What happens when investors expect perfection from the companies they are invested in?  Chances are, those expectations will eventually be disappointed and investors can realize that the level of confidence is unrealistic.  This appears to be the case with Salesforce.com (CRM) which is trading 4% lower in early trading after announcing earnings last night.

Earnings per share grabbed most of the attention with the company posting a 100% increase and booking $0.16 per share for the quarter.  The revenue figure was much less impressive with an increase of just 20%.  Salesforce is at a critical juncture where revenue has grown to a place where it exceeds fixed costs, so small increases in the revenue base can have a much larger impact on earnings (on a percentage basis).  The million dollar question is whether the company will be able to continue to keep costs low in order to leverage their revenue growth.

While management tried to put a positive spin on the forward guidance, there were some significant red flags which will likely cause further selling in the stock.  First of all, the level of deferred revenue dropped from Q2 to Q3.  This is significant because CRM has many long-term contracts with customers where the client pays an up-front fee and then CRM offers service for several quarters or even several years.  This up-front payment cannot be booked as revenue because CRM has not actually performed the service yet.  Instead, the payment goes to an account called deferred revenue which then is recognized as revenue slowly over the coming quarters.

If the level of deferred revenue is dropping, this has negative implications for future revenues and earnings.  Essentially, this means that the company sold less in the way of new agreements, than it completed during the quarter.  If this happens too many times, we will eventually see a decline in revenues which would be bad news for this high priced growth stock.  The other takeaway from the decline in deferred revenue, is that the economy as it pertains to business spending may be recovering more slowly than many anticipate.

The second red flag relates to the headcount of employees which is a major portion of the company’s overhead expenses.  During the third quarter, management stated that an additional 160 sales representatives were brought on board to help grow revenue during the fourth quarter.  Additionally, the company expects to hire another 160 representatives in the fourth quarter in what appears to be a dangerous bet that the additional headcount will pay for itself in the form of new business.

To its credit, the company did land an additional 5,000 customers which brings the total client count to roughly 70,000 relationships.  It appears that low attrition rates also point to the fact that customers are happy with the service and CRM is providing value.  Salesforce and Cisco (CSCO) are set to announce a new product in January which will be instrumental in connecting call centers with customers.  That product launch could significantly add to revenue which appears to be what investors are betting on.

Tuesday, the stock closed above $65. which is quite a hefty price considering the company is expected to earn 62 cents per share this year (fiscal year end is January 31) and 84 cents next year.  Assuming these analyst expectations are correct (and I wouldn’t be surprised if they are revised lower this week), investors are willing to pay more than $77 for every dollar the company earns.  That’s an incredible price which is very difficult to justify.

It has been difficult to act on short ideas this year as the market continues to trade higher regardless of the fundamental underlying issues.  CRM could certainly continue to trade higher in the short-run as management does a good job of creating excitement.  But the risk is very difficult to overlook and at some point soon I expect CRM to give up a good bit of its gains.  The 200 day moving average is currently at $45 which still seems like an aggressive stock price for the earnings level.  So watch for volatility and short at your own risk, but don’t be surprised if this stock loses 1/3 to 1/2 of its value over the next two quarters.

FD: Author does not have a position in CRM

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