Categorized | Featured, Short Ideas Earnings Fail to Impress (CRM)2010 is likely to be one of those years in which traders who participate on both sides of the tape (both long and short) will have a better chance of succeeding.  Investors in the Sound Counsel Investment Advisers absolute return model are currently weighted with significant short exposure due to the high market valuation and the potential for a second bear market in equities.  One of my highest conviction short positions is (CRM) which reported earnings earlier this week.

ZachStocks Free is one of the leaders in cloud computing technology which helps IT administrators make more efficient use of their resources.  In the past, companies would need to own a server for every major function or individual operating system.  The result was often a room full of dozens of servers which were all running at 20% to 30% capacity.  The situation was an incredible waste until cloud computing technology allowed servers to run multiple systems and efficiently allocated resources between the servers.

It’s easy to see how this exciting technology could lead to growing sales.  After all, large and small corporations could save on IT costs by using the technology.  And that’s why has been able to grow revenues at a steady clip for several years.  Most recently, the fourth quarter revenue was up 22% to 354 million and for the full year the company collected $1.306 billion in revenue which is up 21% year over year.  Earnings were strong with the company posting GAAP earnings per share of 63 cents for the year – an 80% increase over 2008.  But while these figures appear very favorable, it looks like investors have bid the price of shares too high and may be ignoring some of the dramatic risks in the stock.

One of the biggest red flags that I saw when reading the quarterly report was the deferred revenue item.  For companies like CRM which receives 92% of its revenue from subscription and support, much of the revenue is received well ahead of time because of long-term contracts which are paid in advance.  Due to accounting rules, the company is not allowed to record the revenue until service has been rendered – so revenue for future quarters gets allocated to an account called “deferred revenue.”

ZachStocks AdvertisementAt the end of the quarter, CRM had deferred revenues of $704 million – which was only up 19% year-over-year.  While positive movement is certainly a good thing, the company will need to attract a significant amount of new business in order to keep up with its recent sales growth.  The company has 73,500 paying customers which is up 4,600 during the quarter and that performance will have to continue to justify the share price.

For 2010, the company is guiding GAAP earnings between 58 and 60 cents per share.  I found it a little disturbing that CRM offered “non-GAAP” guidance of $1.25 to $1.27 in earnings when it appears that this figure simply does not account for stock-based compensation (there are a few smaller items as well).  To the non-suspecting investor, it might look like the company is really generating $1.25 to $1.27 in additional value for shareholders but stock based compensation truly is an expense and should be treated as such.  Although the company does not have to pay cash for this compensation, the additional shares issued has the very real effect of diluting current shareholders.

Finally, if you look at the current price of the stock ($66.75 as I write), and compare it to the earnings expected for this year, you can easily see that investors are paying 111 times earnings to own the company.  Despite the fact that CRM is growing, the multiple is ridiculous and will almost certainly lead to a sharp decline in the stock sometime in the next year.  I am completely astounded at the valuation and hope to profit when the stock trades back to a more reasonable level.

Thursday’s trade offered some mixed signals for short-term traders.  Initially, the stock gapped down well below the 50 day average as investors digested the earnings report.  But by the end of the day, CRM followed the market back higher to recover much of its losses.  Still, the stock was down on the day on volume that was well above average.  My suggestion would be to buy some out of the money puts on this stock (which are actually relatively expensive) or watch for a clear break lower on volume to set up a short position.  Keep your stop levels tight and don’t be afraid to stop out and then try another short trade when the stock breaks down again.

Other Articles of Interest Shocks Market With Debt Offering
Consumer Confidence Pressures Rebound
Forbes:’s Froecast Falls Short
FMMF: What the Heck is Cloud Computing?

My sense is that eventually this stock will run significantly lower and while the price action will be sharp, it may take several weeks to a few months before CRM finds any significant support.  Damage control remains an important part of investing, but wise and careful shorting of this high-flying Wall Street darling could turn out to be very profitable. (CRM)

FD: Author has a short position in Sound Counsel Investment Advisers accounts

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8 Comments For This Post

  1. inthemoney Says:

    it looks like another PALM, everybody is in love with it, but eventually it will have to go back to reality. I am short CRM as well.

  2. KungFuPanda Says:

    Deferred revenue while providing insight into the future isn’t quite the “tell all” you make it out to be with regards to the company’s backlog of potential earnings. Salesforce’s mix of clients has expanded from traditional SME’s and into larger companies and the very nature of those types of sales and how those companies do business would NOT be to pay 1 year of service in advance especially given the macro economic environment. More than likely these larger organizations who have purchasing power are paying in advance quarterly installments. Therefore deferred revenue is only measuring what has been “billed” to customers that has yet to be earned. There is still a portion of sales contracts for which no billing has yet to occur that isn’t reflected in deferred revenue.

