In December of last year, ZachStocks urged caution on Salesforce.com (CRM) as the stock appeared to be over-priced with an economic backdrop that caused concern.  After the article was published, readers had an opportunity to bag a 27% gain over the next two months as the stock dropped from the mid 30’s to the mid 20’s.

As the current market begins to rally, Salesforce is once again trading at a price that appears unsustainable.  Investors are hopeful that a recovering economy will drive users to subscribe to CRM’s cloud computing offerings which allow companies to use programs that would typically be very expensive to install – on a per user, or per login basis.

The business model is certainly attractive, especially in a difficult market environment where small and large businesses alike are looking for opportunities to cut costs.  The company has seen revenues grow significantly quarter after quarter, and management is very proud to have crossed the $1 billion mark in annual sales.  However, the rate of growth for the company has begun to slow and that may be more concerning than some investors believe.

The last four quarters have seen revenue growth of 52%, 49%, 43% and finally 34% for the last quarter.  Using the high point of management’s guidance for the first quarter, we can expect to see revenue growth of 23%.  Now I know that it is impressive to be growing revenue at all in this type of market, but as investors we need to be aware of this trend of decelerating revenue growth.  Regardless of the economic environment, it becomes much more difficult for a billion dollar company to grow exponentially compared to a younger startup.

Lately some concerns have been expressed regarding the cash-flow trends as well.  Since Salesforce.com receives the majority of its revenue from its subscription and support segment (91.8%), it can be concerning when cash flow numbers begin to drop.  In this case, the company could still report strong revenue for a time as past subscriptions continue to be recognized in subsequent periods.  But it is harder to mask this weakness when looking at cash flow numbers which were disappointing this past quarter.

Deferred revenue is a helpful metric in determining future revenue.  This is revenue customers have already paid for subscriptions.  The deferred revenue came in below expectations which is just another metric that shows how difficult it is becoming to win new business.  Now the company is sitting on $883 million in cash and securities and has essentially no debt.  That should add stability to the company, but does not necessarily justify the extreme stock price.

Management has begun to reduce guidance for Fiscal Year 2010 (the year end is Jan 31).  At the same time, however, headcount is increasing as new sales positions are filled.  The hope is that the additional employees will allow Salesforce to reach out to a broader client base.  But the investment could be risky in such a difficult economic period.

At this point last year, the company was very vocal in its excitement over new financial services clients.  However, these “all-star” clients like Citigroup (C), American International Group (AIG), and Genworth Financial (GNW) are now in the cellar and no longer represent the strong customer base CRM was trying to build.

While Salesforce.com is certainly a strong, viable company; the stock as an investment still looks extremely dangerous.  If I were to apply what could be considered a “generous” 25 multiple to this year’s expected earnings, the stock price would only reach $13.75.  The current price in the mid 30’s just doesn’t make sense.  I would recommend shorting CRM or possibly buying puts to benefit from a drop in the stock price.  Timing could be difficult as the strong market can continue to prop up this name, but over the next 6 months I expect to see much lower prices.

Chance to Short with Spread Trading

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FD: Author does not have a position in CRM
CRM Notes
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