Greenberg: What if Investors Looked at Salesforce’s ‘Real’ Earnings

Shouldn’t growth stocks grow earnings?

Of course, but it depends which earnings you’re talking about: GAAP or non-GAAP? (Oh, please, Herb, not that dead horse again!), a leader in customer-relationship software, is a poster child of positioning itself as a non-GAAP company. Wall Street obliges by valuing the stock on earnings excluding options and such things as the accretion of debt. These are, after all, non-cash expenses—as if they just vanish into thin air. (Sarcasm, intended.)

But (and I would bold-face this line if I could) they are eventually expenses and “they represent real economic expenses,” argues private analyst Tom Doyle, who used to run a hedge fund (and owns some puts on Salesforce.)

It’s one thing, he says, if the company or investors want to view Salesforce “operationally” without the non-cash expenses; it’s another if shareholders are trying to value the company using the same measure.

Doyle, who writes detailed reports for himself, really comes down hard not on Salesforce the business—he likes it—but on the street’s focus on Salesforce as a non-GAAP story.

“One sell-side analyst that I traded emails with after the third quarter suggested to me that the more he tried to model accelerating revenue growth, the more his expense estimates chewed into incremental revenue,” Doyle tells me. “Or stated differently, he doesn’t see the lack of operating leverage in the business improving in the intermediate term.

“Which comes back to why i got interested in this story on the short side. It reminded me of Amazon in—I think 2005—when investments in revenue growth caused significant declines in operating margins. Unlike this one, the stock traded accordingly: It got crushed.

Not that I consider myself one, but from my understanding what the momentum buyers have historically looked for is revenue growth, accompanied by increasing leverage over operating costs. This company, in contrast seems to be growing revenues largely by driving its expenses higher. It is a real head-scratcher.”

Among key issues investors might want to consider:

Sales are rising at double digits (pretty much in line with Microsoft and Google , which trade at a fraction of Salesforce’s valuation.)

Non-GAAP earnings are also lifting at double-digit rates.

GAAP earnings, by contrast, are inching higher in the low single digit and at a sharply decelerating rate of growth.

Operating margin of this software/clud company is a paltry 8.2%. Compare that with 43% from Microsoft and 35.3% for Google.

And while revenue guidance has been increased each quarter this year, earnings guidance has been cut and remains below where it started the year.

Then there’s cash flow: Ken Hackel of CT Capital, who wrote the book, Security Valuation and Risk Analysis—he’s also a cash flow aficionado—says investors should pay attention to the discrepancy between the fast growth in Salesforce’s free cash flows and the more tepid growth of its profits.

That discrepancy, he says, “evolves from its large growth in subscription revenues, a result of growth in deferred revenues, which provides cash but, because part of the service has not been performed, has not been recognized as income.”

Meanwhile, Salesforce continues to spend heavily on marketing and new bodies, an investment which so far has paid off. But at nearly 100 times expected 2012 non-GAAP earnings, Hackel, Doyle and others don’t believe Salesforce can hold its valuation.

“I have problems recommending purchase in stocks like, despite its successful business model and growth in its free cash flows of 35 percent per year over the past seven years and 11.1 percent compounded annually over the past three,” Hackel says.

“If Salesforce sees growth in free cash flows of 15 percent per year compounded over the next 22 years—a pretty tall assumption—its stock is still only worth just $114 currently. That’s because its valuation is extremely high ($17 billion) with just $250 million in annual free cash flows.”

Doyle thinks that based on current numbers it’s worth closer to $50.

His take: Salesforce has demonstrated little operating leverage on revenue growth that is only “slightly higher than that generated by Microsoft and Google.”

To date, he muses, analysts have looked past the ‘investments dragging down earnings growth.

“And despite all the talk of the ‘cloud,’” he says, “their product is sold the old-fashioned way – through well compensated commission sales people.”

Using CRM software, no doubt.

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