    Subscription companies like Salesforce aren’t poor fits for traditional GAAP rules, too many of the revenues and costs are not matched the largest being sales costs is taken as incurred while revenue is taken out over subscription period which in turns skews earnings and P/E. Companies like this are best measured using FCF’s and renewal rates, if someone’s short thesis is tied to deferred revenue and PE figures, then I question how much someone knows about a SasS type business model.

  3. Bottom Up Investments Says:

    This stock is trading at roughly 39x last year’s free cash flow and they have said that next year’s margins and cash flow numbers are going to be impacted by the investments they are making for growth. That’s fine if you are going to be growing top-line at the rate they were from 2005-2008, but they are only guiding for 15-16% sales and earnings growth. This stock is beyond “priced for perfection,” in my opinion. Only thing that’s supporting them is that it’s a large, liquid pure play on the shift to the “cloud.”

  4. Bernard Lunn Says:

    From today’s market action it seems that Mr. Market is ignoring the short thesis you have here. I tend to look at actual Q-Q revenue growth and that was very impressive and a big surprise to the upside. Re deferred revenue, I think KungFuPanda has the issue nailed. The SaaS trend is to month to month contracts. That reduces Customer Acquisition Cost (CAC) and that is what matters. Churn is less related to contractual status than to how useful it is and how much it becomes baked into work habits. The reality for good SaaS software is that churn is low.
    Yes CRM will be a trader’s stock. 10.5% of float is short. But methinks it will be traders on the short side and people who know SaaS on the long side.

  5. KungFuPanda Says:

    This is my take from some of the info that came out on CRM. (… reported a bookings growth rate of 24 percent, which according to Kaufman Bros. analyst Karl Keirstead was at the high end of investor expectations.) This is huge and just shows that in this down macro-environment people are opting for the lower upfront costs/plug and play SasS platform vs a traditional large and long implementation of enterprise solutions. FYI bookings is the value of the sales contracts sold by CRM sales staff and is the true measure of future revenues, not deferred referred revenue which merely provides for the accounting of timing differences between AR and the earning process.

    To further understand the sales win, (…the company’s “solidly beat” fourth-quarter expectations “across every key metric, driven by the combined impact of increasing sales headcount, improved bookings per head, and abating churn.”) which means CRM took on upfront costs of adding to their sales staff, this larger staff sold more $’s per head AND existing customers continue to renew at high rates.

    What I find crazy is what is being characterized as a negative. (the “key negative” for the fiscal fourth quarter was that margins fell short of his expectations). As I said before GAAP doesn’t present fairly subscription operations, sales costs and never matched or aligned with sales revenues. All the sales costs associated with their increase in headcounts are period costs taken in 4Q with upwards of 90% of the revenue from 4Q sales to be earned in future periods. Because of this GAAP growth (margins/earnings) will always look lumpy rather than smooth . It would appear that some of this lumpy in manifesting itself in future guidance and the company is taking a hit for it which just means to me buying opportunity.

    Growth for a company like CRM is measured very simply: $ contract value of existing customer base + $ contract value of new/upgrade customer business – $ contract value non renewing customers (churn) = $ contract value of new customer base. They sold on the high end of guidance and churn remains low, I call that WIN-WIN.

    Is CRM a value buy? It was sub 50’s but no longer, however it don’t think it’s priced for perfection either. For me the difference breaker will be, the monetizing of the platform upon which the company delivers their service. They have an app-store of their own and the offerings their potentially greatly expand the company’s target market to beyond just the sales organizations of their customers.

  6. Bottom Up Investments Says:

    You are correct. The timing between their revenue recognition and when sales and marketing expenditures hit the P&L are mismatched, and this is weighing on next year’s results. But this dynamic was also why they were able to show such incredible margin expansion last year (they cut marketing and slowed hiring, but their revenue was not impacted because they operate on a subscription basis). So, it cuts both ways.

    I think the concern is that, in order to grow top-line, they will have to keep investing in marketing and sales. Thus, all of the amazing operating leverage that people are expecting several years down the line (which is the only reason why people would by a stock valued as richly as CRM) may not come to fruition. Add in the increased competition coming into this increasingly popular space, and it will be a dog fight to increase or maintain profit margin.

    I actually think that they start buying companies to offset decelerating core earnings growth with accretive (on a non-GAAP basis, at least) transactions. At this point, it will come down to whether they can identify complementary companies and integrate them into their business effectively.

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