Salesforce.com 10Q: Stock Expense, Deferred Revenue and CMO’s

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By Todd Sullivan of Value Plays

I’m not going to rehash much of what I have already said regarding deferred commissions and amortized software expense accounting. IMO it is overly aggressive and hides the true current financials of the company. Nor will I talk about the $500M .75% convertible bond deal that will have the company eventually paying loan shark like rates upon conversion (barring a collapse to $85 in the stock price). Do a search on the blog for CRM and those post will come up.

Let’s get right to the stock based comp. Here is the applicable section from the last four 10Q’s filed.

November 2010:

During the nine months ended October 31, 2010, the Company recognized stock-based expense of $78.7 million. As of October 31, 2010, the aggregate stock compensation remaining to be amortized to costs and expenses was $237.7 million. The Company expects this stock compensation balance to be amortized as follows: $29.3 million during the remaining three months of fiscal 2011; $101.4 million during fiscal 2012; $64.7 million during fiscal 2013; $38.2 million during fiscal 2014 and $4.1 million during fiscal 2015. The expected amortization reflects only outstanding stock awards as of October 31, 2010 and assumes no forfeiture activity. The Company expects to continue to issue share-based awards to its employees in future periods.

April 10Q pg 18

During the three months ended April 30, 2011, the Company recognized stock-based expense of $47.6 million. As of April 30, 2011, the aggregate stock compensation remaining to be amortized to costs and expenses was $542.1 million. The Company expects this stock compensation balance to be amortized as follows: $150.8 million during the remaining nine months of fiscal 2012; $166.5 million during fiscal 2013; $138.3 million during fiscal 2014; $85.4 million during fiscal 2015 and $1.1 million during fiscal 2016. The expected amortization reflects only outstanding stock awards as of April 30, 2011 and assumes no forfeiture activity. The Company expects to continue to issue stock-based awards to its employees in future periods.

July 10Q pg 17

During the six months ended July 31, 2011, the Company recognized stock-based expense of $102.2 million. As of July 31, 2011, the aggregate stock compensation remaining to be amortized to costs and expenses was $582.6 million. The Company expects this stock compensation balance to be amortized as follows: $114.0 million during the remaining six months of fiscal 2012; $193.3 million during fiscal 2013; $163.2 million during fiscal 2014; $106.0 million during fiscal 2015 and $6.1 million during fiscal 2016. The expected amortization reflects only outstanding stock awards as of July 31, 2011 and assumes no forfeiture activity. The Company expects to continue to issue stock-based awards to its employees in future periods.

Current 10Q pg 18:

During the nine months ended October 31, 2011, the Company recognized stock-based expense of $159.2 million. As of October 31, 2011, the aggregate stock compensation remaining to be amortized to costs and expenses was $582.3 million. The Company expects this stock compensation balance to be amortized as follows: $58.4 million during the remaining three months of fiscal 2012; $208.9 million during fiscal 2013; $179.0 million during fiscal 2014; $121.2 million during fiscal 2015 and $14.8 million during fiscal 2016. The expected amortization reflects only outstanding stock awards as of October 31, 2011 and assumes no forfeiture activity. The Company expects to continue to issue stock-based awards to its employees in future periods.

Notice the trend?? In every 10Q the company’s estimates of future stock expense is rising over the previous 10Q’s estimate for 2012/13/14. It isn’t due to additional restricted shares vesting as the company now is well aware of the vesting schedule for the next several years. What could possibly have happened that the company, in estimating FY 2013 stock expense (FY ends 1/31) that their initial $64M projection in Nov 2010 ballooned to a now $208M and sure to go higher? It has nothing to do with the share price as $CRM’s stock today is priced virtually where is was in Nov. 2010.

It is the number of share being exercised. We have seen this the last few days as insider are rushing to cash out options 3 and 4 years ahead of expiration. Actually, insiders have been selling non stop for years but it has accelerated this year. Normally this is done through 10b5-1 trading plans (pre planned sales) so as to avoid “insider trading” charges (selling/buying before bad/good news etc.). In fact, if you look at may of the $CRMinsider sales, they are done through these plans. But, these plans can be altered by participants during certain periods. While the details of these insider plans are not public, I think we can assume that the massive underestimation of stock expense just a year ago can be traced to the current wave of insider selling.

If a company knows the insiders 10b5-1 plans today for 2013 they can estimate the stock expense for the next year. If, during one of the eligible periods to alter the plans insiders decide to accelerate both the exercising of their options and the selling of those shares, the earlier estimates will be way off. Now, there is nothing illegal or immoral about any of this. I think it goes more to illustrate what even insiders at the company are thinking about the stock price next year or the year after. Why would they cash in today an option that does not expire for 3 years if you think the stock will be higher in 3 years? Unless you think it wont…..

Now, again, if this is one insider doing it, that is something to ignore (maybe they are buying a home etc) but when they all are and are consistently …….it is time to take notice.

Here is another thing. Why does $CRM hold ~$130M of CMO’s and mortgage backed securities? Are they a hedge fund or a software company? Are they chasing yield to make up for operating losses?

Now, there is no detail on what these are other than to say that 27% of them are current being held with “unrealized losses” of $770k and that the company believes they are temporary.

For the full quarter, the company saw loses of almost $5M on its marketable securities holdings:

Now, again, noting illegal or wrong with any of this. I’m just not sure if I was a shareholder in a company hell bent on growth I’d want them playing hedge fund in the CMO market. A bad move there (some people have been rumored to make them in the mortgage market the past few years) might disrupt those growth plans.

Also:

Yesterday the CFO was downplaying the “deferred revenue” metric analysts have been using the gauge the company’s future growth. From the 10Q pg. 36:

Seasonal Nature of Deferred Revenue and Accounts Receivable
Deferred revenue primarily consists of billings to customers for our subscription service. Over 90 percent of the value of our billings to customers is for our subscription and support service. We generally invoice our customers in either quarterly or annual cycles, with a disproportionate weighting towards annual billings in the fourth quarter, primarily as a result of large enterprise account buying patterns.

Additionally, our fourth quarter has historically been our strongest quarter for new business and renewals. The year on year compounding effect of this seasonality in both billing patterns and overall new and renewal business causes the value of invoices that we generate in the fourth quarter for both new and existing customers to increase as a proportion of our total annual billings.

Accordingly, the sequential quarterly changes in accounts receivable and the related deferred revenue during the first three quarters of our fiscal year are not necessarily indicative of the billing activity that occurs in the fourth quarter as displayed below:

Seems reasonable, right? The only problem comes into play when you look at the following chart (10Q pg 36):

The problem with focusing on Q4 and saying that it is seasonably the best quarter ignores what just happened in Q3. Q3 was the first quarter since FY 2010 that both accounts receivable and deferred revenue decrease sequentially. In fact it was the decrease in AR for me that was the most stunning as $CRM went from quarterly 10%-20% sequential quarterly jumps in AR to a near 10% decline. That is a cause for alarm and is especially so when you combine that with the first sequential quarterly decline in deferred revenues since October 2009 (at least in that quarter AR rose 14%). If you are a company focusing people’s attention on your revenue growth, not a silly little thing like profits, when two growth metrics slow, people absolutely must be alarmed.

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