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The Curious Case of CRM

The Curious Case of CRM

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Published by kylejones245
Interesting analysis on CRM.
Interesting analysis on CRM.

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categoriesTypes, Research
Published by: kylejones245 on Feb 09, 2013
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06/06/2013

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The Curious Case of CRM
 As Kyle Bass has stated in regards to his negative bet on Japan, he does not know the specific timingwhen Japan falls apart, but the ingredients are there for an explosion to the downside. An investor canuse this reference to CRM as well
 –
all of the
ingredients
are now finally here.CRM has been written about extensively by both bulls and bears. This write-up very briefly identifies thecurrent points to the bear thesis, and then discusses 3 very incremental points (and untalked about) thatthe market is missing.The bears constantly focus on things such as:
Increased competition from larger tech giants (i.e. Oracle, Microsoft) and increased competition fromsmaller rivals (i.e. SugarCRM)
 –
this has not dented reported topline growth as much as some haveanticipated, but clearly has negatively impacted profitability through severe price discounting andincreased spending (expense growth higher than sales growth).
Salesforce.com
’s
core product is becoming commoditized -
“SFA
(Salesforce Automation)functionality is not materially different than other SaaS CRM products. In fact, in many areas it has
fewer feature sets than several competitors” –
crmsearech.com
Significant price discounting to gain new business (Seeking Alpha: Salesforce.com's Incentive PricingWill Stick, 12/19/11)
 –
creating structural pricing issues for the company long-term
Significant deterioration in GAAP profitability
 –
large increases in subscription, sales, marketing costsas a percent of revenue
Weak free cash flow quality driven by high non-cash stock compensation which has nearlydoublesdyear-over-year and CRM is stretching out payables
Sizeable unexercised options and restricted shares
 –
nearly 36mn shares out there waiting to diluteshareholders (for what it is worth, all my contacts at the company (who are rational and objective and
have a basic level of a financial background), can’t believe how high the stock is and sell their stock
every chance they get)
Accounting revenue gimmicks - changing in invoicing terms from quarterly/semi-annual to annualcontracts to boost deferred revenue (hence artificially increasing deferred sales/billings growth)
Unusual changes in accounting
 –
changes in revenue recognition in FY12 10K (recognition policy of 
sales when “the service has
been or is being provided
” from “when the service has been provided”
)
 
Aggressive accounting - increases in depreciable life of assets, large increase in capitalized costs (i.e
 
plant, property, software costs) on its balance sheet over the last several years, large increases indeferred commission expense on its balance sheet (Forbes.com: Salesforce Boosts Profits With Aggressive Accounting, Bernstein Says, 8/25/11)
High attrition rates relative to other software/cloud tech companies
 –
Salesforce.com has double-digit
 
attrition vs established peers mid-single digits, with sales over $3bn attrition is going to become alargely problem to overcome given the magnitude on a dollar basis
Deterioration in the balance sheet
 –
sizeable increase in capitalized software and PP&E (absoluteand as a percent of sales), increase in deferred commission expenses (i.e. pushing out expenses),increase in payables to benefit reported cash flow from operations (masking deterioration inunderlying cash generation)
No competitive moat - customer exit costs are low compared to prior software publisher models, the
 
market is fluid and the company faces significantly increased competition
Excessive insider selling
Egregious valuation on any metric
Slowdown in core organic subscription growth
For a $23bn company, CRM’s disclosure around sales and billings growth is relatively opaque which hasled many investors and “analysts” to “analyze” reported growth rates without taking a deep look to assess
underlying (i.e. organic) growth rates.
 
