing that perhaps the cloud is more the future, instead of forcing their customers, big or small, to spend numbers close to 100k on hardware, servers and inhouse engineers, and then spend more for each upgrade, features, and customizations. They have a long way to go to catch up to us because they haven't yet figured out how to develop their software on easy open code.

If you like Facebook, you will like us. We are consistently growing because our customers love us.

As I am in the process of completing my MBA, I know that you are either missing or miss-reading key information. That's why your numbers are not adding up. I think you know this though, based on your comment: "we have been wrong so far".

In any event, I recommend you try us out to get a better understanding.

Cheers,

Jess
yswolinsky
Yswolinsky - 7 years ago    Report SPAM
Hi Jess,

Thanks for your response.

I would first like to ask you if you do not mind if work in the PR department for Salesforce. If you do not, do you have company stock options? I am unbiased as I have no position in the company. I do have a personal benefit when people read my articles, but besides that there is no big money involved, and therefore I consider myself a neutral observer.

Second, I did not write this analysis I was posting analysis done by Whitney Tilson. However, while I do not short (especially based on valuation), I see the stock is trading at a very high valuation, according to almost any common metric used. While you point out the salesforce is a great company, there is a difference between a good company and a good stock. In fact, numerous studies have shown that bad companies at low valuations outperform good companies at high valuations. You can read this excellent free booklet from Tweedy Browne, here is the link-http://www.tweedy.com/resources/library_docs/papers/WhatHasWorkedInInvesting.pdf

I wish you success in your future endeavors.

Regards,

Jacob
Adib Motiwala
Adib Motiwala - 7 years ago    Report SPAM
Jess,

Can you kindly point out what key numbers we are missing / misreading? And which numbers are not adding up?

The article presented factual information, mostly covering valuation, earnings decrease, sales increase, cash flow and the insider selling.

We would like to hear the other side of the story which would include information such as how the profits and margins and cash flows are going to increase to justify the valuation.

- Adib

Jonathan Poland
Jonathan Poland - 7 years ago    Report SPAM
Regardless of whether Salesforce.com offers a great service or not, the stock is over priced, trading with a current P/E of 250 and a forward P/E of 75. "Don't mistake social progress for a good investment." Whitney Tilson doesn't need to explain why he's shorting it, the answer is pretty simple. But, therein lies the problem, because even a company trading at an outrageous valuation can continue to appreciate. I think this is why Buffett never shorts stocks. And, Jess... really with trying to push your product on here!?

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