I hooked up my accelerator pedal in my car to my brake lights. I hit the gas, people behind me stop, and I’m gone. Steven Wright
The Endless Search for Value
I know we have lessons to complete in Quantitative Value, but I also use this blog as a poster board to refer back to when assessing events, thoughts, and ideas.
After spending four hours groping through the Value Line’s 2,000 companies, I don’t find much of interest besides the uglies of Russian and Brazilian stocks, coal, uranium, silver and gold miners. Most readers here are too refined even to think of investing in such cyclical companies. What would your Momma say?
I find the relentless buying by insiders in small mining stocks to be interesting while corporate insiders in other companies want cash now and not stock. For example, https://www.canadianinsider.com/node/7?ticker=LYD
Wow, well said and rare. Doubt if control grid mainstream media will be having this white hat on the air. Orioles Executive Vice President John Angelos, son of majority owner Peter Angelos:
“Speaking only for myself, I agree with your point that the principle of peaceful, non-violent protest and the observance of the rule of law is of utmost importance in any society. MLK, Gandhi, Mandela, and all great opposition leaders throughout history have always preached this precept. Further, it is critical that in any democracy investigation must be completed and due process must be honored before any government or police members are judged responsible.
That said, my greater source of personal concern, outrage and sympathy beyond this particular case is focused neither upon one night’s property damage nor upon the acts, but is focused rather upon the past four-decade period during which an American political elite have shipped middle class and working class jobs away from Baltimore and cities and towns around the U.S. to third-world dictatorships like China and others.
The outcome plunged tens of millions of good hard-working Americans into economic devastation. Then they followed that action by diminishing every American’s civil rights protections in order to control an unfairly impoverished population living under an ever-declining standard of living and suffering at the butt end of an ever-more militarized and aggressive surveillance state.
The innocent working families of all backgrounds whose lives and dreams have been cut short by excessive violence, surveillance, and other abuses of the Bill of Rights by government pay the true price, an ultimate price, and one that far exceeds the importance of any kids’ game played tonight, or ever, at Camden Yards.
We need to keep in mind people are suffering and dying around the U.S., and while we are thankful no one was injured at Camden Yards, there is a far bigger picture for poor Americans in Baltimore and everywhere who don’t have jobs and are losing economic civil and legal rights, and this makes inconvenience at a ball game irrelevant in light of the needless suffering government is inflicting upon ordinary Americans.”
The art of contrary thinking consists in training your mind to ruminate in directions opposite to general public opinions; and to weigh your conclusions in the light of current events and current manifestations of human behavior.
The purpose of contrary opinions is to avoid the predictions that go wrong, notably in the stock market.
It is axiomatic if you stop to think about it, that when everyone is bearish, or bullish, the first of the price momentum is broken.
Be a nonconformist when using your mind; when everyone thinks alike, everybody is likely to be wrong. Imitation and contagion are the two culprits most responsible of conformity and sameness of thinking. Preconceived opinions leave little room in our minds for contrary viewpoints. –H. Neill, The Ruminator
Charlie Munger once said, “A thing not worth doing is not worth doing well.” When I look at CRM, I immediately see that it is not worth much time analyzing except if you wanted to go short perhaps. The company seems grossly overpriced. But let’s quickly go through the numbers. I also use ORACLE as comparison–ORCL and CRM Value-Lines.
If I buy CRM today at $169 per share and expect my required rate of return of 10% (Many value investors expect 15%) so.
3.8 bil. in sales ($27 per share (2013 E) times 20% growth for 10 years (which is extremely rare) =
$23.4 bil. in sales
Net profit margin rate the same as powerhouse/franchise:Oracle/successful software franchise
In net profits at the end of 10 years
Outstanding shares at 5% growth for 10 years
Multiple = However, many big cap tech franchises have multiples of 10 to 12 like MSFT, AAPL, INTC
$169 CAGR 10% for 10 years = $438. So CRM would have to grow 20% per year at least and then obtain industry leading profit margins even though it has yet to show a profit after 11 years in its quest to build market share. I was curious if management would bother to tell shareholders when profits may be expected to arrive so I downloaded the annual report:CRM 2012 Annual Report, but the one page letter was just a cheering session. An F for shareholder disclosure.