In an
attempt to “peel back the onion”, so to speak, I have attempted to leverage managementconference call commentary, SEC filings, and technology dedicated websites, to assess CRM’s organic
billings trends for new subscribers over the past five years.In th
e table below, I detail a “build” to the growth rate in organic new subscriptions billings –
a key driver of long-term value for CRM. The math is simple
 –
getting all the data is a cumbersome process.- First, one needs to calculate reported billings (subscription sales + change in deferred sales).- Second, one needs to adjust for the impact of CRM moving many customers to annual billingcontracts or multi-year contracts
 –
in both cases, it accelerates the amount of deferred sales CRMreports relative to prior periods when contracts where not annual or multi-year. CRM has disclosedthe impact on its quarterly conference calls available on their website.- Third, one needs to subtract contract renewals in order to derive new subscriptions billings. CRM alsogives a percent attrition rate on its quarterly conference calls, so you can calculate the numeric value.- Fourth, one has to make assumptions on the impact from acquired revenues, which is generallyfound on technology related websites and blogs.- Fifth, adjust for the positive or negative impact of foreign currency on sales and/or deferred sales. As you can see from the table below, after making the proper adjustments
, CRM’s core organic new
subscriptions billings has been declining notably for over the past 2-years. However, an average investor 
(or “analysts”) would not realize this based on reported sales and billings given CRM has done an
amazing job masking the deterioration through many acquisitions and significant changes in invoicingterms (moving customer to annual and multi-year contracts). Peel back the onion, and you get a $23bnmoney losing company with slowing underlying growth.Conclusion: Core underlying new subscriptions billings growth has continued to slow meaningfully over past two years.
SEC forcing increased disclosure
Several weeks ago, rumors swirled around SEC related correspondence with CRM. This is not the firsttime that CRM has dealt with increased scrutiny from the SEC. As CRM prepared for its IPO in 2005, theSEC delayed the IPO due questions over accounting. The most recent rumbling of SEC correspondenceis not new information as the correspondences has been ongoing for several months. In addition, the
FY2010FY2011FY2012FY2013E
a.)Subscription$1,209$1,551$2,126$2,862b.)Chg. in deferred revenue$110$231$445$362c = a + bReported billings$1,320$1,782$2,572$3,224e.)Less: renewals-$915-$1,122-$1,532-$2,237f.) = c - eNew subscription billings$405$660$1,039$987a.)Subscription$1,209$1,551$2,126$2,862b.)Chg. in deferred revenue$110$231$445$362g.)Impact of move to multiyear contracts & longer invoices$0$0-$156$61h.) = a +b +gAdjusted billings$1,320$1,782$2,416$3,285e.)Less: renewals-$915-$1,122-$1,532-$2,237i.) = h -eAdjusted new subscription billings$405$660$883$1,048 j.)Less: Acquired sales$0-$15-$70-$100k.)Adjust for impact of foreign exchange on sales$0$4-$35$40l.) Adjust for impact of foreign exchange on deferred sales$0$0-$13$3m.) = i - j + k + l
Organic new subscription billings$405$649$765$991
n.)
y-o-y % change = m.)/ f.)60%16%12%
Note: For n.), calculation for FY13 & change, denominator adjusted $156mn to reflect change invoicing in FY12 base
 
correspondence has to deal with mundane issues, outside of more disclosure on cash flows fromoperations.However, what the market and investors have failed to realize, is that this is likely just the beginning of increased focus by the SEC for CRM to begin disclosing more information about the business. Increaseddisclosure will be good for investors in assessing the fundamental position of CRM, however, it will bebad for the company as it will exposure significant cracks in the business model and growth profile.I believe there is an increased likelihood CRM will be forced by the SEC to begin disclosing any or all of the following metrics overtime
 –
which will shed light into the deteriorating in the fundamentals of thecompany broadly.
Number of customers (which the company used to disclose)
 –
essentially allowing investors tocalculate revenue per customer, profit per customer 
Average weighted contract terms (i.e. average contract was 6-months and now it 18-months? 24-months?)
 –
increased deferred sales growth is impossible to gauge considering prior years are mostly6-month to 1-
year contracts, now CRM’s
is now increasing contract lengths (some over 5-years) andfronted loading sales in deferred revenue line. I believe the average contract length has increasedsignificantly, which has distorted the apples to apples growth rate in deferred revenue growth.
Segment revenue data (i.e. Salesforce automation, Force.com, Service Cloud, etc)
More detailed disclosure on the impact from acquisitions (on sales and deferred sales) or reportedorganic sales/billings/deferred sales growth
Increase disclosure on deferred commission expense on the income statement and balance sheet(i.e. length of deferral disclosure)Conclusion: SEC will begin to force Salesforce.com to increase disclosure on more key metrics, which willshow decelerating trends.
$3bn-plus in sales + low double-digit attrition + high incremental margins on recurring biz =deteriorating profitability?
 Arguably, one of the most perplexing issues surrounding CRM is that fact they make no money despitebeing a $3bn sales company, with low-double-digit attrition, and what should be highly profitablereoccurring business.
The analysis in the table below breaks down CRM’s business by recurring business and newly acquired
business (i.e new contracts/customers). For simplicity purposes, I assume a 15% attrition rate. For example, in 2007, I assume $236mn of $281mn in sales in 2006 is recurring in 2007 ($281mn * (100%-15%)) and $213mn is new subscriptions. This exercise is repeated for the remaining years.Lastly, I assume on all recurring business CRM is achieving a 30% operating margin
 –
in line withcompany commentary on what they believe the margins are post initial costs of getting a subscriptionwhich can be costly.
This exercise showcases that CRM’s new business is very unprofitable. For perspective, t
his analysisimplies CRM is losing nearly 65 cents for every dollar of new business. How can CRM be so unprofitablewith $3bn in sales and what is considered to be very high margin business on recurring sales?
I offer a few thoughts….
(1) CRM is really losing that much money on new business as it discounts new products very aggressiveto maintain sales growth. It has been written/talked about how CRM is highly focused on trying to bundleits product offerings. However, in order for the customer to accept the new offering, they are asking for severe discounts on products such as Marketing Cloud, Service Cloud, Force.com, Chatter, etc. This isunsustainable to say the least.(2) Recurring business is nowhere near as profitable as CRM say it is and they are not achieving 30%margins years have the business has been one, but are forced to discount products on renewal and/or 
aggressive “pitch” to retain the old business which can be costly.

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