The Hidden Costs of Salesforce.com's Strong Revenue Growth

Salesforce.com's (NYSE: CRM  ) pervasive use of stock based compensation ("SBC") has been widely covered in the media and is a frequent topic of conversation on Motley Fool and other popular investor message boards, even as it is regularly ignored by Wall St. analysts. That said, there are two key points that I believe are worth highlighting further, as they aren't apparent to those who haven't spent time digging into the footnotes of SEC filings.

The structure and magnitude of Salesforce's stock compensation is changing
The first point requires us to realize that the term "stock based compensation" includes more than simply options. In Salesforce's case, SBC actually consists of a combination of standard options, restricted shares that vest over 4 years, and an employee stock purchase plan (ESPP) which began at the end of 2011 and functions similarly to options (details here for those interested).

The table below details the number of shares of each (adj. for splits), as well as their value, that have been issued over the last four years. Notice how dramatically compensation has been shifted from options to restricted stock.

 

FY10

FY11

FY12

FY13

1H FY14*

# of Options Issued (mm)

13.92

12.48

9.92

8.36

4.56

Value ($mm)

86.0

152.0

122.0

108.2

50.5

# Restricted Shares Issued (mm)

2.48

7.12

11.52

13.72

2.84

Value ($mm)

29.6

191.7

350.9

517.1

123.5

# ESPP shares (mm)

0

0

0

0.74

0.35

Value ($mm)

0

0

0

33.6

13.6

Source: Salesforce.com SEC filings

*not directly comparable to annual numbers because majority of grants take place in Q4

This leads to two quick conclusions: First, Salesforce's assertion (and Wall Street's tacit agreement) that "non-cash" SBC should be disregarded when valuing the company's earnings stream holds even less water than it did before, and secondly management's expectations of future stock appreciation may be growing less enthusiastic.

When they are granted, options are valued based on a theoretical (though widely accepted, and Nobel Prize winning) model, but nonetheless from an employee's perspective, they have a reasonable chance of expiring worthless if the stock stays level or declines. On the other hand, restricted shares are guaranteed to have some real cash money value unless the stock goes to 0 – remember, they are actual shares, not the right to buy them at a particular price.

While restricted shares have more guaranteed tangible value, if you are truly optimistic about a stock, you would prefer to own options because the baked in leverage means that starting with equivalent dollar amounts of each, options will be much more valuable than shares if the stock goes up. Read into the fact that management is increasingly opting for the latter as you choose.

Either way, if you believe that Salesforce.com's salespeople, who are some of the best and highest paid in the industry, don't consider options and restricted shares to be a meaningful part of their salary, I've got a bridge to sell to you. The company itself admits as much, in a line that started appearing in all of their SEC filings beginning with the 2012 annual report:

In the case of stock-based expense, if we did not pay a portion of compensation in the form of stock-based expense, the cash salary expense included in costs of revenues and operating expenses would be higher which would affect our cash position

Accounting rules mean today's SBC expense reflects yesterday's news
The second under-recognized aspect of SBC expenses is that, as reported, they are actually backwards looking. This is because the amount you see on the income statement reflects the amortized vesting portions of grants issued over the prior 4 years. Again, this is the case for all companies, and wouldn't be super concerning except for the fact that Salesforce.com's pace of grants has greatly accelerated in the last several years, so the already high 12% of revenue taken up by stock grants (as shown on the income statement) significantly understates current reality. As the table below shows, in recent years the value of SBC actually issued in a given year is running closer to 21%-23% of revenue.

 

FY10

FY11

FY12

FY13

1H FY14*

Revenue ($mm)

1076.8

1305.6

1657.1

2266.5

1849.7

Expensed SBC (GAAP)

% of Revenue

6.8%

7.3%

10.1%

12.4%

12.2%

SBC granted during period

% of Revenue

8.9%

20.7%

20.9%

23%

10.1%

Source: Salesforce.com SEC filings

*not directly comparable to annual numbers because majority of grants take place in Q4

In large part due to the ExactTarget acquisition, that number will likely be much higher this year. 10.1% of revenue has already been spent on grants in the first half of this year, compared to 3.6% in the first half last year, and this is before the fourth quarter when the vast majority of grants take place.

Should you be buying what Salesforce.com is selling?
Despite impressive revenue growth, in real economic terms, Salesforce.com is a 14-year-old company with annual sales of $4 billion which isn't earning any money. You, the shareholder, are going to have to continue to pay employees either with cash or through dilution. Even if the company cuts back hiring significantly without tanking revenue growth, eventually achieving non-GAAP margins of 35% at "maturity" – a big "if" that, per their investor presentation earlier this week at Dreamforce, management says is at least 10 years in the future – in economic reality, that number will be significantly lower.

This begs the question, why invest in Salesforce.com when instead, you could look to a company like Google (NASDAQ: GOOGL  ) ? In exchange for 10% lower excepted revenue growth (18% vs. 28%) you get an entrenched market leader that has real GAAP operating margins of 23% (including the money losing Motorola business; Google's core business has even higher margins of 34%), trading at a 20x 2014 estimated earnings compared to 108x for Salesforce (the point of this article non-withstanding, we are forced to draw a non-GAAP comparison because Salesforce's GAAP earnings are negative and thus it's P/E is infinite)

At the very least, if you are going to be involved with this stock, already up 30% YTD, be sure to tread lightly. Though hard to say when, at some point revenue growth will not be enough to appease institutional investors and margins/profitability will come into focus. Given the current losses and the fact that management's own estimates imply that, when stock compensation is included, 10 years in the future the company will still be less profitable than other software giants like Google, Oracle, and Microsoft are today, bad things could be in store for shareholders left holding the bag.

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