The main reason I would pass is the difficulty to even maintain a high growth rate in terms of profits. If CRM is not a franchise (able to earn above average profits on each dollar of sales above its cost of capital) then growth doesn’t matter. However, growth is extremely difficult over ten years beyond 15% each year as this article describes: http://money.cnn.com/magazines/fortune/fortune_archive/2001/02/05/296141/index.htm
That’s the problem for big companies: The growing gets hard, and we have two studies to prove it. The first was done a few years ago by Wharton School professor Jeremy Siegel for his book Stocks for the Long Run. Siegel’s primary purpose was to examine how the Nifty Fifty of 1972 would have treated investors who paid the sky-high prices then being asked for them and held on for 25 years–and the answer was “not badly.” But a secondary part of the study looked at the group’s annual growth rates in earnings per share. And only three companies out of the 50 beat 15%. They were Philip Morris, at 17.9%; McDonald’s, at 17.5%; and Merck, at 15.1%.
The second study is one FORTUNE, working with Value Line, did for this article. For three different periods–1960-80, 1970-90, and 1980-99–we examined earnings-per-share growth for 150 large companies. In our sample were the 150 publicly owned companies that (a) at the start of each period were the biggest in the FORTUNE 500 or were in the very top of the “Fifties” lists that we used to do for certain industries, such as commercial banks; and (b) were still independent beings at the end of the period being studied. The fact that we threw out any company that did not last the period (because it was acquired, perhaps, or subjected to a leveraged buyout) gives the results an upward, “survivorship” bias. Beyond that, we know retrospectively that there was no shortage of business opportunity in the years we studied: Though the companies looked big to the world as each period began, they still had plenty of room to grow.
And yet the number that managed to increase their earnings per share over the periods by 15% annually was very small, even when you include the companies that hit the mark because of an oddball situation. For example, Boeing beat 15% in two periods (1960-80 and 1970-90) because it moved from hard times in the base years to prosperity in the later years. Similarly, Fannie Mae had an extraordinary 32% growth rate for the 1980-99 years because it began the period in a near-bankrupt condition, brought on by sky-high interest rates, and later got rich.
Below are several comments from investors who are skeptical of CRM’s valuation:
I’m short the stock, so perhaps am biased, but have tried to do the same blue-sky valuation analysis you have done above. I believe there are a few places where your assumptions are off.
In the essence, it is impossible for Salesforce to lower its R&D or Marketing and Sales (“M&S”) expenditures to levels similar to Oracle or SAP. If you think about the value proposition of CRM, this includes a lower TOC for users. If that is true, then that means lower revenues per customer, and a higher cost per unit of revenue to deliver the goods. Thus, CRM will never be able to do operating profits close to that earned by SAP or ORCL.
There is also the more sinister argument that the firm will do anything to show the Street growth in revenues and deferred revenue, and given that the market seems to be giving them a free pass for now on profitability, they are out there spending several dollars in costs (on their marketers) just to generate one dollar of sales.
For what it’s worth, I see them at $6.6 billion of revenues in Fiscal 2018 (still astounding growth) but they will struggle to do markedly better pro-forma operating margins than they are already doing now (and GAAP margins will still only be in the low single digits). Even in a blue-sky scenario, where they could approach $9 billion in sales that year, and generate 15% pro-forma operating margins, I still only get to a shade over $4 in EPS (and that’s five years away). Generating $9 billion in a single year would be quite a feat by the way: in the past three full fiscal years, they’ve only generated $8.1 billion, in total.
But let’s say that the blue-sky will prevail and that investors will pay 35x that blue-sky EPS number five years from now, that gets you to a future value of about $150/share. Given the corporate governance issues, the exorbitant insider compensation, the acquisitive growth, and the legion of current fans on the sell-side, there is a lot of risk between here and there, so I’d need to earn at least 12% a year on an investment that I thought was going to be worth $150 five years from now. That gets me to $85 today, and again this is in the rosiest of scenarios – and one which I think is extremely unlikely.
I agree by the way that there seems to be scope for the company to play games with revenue recognition. The disclosure in the 10-K regarding their policy is labryrinth of verbosity.
Finally, management is voting with their feet–a continuous sale of their stock. CRM seems like a transfer scheme between public investors and management. Investors buy and management sells.
