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Nortel Accounting All Over Again!


Parsad
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Say hello to the new Nortel...Salesforce.com!  The renewal of proforma non-GAAP accounting is an intriguing study...ten years after the implosion of Nortel.  We have puts on Salesforce.com, so that should be some disclosure on where we stand.

 

They just reported their Q1 report, and they made nothing in Q1 under GAAP.  Under non-GAAP earnings, which is what the media is reporting, they made 28 cents.  So exactly what does their non-GAAP earnings exclude:

 

- $48M in stock compensation

- $10M in intangibles

- $3M in interest on their convertible senior notes and warrants

 

Exactly how are these three items not applicable to earnings...GAAP or otherwise!  At over 280 times earnings, 9 times revenues, 14 times book, 36 times operating cash flow, investors better be sure that this sucker grows earnings and cash flows at better than 25% annualized for the next 5 years minimum!  How much you want to make a bet they don't?  Cheers!

 

http://finance.yahoo.com/news/Salesforcecom-Announces-prnews-2179209151.html?x=0&.v=1

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Hoodlum,

 

How deep in the money, if at all, are your puts?

 

Sanjeev,

 

Do you mind sharing the duration and strike of your puts?

 

I am asking since I bought puts on CRM last Fall on the same thesis and I did not make a whole lot despite being right on the share price short term. They were with a strike price roughly 10% above the underlying. Puts on that company usually trade under high implied volatility making them expensive.

 

Cardboard

 

 

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Guest VAL9000

 

I'll take the opposite position just to add some flavour to the idea (figuratively - I'm not going to put my money for or against CRM).  Actually, I'll state further that I have an inherent fear of short positions so I'm usually game for arguing the long side.

 

The major risk that I see with shorting CRM is where their costs come from.  They do about $500mm in revenue and make no money.  But looking into what their expenses are, you'll see that more than half of revenu goes to Sales and Marketing expense.  That's about $250mm/quarter spent just on growth.  And it's consistent: CRM has always made almost no money because their number one goal is to grow as quickly as possible..

 

So my issue with shorting CRM is when they feel like they've hit a saturation point in the market, they will just scale back that huge cost for marketing and sales (say from 250 to 50 for account management, steady growth, etc.), and then they're instantly earning $800mm/year.  Now that's still a pricey $800mm at $18bn valuation, but it's still a very attractive source of earnings with superior economics.

 

And the growth attempts have paid off.  They have grown their top-line between 25 and 45% every year for the past three years.  The SG&A expense grew in line with that.  The strategy makes sense in that they need to get their customers hooked into their system as soon as possible, because other cloud-based CRM systems are coming online very quickly, and that's the biggest threat to their business.

 

Regardless, I'm completely uncool with these accounting gimmicks.  I don't see why a company like CRM, which has such a great story on its own, needs to partake in these games.

 

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Sanjeev,

 

Do you mind sharing the duration and strike of your puts?

 

Can't comment.  You'll know by 2013 if we made money or lost!   ;D

 

I'll take the opposite position just to add some flavour to the idea (figuratively - I'm not going to put my money for or against CRM).  Actually, I'll state further that I have an inherent fear of short positions so I'm usually game for arguing the long side.

 

I agree with you 100%.  We don't short, and this is the first time we've bought puts on a single stock.  I was dead on the money with Nortel back in early 2000 and I didn't buy puts on the company.  This time the valuation is even more out of whack, and I thought a small bet that expires in January 2013 was worth the risk.  

 

What you've stated regarding CRM's growth is completely accurate.  They are spending their way to market share, and they will have to do this for quite a while, as SAP is going to come at them hard and fast...as well as others.  We are already seeing the impact this quarter, as their spending is way up to generate revenue, and nothing at all is trickling to the bottom line.  

 

They are playing accounting games when reporting results, and that is a real red-flag that the business is doing everything they can to sustain their market valuation.  Insiders have been selling and continue to sell.  Eventually people wake up, and unless they can truly translate their growth to cash flows and earnings, the bubble will burst.  The ones left hurting are the small retail investors who jumped on the band wagon too late.  Cheers!

