YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

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With the end of the first month in 2011, we frequently hear the coined phrase “As goes January, so goes the year.” If this is the case (and we do not subscribe to such superstition by the way) then with the S&P 500 index up approximately 1.6% for the month, we should be in for a pretty good year right? Shares of Salesforce.com trading at around $131 a share, up over 100% in the last year is evidence of the bullishness we’re seeing in the market. How much further can this market go? Where are the bears hiding? And are we going to continue to see more companies like Salesforce.com (CRM) defy valuation and basic common sense? Analysts seem to be turning a blind eye when it comes to CRM’s valuation which based on traditional metrics weighs in at a hefty 297 times the 44 cents a share it’s expected to earn in this fiscal year.

Jacqueline Doherty in her Barron’s article titled “Shades of the Dot-Com Bubble” featured earlier this month states that “investors seem willing to bend the rules for Salesforce because it’s in the crazy-hot sector of cloud computing.” This bending of the rules that Jacqueline refers to is the fact that analysts are stripping out CRM’s option expense (which is about $100 million annually and growing) and analyzing the company on a non-GAAP basis. It’s not just the analysts, but CRM’s management spends all their time talking about their non-GAAP results as well. This was a common practice back in the Dot-Com Era with the hype of the internet and its plethora of start-ups. You cannot ignore options expense – this is a real expense to the business and for CRM is a growing one. The company grants option packages to its employees and uses them to make acquisitions – they use it as a form of currency which has increased the shares outstanding by a staggering 40% since the company went public in 2004. The total shares outstanding now is more than 130 million, up from 95 million seven years ago.

Other CRM signs similar to that of the Dot-Com era are that insider buying has been non-existent. In fact, insiders have been selling like crazy! CEO, Marc Benioff, has lead the selling campaign with having sold close to 17 million shares since the company went public. During the Tech Bubble, companies were living large with high profile, expensive parties and frivolous spending. CRM seems to be following suit with expensive confabs boasting popular folks like President Bill Clinton and Stevie Wonder being hired to impress attendees. Not to mention its recent purchase of a new corporate campus of $278 million in San Francisco. The firm’s headcount surged to 4,758 in its latest quarter with the emphasis on hiring new salespeople to “the point where they’re lowering their standards. If sales productivity slows or goes negative and they slow down hiring in sales, growth will slow meaningfully,” says Peter Goldmacher, a software analyst at Cowen. “If Salesforce loses its cache as a growth stock, the stock won’t just take a hit, it will take a body blow.”

It’s not like CRM is the only player in this shift towards cloud computing. We expect fierce competition from all the big players like Google, Cisco, SAP, Microsoft, Oracle, HP, Dell, etc. who are all moving to take advantage of this phenomenon. We do not see CRM continuing to grow at a rate that justifies the current stock price and certainly without any hiccups. Take for example, F5 Networks, a cloud computing related company that took a hit last week after a disappointing quarter. Salesforce.com fell 10% on the week. The company reports its earnings next on February 24th after the close. We continue to be short Salesforce.com and strongly believe that the company will see a day of reckoning at some point.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Will Kruger | February 01, 2011 | Permalink

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