MorningWord 5/22/14: Mostly Cloudy

by Dan May 22, 2014 9:14 am • Commentary

In early May we initiated a defined risk near term bearish trade on CRM (here) with the idea that it would take a monster beat and raise for the stock to rise on Q1 results, despite its already 20% decline from the all time highs made in late February.  As far as we see it, there is nothing wrong with Salesforce the company – they are a first mover in what is amounting to be one of the largest secular trends in enterprise software in decades, led by what many feel is an exceptional new breed tech CEO.  Our gripe is the hype around the SaaS business model, and whether it should command a dramatic premium to prior software sales models for publicly traded companies.

As an active market participant since the late 90s, I have see my share of mini valuation bubbles form and pop and obviously there have been more egregious examples than that of SaaS stocks of the last couple years.  But it is my view that analysts and bankers dreamed up new found metrics to value this “game changing” style shift in how companies would merely sell their software, for a sector that lacked little excitement for a decade.

The price action of CRM, NOW and WDAY since their recent tops is not indicative of their recent results, merely a change in investor psychology – what they are willing to pay for rapid sales growth with little earnings attached.

Despite what looked like a beat on more than a handful of metrics in CRM’s Q1 results reported Tuesday night, there were two analysts with Buy ratings who lowered targets due to continued expectations for multiple compression in the space (currently 38 Buys, 3 Holds and 5 Sells), and one Sell who reiterated his view, as detailed by Barron’s Tech Trader Daily Blog in a post yesterday:

Goldman Sachs’s Heather Bellini reiterates a Buy rating, and a $74 price target, noting that “All key metrics showed upside versus expectations,”

She does note that a couple things were lighter than expectations, such as the bookings growth projected this year and the implied cash flow from operations:

F2Q15 deferred revenue was forecasted to be roughly flat sequentially, implying a balance of $2.32bn or growth of 30% yoy. This compares to consensus ahead of the print of $2.34bn (+31%). As such, implied bookings growth was forecasted to be +28% yoy versus the Street at +30%. CFO was forecasted to rise ~10% yoy, implying $210mn, which compares to consensus of $221mn.

Bellini raised her fiscal ’15 revenue estimate to $5.34 billion from $5.3 billion, while maintaining her 28-cent EPS estimate.

But she sees multiple compression for the stock along with peers:

We reiterate our CL-Buy on and are maintaining our 12-month price target of $74 as we roll forward our price target to CY15 estimates and hence lower multiples given peer group compression. We continue to view the company as the preeminent SaaS vendor with significant runway ahead as it successfully expands into adjacent markets. At $53, CRM is trading at 32x and 27x our CY14 and CY15 forecasted CFO of $1.65 and $1.97 (prior $1.65 and $2.13). This compares to consensus prior to the print of $1.63 and $2.15.

Canaccord Genuity’s Richard Davis reiterates a Buy, but cuts his price target to $65 from $80, even though he rasied his fiscal ’15 expectations to $5.33 billion and 51 cents a share from a prior $5.28 billion and 50 cents.

Davis was encouraged by things such as a pick-up in sales in Asia and low customer attrition:

Revenue in the Americas grew 39% y-o-y, accounting for 71% of total revenues. Europe and Asia grew 35% and 26% from a year ago at a constant currency, accounting for 19% and 10% of revenues respectively. Asia showed a nice uptick in growth, compared to recent quarters. Retention continues to improve. CRM’s dollar-based attrition was again in the high single digits, marking the firm’s 19th consecutive quarter showing sequential improvement on this front. Margins continue to reflect modest ExactTarget dilution. Margins continue to reflect the acquisition of ExactTarget, with gross margins down 70bps to 79.5% from a year ago and non-GAAP operating margins down 80bps from a year ago to 9.7%.

Nevertheless, his new target reflects broad contraction in software multiples:

We are slightly lowering our CRM price target to reflect the broader valuation correction in cloud software. Our new $65 target is based on a 6.3x EV/revenue multiple and 40x EV/FCF based on our F2016/C2015 estimates plus roughly $1.2B in prospective net cash and assuming ~650M shares outstanding.

On a much more negative note, Cowen & Co.’s Peter Goldmacher reiterates an Underperform rating, and a $29 price target, writing that it’s not really clear how much organic growth the company is producing, given acquisitions such as Exact Target, and he is concerned productivity may be declining:

The inconsistent reporting of the moving parts in the model including the impact of M&A (ET details not provided for the year-ago quarter) and lengthening invoice durations make it difficult to determine organic billings and productivity growth. Based on ET’s low-double digit boost to metrics last quarter (4Q) and on our estimate for the balance sheet impact of annual invoicing, we estimate that productivity (billings/year-ago period S&M spend) likely declined organically in the low single digits, while organic billings growth was likely in the mid-20% range. We continue to believe that CRM’s products are solid and the market is large, but we remain concerned that management’s focus on driving top line growth even in the face of diminishing returns will be problematic when the stock transitions from a growth story to a margin story.

It’s the last line that matters the most – “when the stock transitions from a growth story to a margin story.”  It’s very hard to say when that will happen.  AMZN is a case in point.  The stock is trading only 25% above where it was trading in mid-2011, but at one point in January was at a much higher level.  Very little has changed at AMZN the company, but AMZN the stock finally reflects investor fears about the transition from a top line growth story to a bottom line margin story.

We are generally skeptical when a company fails to improve profits for many years even as the top line grows quite quickly.  AMZN has increased sales by 6x since 2007 but profits are flat.  CRM has tripled sales in the past 4 years, but EPS is only up by 50% (and off of a very low base).  In these types of situations, while the investment community focuses on scale and eventual profits, we prefer to see the bottom line reflect some of the long-term optimism.  In rare cases, the scale will matter, and profits will eventually catch up to valuation. But in most cases, the lack of profits reflects the reality of a low operating margin business and significant competition, rather than a need for scale.  In CRM’s case, we choose door number 2.