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The marketing expense is an interesting excuse for CRM, but there again some cracks are starting to appear.

 

Take Microsoft for example which is well past its high growth phase and still spends 20% of revenues in Marketing and Sales. Same range of number at Oracle which is growing faster than Microsoft, but getting mature. Then take Coca-Cola and Philip Morris and you start to realize that Marketing and Sales still need to exist past the high growth phase if you still want to maintain your sales stable. I have never seen a company escaping that reality and I don't think that SalesForce.com will be any different.

 

Now, assume that a more reasonable on-going spending rate for CRM on Marketing and Sales is 20% like MSFT vs the current 50.4%. That brings operating income up to $150 million for the latest quarter. You can agree or disagree with this rate, but here is something more interesting since it works for different rates.

 

If you assume that same 20% for the 1st quarter of last year, it brings operating income up to $133 million. If we go with percentages, it means that sales have grown by 33.8%, but this adjusted operating income has grown only by 12.8%. Moreover, operating income margins have decreased from 35.3% to 29.7%.

 

It is a simplistic way to look at it, but I think that they will need to justify at some point that their spending on Marketing and Sales is effective on both the top and the bottom line. Once that happens, I think that the Street view and expectations will be completely different for the company.

 

I think that I will wait here a bit longer to see what happens with the chart. It has been going sideways for 6 months now. If this new attempt to break through the $144-148 level fails again, it will tell me a lot about the sentiment out there on the company. Things could get crazier still, so I want to see how far they are willing to take this. Then I may short via in the money puts.

 

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Guest VAL9000

Things could get crazier still

NYSE:LNKD anyone?

 

You guys are probably both right here.  The 20% M&S expense ratio is new to me.  I would expect CRM's to be lower because their revenue stream is recurring, but I could be wrong on that.  And really, even with a 0% spend, the $18bn is still tough to justify.  Perhaps we're reaching a turning point.

 

Good thoughts guys.

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Sanj,

 

How do you get comfortable with the premium implied in the puts (is it too high or low) and where relative to the current price have you typically purchased the puts?  Thx for sharing this idea and concept.

 

 

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Sanj,

 

How do you get comfortable with the premium implied in the puts (is it too high or low) and where relative to the current price have you typically purchased the puts?  Thx for sharing this idea and concept.

 

With puts, we generally buy out of the money, usually 20-30% higher than what we feel is fair value for the stock price.  We'll then see if there is anything out of whack in the bid/ask in that range, and buy where we think we have a bit of an advantage.

 

For calls, we generally buy in the money calls, so that our cost is nearly identical to the current market price, or at a very low premium.  Again, we'll see where we have an advantage...if any. 

 

Buying puts and calls brings another risk factor into the equation...time arbitrage.  We don't do it often...only when we feel valuations are really out of whack.  We've never actually bought a put on a single stock until now.  CRM's price is ridiculously stupid!  Probably one of the worst overvaluations I've ever seen.  The business is good, it will be around for some time and has an excellent balance sheet...but the valuations are just plain dumb.  Investors would be better off putting the money under their mattress at these prices!  Cheers!

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Go to page 59 to see a short case for CRM, also long case for MSFT starting on page 40.

 

It's classic Templeton right now!  Go long the most undervalued and unloved security, and go short the most hideously overvalued.  We have exactly the same position. 

 

We are sooooo long MSFT right now it isn't even funny, and we think CRM will fall to more reasonable valuations.  We haven't owned Microsoft in quite a while, but we think valuations in the tech sector are exactly as they were in 1999...except Microsoft is now unloved Berkshire, and the cloud computing stocks are now the internet darlings.  As Microsoft goes down...back up the truck!  Cheers!

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I am warming up a lot to Microsoft as well. Very unusual for me to look at the mega caps. Apple looks also very attractive in the $330 range.

 

I recall vividly the "brick and mortar" vs "Internet" saga Sanjeev. Times rhyme, don't they?

 

Looks to me like Karen Finerman did not see the parallel with her short on BKS. Ouch!

