06-04-12 CRM

Salesforce.com (CRM) 0.75% converts due 01/15/15 trade at 164.25 vs. 131.5, which using 150 credit spread implies volatility of 43. Options implied vol 2014 is much higher at about 50. The converts have a theo delta of 87. We can put this trade on a slightly higher delta of 90 to better capture the downside move.

I chose 150 credit spread based on big cap tech comps including 5 yr cds for Dell at 220, HPQ at 210, ORCL at 65, and CA at 156.

I believe that the stock is likely to have a big downside move for several reasons:

1)      In recent months, many tech bellweather companies have warned about a slowdown in tech spending, particularly in Europe and US government but also enterprise spending in general. Companies that guided down significantly include Cisco, Dell, and Network Appliance, all of which have off quarters (April ended) and thus reported after CRM and most tech companies. Since CRM software is often bought in conjunction with servers, routers, and storage, it is difficult to see how CRM can escape unscathed. CRM relies on closing large million dollar deals to make its quarters. Europe accounts for 18% of CRM sales.

2)      Tech spending is famous for the year end budget flush. The seasonal trend for corporate spending on technology tends to be companies spending some of the budget early in the year to meet strategic initiatives, followed by a slowdown in the spring and summer months, and then close the year with a “spend it or lose it” directive before year end. CRM apparently benefited from the budget flush in 2011 as many corporations decided that CRM software was the product that it needed.

3)      CRM trades at 80x 2013 EPS. The stock is pricing in a sustained period of high growth. For example, from 2012 to 2023, Nomura has CRM growing sales from $2.26B to $14.7B (18.5% annual growth for 11 years) and EBIT margins growing from 12% to 39%. Even with these aggressive assumptions, their DCF value works out to only $156 (about 18% upside). Is this unreasonable? A good comparison is to look at ORCL at a similar stage of growth from 1994 to 2005 (11 years), the company grew sales from $2.0B to $11.8B (17.5% annual growth for 11 years) and EBIT margins growing from 21.9% to 37.1%. Investors are already expecting CRM to accomplish in the next 11 years what ORCL did. One slip-up and the stock will come crashing down.

4)      This does not get talked about much but CRM reports non-GAAP numbers, which analysts are happy to use as well. However, when factoring stock compensation expenses, CRM’s 2013 EPS would be -0.76c rather than $2.10. There are arguments for and against this practice but it nonetheless creates skepticism about the quality of CRM’s earnings, although no one seems to care right now.

Company description

CRM is a software provider with 5 products in the broadly defined Customer Relationship Management (CRM) market. These 5 products are:

1)      Sales force automation (SFA) 76% of sales

2)      Customer service and support software 14% sales

3)      Contacts database (Jigsaw) 4% of sales

4)      Private social network (Chatter) 3% sales

5)      Custom software development (Force.com) 3% sales

CRM’s growth is due to its software as a service (Saas) model where customers can subscribe to web based software rather than the traditional model of customers buying licenses and paying an annual maintenance fee. In recent years, CRM began signing large multi-year deals with big corporations that cover all employees. This has fueled its growth but also created more volatility because these large deals tend to be lumpy and hard to predict. Additionally, its flagship SFA software is becoming saturated so the company needs to successfully cross sell its other products to meet high growth expectations. While entirely possible, there’s no guarantee that the other products will become as dominant as the flagship product.

Because CRM only recognizes revenues retroactively (amortized over several years after a new order), analysts focus more on deferred revenues and new orders than the current year’s revenues and EPS.

Credit analysis

CRM has $1.6B of cash and its only debt is the $575m in converts. The company generates about $400m per year in FCF. As a software company, its cap ex requirement is low at about $200m per year.

This is a strong credit and I feel comfortable using 150 spread for the converts.

Post a comment or leave a trackback: Trackback URL.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>