Porter Stansberry loves to take strong, vocal positions on controversial stocks, and some of those have worked out well. He also rubs a lot of people the wrong way, partly because of his abrasive libertarian screeds and his aggressive marketing campaigns and partly just because he comes across as brash and wealthy. I’ve met with Porter and he seems like a perfectly reasonable guy in person, but I’m sure he also knows that bold statements and certainty sell newsletters — waffling and quibbling and “on the other hands” don’t catch readers’ attention in our information-saturated age (unfortunately, waffling and worrying about both sides of an argument are your friendly neighborhood Stock Gumshoe’s cross to bear … I’ll happily take your subscription dollars anyway, but I can’t promise much in the way of clear and bold certainty).
And Porter is a vocal proponent of some things that many investors don’t particularly like doing or feel comfortable doing, like income-generating options trades, corporate bonds, and shorting stocks. So when several readers sent me copies of his latest letter over the weekend, I thought I’d take a look.
This particular letter Porter wrote, which was published on his Daily Crux site, is not an investment recommendation, it’s a story about leadership risk, for lack of a better term. The example he focuses on is “Chainsaw” Al Dunlap, who was, so Porter says, a psychopath who used suspect accounting, acquisitions, and mass layoffs to build a reputation as a turnaround artist of a CEO, with stints at Scott Paper and Sunbeam particularly leading to his celebrification as a corporate leader. You probably remember Dunlap, who was a media darling for a little while in the mid-1990s, and I won’t run through the whole story, but Porter focuses not just on the accounting misdeeds that later came to light, but particularly on the destructive power of employee stock options, which he says were used by Dunlap (and, as you’re probably more aware, by lots of tech boom companies in the 1990s) to essentially take employee compensation off the books as an expense.
And then he starts hinting around about someone who might be the next disaster in waiting …
“I’ve been pondering the question of whether a certain major software executive, someone who is today lauded by all of Wall Street as a ‘genius,’ might in fact be – like Al Dunlap and Henry Nicholas – a genuine psychopath who’s going to destroy his company and wipe out millions of investors….
“For me, the telltale sign of a psychopath is someone who knows… or has reason to know… that the policies and procedures he’s using aren’t going to work. Consider Al Dunlap. From the very beginnings of his career, he was getting fired for horrendous personal behavior and accounting shenanigans. It seems clear that he couldn’t control his urges to abuse people and lie.
“I’ve spent the last few days researching one company whose CEO is brilliant. He’s far too smart not to recognize that his abuse of employee stock options grants is completely unsustainable. But still… stock-option expenses are now growing faster, year over year, than revenues. Over the last three years, the results of these policies have been massive losses – which are growing larger, year after year.
“So far, this CEO has succeeded in distracting Wall Street from these facts with several acquisitions. He’s paid the investment banks a lot of money to do bond issuance for him, which has kept the analysts from downgrading his stock.
“But… the most recent deal will prove to be his undoing. It was a $2.5 billion deal. And he was forced to pay in cash. Suddenly, the companies he’s buying won’t accept his stock as compensation. That’s a sure sign in Silicon Valley that something is about to go terribly, terribly wrong….
“Here’s a prediction: Sooner or later, we’ll find out that this guy wasn’t merely a bad businessman. He was a genuine psychopath.”
So as I said, it’s not really a stock tease — but it implies to me, given the fact that I know Porter has recommended short selling several times in the past for subscribers of his Stansberry’s Investment Advisory, that he’s probably recommending a short sale of this stock. Probably.
What, then, is the company?
This is, sez the Thinkolator, Salesforce.com (CRM). And the potential psychopath must be CEO Marc Benioff.
But if you want to go out and short Salesforce.com, do keep in mind that you will be in a crowd — it may be that most people probably wouldn’t call Benioff a psychopath, and I doubt that all the short sellers are expecting accounting scandals or a disaster that sends the company under, but CRM is probably among the most-shorted stocks in America. Close to 10% of the shares are sold short, and since there is high insider ownership and huge institutional ownership that causes somes sites (like Yahoo Finance) to classify CRM as having 75% of its float sold short. “Float” is a tough concept to use in this case, since it cuts out a lot of the institutional ownership and Salesforce.com shares are very, very actively traded, but the “days to cover” is pretty big too — at their average trading volume it would take seven or eight days to clear the short positions by buying back shares, which means CRM is one of those stocks that’s both often touted as a short and frequently talked about as a “short squeeze” candidate.
Selling a stock short is fairly simple in practice — you do a “sell to open” transaction instead of a “buy to open” transaction, but behind the screen of your brokerage trading window what’s happening is that you’re borrowing the stock from another investor and selling it at the current price. That means you owe that investor not a specific amount of money but the return of their shares — so if you sell short 100 shares at $36, you have to return those hundred shares to the investor who lent them to you (you’ll also have a cost to borrow, determined by your broker — a percentage that you’ll pay effectively as interest on the value of the shares you sold). In order to return them, you’ll have to buy them back to close the trade — so the hope is that you can buy them back at a lower price and book the difference as your profit. You don’t really “buy” anything to start this transaction, but you do commit your fundsd and your broker will hold some of your cash and/or your margin account as collateral to make sure you can close the trade.