There was an interesting article in The Economist this past week about the numbers behind voting to draw the 2012 U.S. presidential election to a close. Economists (and as we known, academics in the finance department at institutions worldwide) love to lean on a simple premise that materially influences what they ultimately conclude about the world around us: Human beings are rational and keenly focused on utility-maximization. With that as a given, the obvious question is asked – why do people bother voting when the probability that their single vote will actually have any impact is zero? As they note, you are more likely to get struck by lightning on the way to the polling station than to be the deciding vote in the U.S. presidential election.
They quickly address and dismiss a few common responses as to why one could still justify voting, including “what if everyone else didn’t vote either” (the smart money for the last 57 elections in the U.S. has been that some people will go to the polls), the importance of “preserving democracy” (one skipped vote is unlikely to result in the country’s demise), and the good feeling that comes from performing a “civic duty” – an often cited argument and hardly a surprising one: people tend to do what’s in their self-interest (to make them feel good about themselves), and the investment of one’s time is a small price to avoid any personal shame. While these responses (particularly the third) each have their place in the discussion, there’s one argument from the piece that I personally agree with: “some academics reckon that voters are simply bad at calculating probabilities.”
In connection with equity investments, that statement alone doesn’t do justice – absurd valuations aren’t solely built upon the fact that people are poor at calculating probabilities; instead, it appears that people have a way of always convincing themselves that this time truly is different (much like our voter who has convinced themselves their voice counts, even though they don’t need a calculator to figure out that 1 divided by 123 million – the number of votes in the 2008 general election – is a percentage of microscopic proportions). They end up believing that by a miracle of sorts, the company will justify this valuation – and a much higher one – over time.
A great example of this is from the tech boom at the turn of the century; in a Business Week article written in April of 2002, Scott McNealy, CEO of Microsystems, was quoted as saying the following about his company’s stock, which had previously traded at 10x revenues:
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no tax on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock for $64? Do you realize how ridiculous those basic assumptions are? You don’t need transparency. You don’t need footnotes. What were you thinking?”
We don’t need to search very far to find a comparable example in today’s market: Salesforce.com (CRM) has traded at more than 10x revenue a couple of times over the past twenty-four months; according to Marketwatch, the analyst community (calculating probabilities must surely be in their job description) currently has a Buy-to-Sell ratio of fifteen-to-one, essentially saying that they uniformly agree that CRM is a strong buy.
As I noted in an article a few months ago, CRM would need to attain annualized revenue of growth of 25% over the next decade (ahead of Microsoft’s 20.8% annualized growth rate in the decade after the release of Windows 95), as well as reach a mid-twenties net margin in line with the current average for computer software firms – likely the company’s closest comparable industry (remember, they compete with giants like Microsoft, Oracle, etc, and have struggled to report positive earnings for some time now). If all this were to happen, and the company was given an earnings multiple in the mid-teens (in-line with the current large cap tech companies), the annualized return to shareholders would be in the high single digits (assuming a starting price in the low-mid $150’s per share).
Again, that’s in the scenario where things work (by any reasonable measure) perfectly. What is the probability that CRM is able to attain a revenue CAGR of 25% over the next ten years, and will be able to handily dominant its peers in the space despite their considerable share of mind among CIO’s at the largest companies in the world? More importantly, assuming that this scenario is considered to be a 100% certainty, what are these analysts modeling in the bear case scenario? At this valuation, and to continue to pushing CRM as a buy, one has to wonder – is there even a bear case scenario in these analyst projections?
Whether or not Salesforce ends up justifying this valuation over time is to be seen (CEO Mark Benioff certainly seems convinced that this company will change the world); personally, I would try my luck at voting before I considered going anywhere near CRM common stock.
About the author:
I’m a value investor, with a focus on patience; my sweet spot is great companies that are suffering from short term issues, and load up when those opportunities become present.
A question like that makes me into a religious man, “What the $%^&!, God $%^& Damn %^&@# It, Jesus the $%^&*! Christ!
My answer: OK, instead of asking, “What is it worth?” Ask, what would need to happen if I paid today’s price of $169and required a 10% annual return? What would CRM need to provide to me (sales, cash flows and margins), the investor, over the next ten years? What does the current price for CRM infer?
Does someone wish to answer this for the reader? Here is the Value-Line: CRM. The best volunteer gets an emailed prize. I will reply in full next week.