 

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I am warming up a lot to Microsoft as well. Very unusual for me to look at the mega caps. Apple looks also very attractive in the $330 range.

 

I recall vividly the "brick and mortar" vs "Internet" saga Sanjeev. Times rhyme, don't they?

 

Looks to me like Karen Finerman did not see the parallel with her short on BKS. Ouch!

 

Cardboard

 

We are in the same boat. Tech stocks are the oil stocks of last year. Im looking at Intel and Microsoft (despite that Skype buy).....

 

I am quite shocked Linked In doubled, Prem was right, value investing will always work......

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Where are the catalysts?

 

I think the best way to see values is to split some assets out:

 

IPO MSN/Hotmail and Bing. Turn MS Office and Windows to income trusts.

Form a consultant company that works like HPQ and IBM.

IMO, it's just too big without clear focus.

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Parsad, do you ever sell puts as a way to enter a stock?

 

John Templeton allegedly would keep outstanding limit orders on the stock market at very low prices, knowing that if the market ever did tank that he might not have the courage to execute what would be a very favorable trade. Taking Intel as an example, I can sell the $17.50 Jan 2013 put for $137. If the put is called, I get an effective purchase price of nearly $16. Otherwise, I get a guaranteed 5 percent annualized return on my money. I would only contemplate this for a bedrock company like Intel, however.

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Go to page 59 to see a short case for CRM, also long case for MSFT starting on page 40.

 

It's classic Templeton right now!  Go long the most undervalued and unloved security, and go short the most hideously overvalued.  We have exactly the same position. 

 

We are sooooo long MSFT right now it isn't even funny, and we think CRM will fall to more reasonable valuations.  We haven't owned Microsoft in quite a while, but we think valuations in the tech sector are exactly as they were in 1999...except Microsoft is now unloved Berkshire, and the cloud computing stocks are now the internet darlings.  As Microsoft goes down...back up the truck!  Cheers!

 

I am delighted to know that Sanjeev. Always good to know you are not on the other side of my trades. Except that I believe MSFT is not the only large cap that ridiculously undervalued in tech.

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Parsad, do you ever sell puts as a way to enter a stock?

 

John Templeton allegedly would keep outstanding limit orders on the stock market at very low prices, knowing that if the market ever did tank that he might not have the courage to execute what would be a very favorable trade. Taking Intel as an example, I can sell the $17.50 Jan 2013 put for $137. If the put is called, I get an effective purchase price of nearly $16. Otherwise, I get a guaranteed 5 percent annualized return on my money. I would only contemplate this for a bedrock company like Intel, however.

 

No, but that is a very good idea.  We keep it simple...average in when the price is in your range, and average out as it moves back up to intrinsic value.  Unfortunately, our timing stinks usually.  We are almost always early in and early out due to our conservative nature. 

 

The number of investments where we gave up huge gains in the last year...LUK, WFC, RRGB, WINN...we were out on all a good 15-25% early!  The only one we got dead on was MKL...we were in at $330 and out between $405-415.

 

I am delighted to know that Sanjeev. Always good to know you are not on the other side of my trades. Except that I believe MSFT is not the only large cap that ridiculously undervalued in tech.

 

I agree, but MSFT is the one with the best balance sheet, cash flows and earnings, and trading at the greatest discount relative to those metrics.  Cheers!

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How much of your overall portfolio would you feel comfortable allocating to a single sector like tech?

 

Other than options, we don't buy any position that is less than 4-5% minimum.  If it is a solid idea, then we can go all the way up to 25% in one idea, but that is very rare.  In MSFT's case, our position is through in the money call options...nominal value is 3%, and notional value would be 20%...so we are pretty long!  If the price gets hammered, then we will step in and buy equity. 

 

The reason being is that discounted prices can last years, but heavily discounted or absurd prices, usually don't last that long and the long-term survival of the business becomes less important.  Markets will correct a significantly undervalued opportunity rather quickly, whereas moderately undervalued businesses can remain that way for years.  This occurs because the severly undervalued opportunity tends to get recognized much faster by the investing community.  Cheers!

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