A Reader’s Question on Valuation Ratios. This sheet may be good as a guide to go through an annual report, but none of those ratios means anything without context. Is growth good? It depends. Only profitable growth within a franchise. How about asset turnover? For some companies like Costco asset turnover is critical but not for Boeing (gross margin). Why not take those ratios and work through the financials of these trucking companies. Which company is doing the best? Why? Follow the money! Those ratios may help you structure the information you pull out from the financials. But first focus on how does the company provide a service to its customers and then trace the financial effects back to your returns as an investor.
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.
Curious to know where you think this flagging market is heading from here. I’m content to sit on the sidelines and watch a little longer.
My reply: The only idea more frightening than someone believing I know where the market is headed, would be if I believed I could predict the market. Predicting the market which is a complex adaptive system falls into the area of important but unknowable.
A complex adaptive system is an open, dynamic and flexible network that is considered complex due to its composition of numerous interconnected, semi-autonomous competing and collaborating members. This system is capable of learning from its prior experiences and is flexible to change in the connecting pattern of its members in order to fit better with its environment. No wonder that neither mathematical formulas nor science can capture or predict human action. I think Ben Graham said roughly in these words, “Don’t confuse fancy math for thinking.”
As a reader recommends:
No need to predict the market
But an investor doesn’t have to predict, he or she has to find lopsided bets or “value.” I try to buy franchise companies–those with competitive advantages evidenced by steady market share and high returns on ivested capital over time–usually a ten year time period. These companies are rare but obvious like Coke, Novartis, General Mills, Stryker, Exxon, etc. The issue is what price to pay. Two years ago, several franchise companies were trading at or below the average company; they were bargains. Why? Perhaps because prices adjusted from the over-valuations of ten years ago (Coke being an example). Most of the time you track these 80 to 140 companies and wait for a sale to occur during a market downturn, “missed” earnings report, product recall or some temporary problem.
You also need to be aware of companies that can become franchises or can dominate a niche–Autozone, WDFC, and Cell Tower Companies, etc.
Then you have special situati0ns where there is some event to unlock value–SHLD spinning out SHOS, for example. the stock is up 50% in three months, so opportunity is everywhere.
Look for where the fear is greatest or where there is MAXIMUM PESSIMISM
Even with the “market” flirting with new highs, you have segments like junior mining c0mpanies (GDXJ) making new multi-year lows as people throw in the towel after years of disappointing returns. Usually, the problems are well-advertised–Mining companies are losing speculative buyers to ETFs, costs are rising faster than revenues, capital is scarcer, companies have misallocated capital in the quest for size, stocks are back to where they were five years ago but the gold price has doubled–and known. A mining company is a hole in the ground with a liar on top, so you better be careful if you wish to pick through the debris or just ignore and look elsewhere.
Focus on the particular
So who cares where the market is going? Focus on particular companies and where the fear, disgust and neglect are greatest. Unfortunately, for me that appears to be the precious-metals mining sector. If I can find several free call options on gold and silver, I will buy as long as I don’t over concentrate. Pray for me.
Another trick is to ask yourself why the pundit on CNBC is sharing their prediction of where the market is going. Why tell?
As the two-penny philosopher once opined, “There are many who don’t know that they don’t know while those that know, don’t say.”
Understand the manipulation of hampered markets
That said, this writer suggests any investor go to www.mises.org and download the free books there and understand the Austrian Business (Trade) Cycle. There are huge misallocations of capital going on now, so be prepared.
Jim Grant on our current situation
Listen to what Grant’s has to say about the Fed and the money madness.
As of December 31, 2012, the quant model recommended purchasing Herbalife. The firm is very high quality and became excessively cheap after Ackman came out with his “short news.” My guess is Loeb bought our book over the holidays, read it, and then was determined to by I Want This”
How did the Fraud/Manipulation/Bankrupty models stack up?
Accrual measures relative to universe of stocks
Accrual Anomaly: 81 percentile
Net Operating Asset Anomaly: 18 percentile
Average: 49.5% percentile–basically, no issues
Manipulation prediction model: Less than a 1% probability of manipulation; no red flags on any single manipulation metric
Bankruptcy prediction model: The absolute probability of HLF going bust is low, butHLF scores at around the 89% percentile on this metric relative to the universe analyzed (stocks over $1.4B). This is something to watch, but the absolute probability of this occurring is very low (<1%)
Overall, the statistical results indicate that Loeb’s position is a better bet than Ackman’s position. Of course, this is in reference to the 12/31/2012 HLF stock price. As of yesterday, HLF is no longer included in the quantitative value screen because it has become too expensive.
I am not an expert on Apple (AAPL) but it makes a great case study on investor expectations. The price has fallen 38% from its all-time high in Sept. 2012 and now is at $450 or so. Apple has about 137 billion of cash equivalents with 69% of it overseas. Adjusted for taxes, cash works out to $110 per share. The dividend is $10.60 per shares. Assume a cost of capital of 10% (Apple trades at a 10 pe) with a growth rate of 2%, the NPV of those dividends –$10.60 divided by (10% – 2%) or $132. Add that to the $110 and you have almost half the current price. The market doesn’t expect much from Apple.
If you learn anything from this post, it is this–avoid glamour and high expectations and seek out low expectations within your circle of competence. A money manager on CNBC last Friday said he sold his Apple stock because the future product pipeline was uncertain. Whoa! And six months ago, it wasn’t? Yet, people like him are running billions. Are you surprised that there has been a $300 billion change in valuation despite no to slight fundamental change in the company over the past 4 months?
A Reader’s Question
Would it be possible for you to share ‘Grant Interest Rate Observer’publications on the blog or by email?
Have already spent enough money on MBA and partly on CFA also, can’t afford to spent hefty amount once again at this point in time.
My reply: I must obey the wishes of Grant’s copyright, plus you have to have a special PDF viewer. I suggest that you sue your Graduate business school and the CFA Institute to get your money back. Why get a CFA AND an MBA?