Last month's announcement by salesforce.com (NYSE: CRM ) of its pending acquisition of ExactTarget (UNKNOWN: ET.DL ) introduced a new set of worries for those who are trying to make sense of the company's growth potential. While CEO Marc Benioff rather grandiosely described the announcement date of June 4 as a "historic day for cloud computing," some investors were undoubtedly wondering about a much more mundane topic: Whatever happened to fiscal responsibility and liquidity?
A little history
At the end of its last fiscal year, Jan. 31, 2013, Salesforce posted its seventh straight quarterly net loss. While the company is fond of separating out "non-GAAP" earnings to show adjusted positive income, long periods of GAAP losses tend to tell on a company's financial resources -- there's no escaping reality. Balance sheet conditions had deteriorated to a point where the company's current ratio (the ability of current assets to meet current obligations) was upside down, at a worrying 0.69%.
By the first quarter of 2013, the company's current ratio had improved dramatically. Working capital, the difference between current assets and current liabilities, turned from a deficit of $902 million into a surplus of $146 million. How did the company manage such a quick, billion-dollar turnaround in its working capital? By issuing long-term debt, in the form of a convertible senior note offering of $1.15 billion in March of 2013. It turns out that the convertible note issue was in preparation for the ExactTarget acquisition, so the boost to the current assets portion of the balance sheet was simply a temporary phenomenon.
Calling every dollar
On the acquisition announcement conference call, CFO Graham Smith noted: "We exited Q1 with approximately $3.1 billion in cash and marketable securities and we'll finance the transactions through cash on hand, along with a term loan to provide greater financial flexibility in the near term." Documents filed with the SEC show that the term loan is through Bank of America, in the amount of $300 million, and is collateralized by the stock of Salesforce's subsidiaries.
According to the company, another $70 to $80 million of operating cash flow will be consumed as a result of the acquisition. So let's do some napkin math: Salesforce has $3.1 billion on hand, plus another $300 million from Bank of America, which totals $3.4 billion. A more recent acquisition figure filed with the SEC of $2.64 billion, plus the operational cash outflow (let's use $75 million) equals $2.72 billion -- call this the acquisition cash expenditure. When all is said and done, Salesforce will have $680 million of cash left in its coffers. Salesforce should be able to look at its bank balances and sleep well at night after the acquisition, right?
Perhaps the company will need a mild sedative. A large portion of the remaining cash theoretically should be set aside and not used for operations. This is because another set of convertible notes in the amount of $575 million that the company issued in 2010 have been fully convertible by note holders for some time.
Salesforce is properly accounting for this possibility by booking a current liability of $527.8 million, and it needs ready money available in case the notes are converted, in which case it would use the cash to return the remaining principal amount of the notes (before addressing any additional cash or shares owed to note holders due to the conversion feature). The liability will likely remain for the near future. Even though Salesforce's stock has declined nearly 17% since hitting a peak in May, the shares would still have to fall 40% from their current level before the notes moved back into non-convertible territory, thus releasing Salesforce of the current obligation. And as the notes approach their due date of Jan. 15th, 2015, the probability of conversion increases. The company rightly characterizes the notes in its annual report as a claim against working capital.
Let's take a look at the transaction again, factoring in the convertible note claim against working capital. This visual shows graphically how thin Salesforce's cash resources will be, post-acquisition. The numbers shown are taken from SEC filings and are slightly more accurate than the thumbnail math I used above:
Why this deal is curious
The acquisition of ExactTarget is only expected to boost Salesforce's revenue by about 3% in fiscal 2014. This is one of the more curious aspects of the deal. As we have discussed, the acquisition, when complete, will really wipe out Salesforce's already shaky working capital. Is the company over-reaching?
Certainly it is under pressure to continue to fend off a host of well-capitalized competitors. For example, IBM's (NYSE: IBM ) acquisition of public cloud provider SoftLayer was rumored to be in the neighborhood of $2 billion(the deal closed this month and financial terms were not disclosed). But IBM has net working capital of $6.8 billion, and generated $19.6 billion in cash from operations last year. IBM can easily afford to acquire all manner of small cloud companies, from service providers to compete with Amazon.com, to more specialized companies which can tap into IBM's already formidable big data and analytics capabilities, for the purposes of replicating Salesforce's offerings.
Similarly, German software giant SAP (NYSE: SAP ) has $1.1 billion of working capital on hand, moreover, it generates $5 billion of cash flow from operations annually, so acquisitions such as its recent purchase of cloud provider hybris, said to be in the $1.0 billion to $1.5 billion range,really don't impact resources in a substantial manner. What for Salesforce is a huge transaction in taking over ExactTarget is simply a course of business purchase in a relatively new revenue stream for the likes of SAP and IBM.
With its trail of quarterly GAAP losses and a depleted balance sheet, Salesforce has weakened its financial flexibility for at least a year, if not further. Should it need to bulk up its resources, it can always issue more shares, diluting current shareholders, or issue more convertible debt, further blemishing its debt-to-equity ratio. But investors should be very wary of purchasing this stock, especially given its high valuation -- the foundations are beginning to look very weak.
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