A short squeeze is when those who have sold the stock short are forced to buy it back, either because it rises far enough that it hits their stop loss position or because their broker cuts off their credit and does a margin call to force them to cover the short. Being short means you’re taking on liability that’s theoretically unlimited — you haven’t put up any cash, perhaps, but if the stock jumped from $36 to, say, $300 overnight for some crazy reason you are obligated to buy back the 100 shares (or whatever number) at that current, dramatically higher price, so most people need to have a margin account to cover that potential liability, and the broker can force you to act if they think the liability is getting too high.
Would you consider selling Salesforce.com short? If so, you certainly wouldn’t be alone — the stock has come down a bit from recent highs but is still ridiculously expensive by any measure you can imagine (it topped out around $47 a few weeks ago, is now at $36 — if you see much higher numbers like $170-180, those were before the 1:4 stock split a few weeks ago). CRM is the example stock that value investors flock to when they’re looking for the shockingly bad opposite of the great low-valuation stock they’re pitching. It trades for 9X book value, has been losing money for more than a year despite increasing revenues, and did indeed just agree to a $2.5 billion cash acquisition of a marketing company, ExactTarget (ET), that went public only a year or so ago. ET, for what it’s worth, also loses money thanks in large part to stock options.
And even that stock split points to the importance of options to Salesforce.com and its employees and management — it seems likely that part of the reason for the split was not just to make the stock more appealing to retail investors, which is the core reason for splitting stock even if it’s often a silly rationale, but also to increase liquidity to make it a bit easier to absorb ever more stock options and offer lower-strike options to new talent they want to hire (potential employees are just as likely to focus on a low share price as investors are, even if buying one share at $140 is really the same as buying four at $35 each, so having your options struck at $35 seems like it offers more upside than having your options struck at $140).
But selling CRM short has been a popular trade for years now, and it has worked very badly for all but the most nimble of traders — the stock has been moving up and up and up over time on the strength of the revenue growth and the software as a service (SaaS) story that has them taking more and more business from enterprise software companies like Oracle (ORCL). It must be an incredibly frustrating stock to be short — it’s clearly very overvalued, but investors keep buying when the stock dips. There’s a good article here from Ycharts about the difference between GAAP accounting and the non-GAAP that Salesforce.com and other companies use to show the numbers without the impact of some acquisitions and stock options costs.
The optimism that keeps people buying CRM is based on their compelling revenue growth, which at roughly 30% in recent years is indeed pretty spectacular for a company of this size (market cap of $20 billion), and on their high-margins as a software company — but those high gross margins, while lovely, do not show any sign of making it down to the actual profit margin line, every increase in sales seems to bring an increase in selling costs. So my impression, without knowing CRM well or studying it very closely, is that Salesforce.com is feeding a beast — they keep expanding their offerings by bolting new companies onto their platform of customer and sales management and marketing systems, but then they have to keep trying harder (and spending more) to sell customers on those expanded offerings, either because of softness in the economy or because of strong competition in their space or for whatever other reason, and they’re not getting sales increases that get them above their rising costs and let them turn that revenue growth into profits. They are reporting positive operating cash flow and free cash flow, since those numbers aren’t impacted by options grants or amortization, but free cash flow at 99 cents/share over the last year still means they’re trading at a very high multiple. The free cash flow is growing, or at least it has been up until this acquisition, so that’s something you can grab onto if you’re looking for positivity.
As long as costs keep rising as fast as revenues, there’s no indication to me that CRM has any real scalability these days, so buying the stock here is buying belief in the story that they will somehow turn that around. Shorting it seems clearly to be a saner decision to me, but shorting a company with 30% revenue growth can bring a lot of pain if they’re able to turn the switch that gets them a profit. That doesn’t seem particularly likely to me right now, especially as even CRM is saying that the ExactTarget acquisition will be dilutive for this first year and bring their “earnings” per share down (those are the non-GAAP earnings forecasts, I presume, since they aren’t likely to have actual earnings), but you never know. There are, of course, folks who think that this kind of revenue growth is exciting enough to pay up for, and those who think the recent acquisition is a good strategic fit (as pointed out in this piece from the Motley Fool, whose newsletters have recommended the stock in the past). The typically valuation-focused folks at Morningstar are cautious about the price and have a $30 fair value tag on the stock, but the vast majority of analysts rate it a buy or a strong buy even as value investors pull out their hair yelling about how ridiculous the accounting and the valuation are.
I’m staying away from this one, I don’t know if Marc Benioff will turn out to be a value-destroying psychopath or a visionary industry-creating leader (or both), but I do know that I certainly don’t want to buy a company that can’t make money even with this kind of ridiculous revenue growth … and I also don’t want to sell short a company that has this kind of revenue growth. My bet would be that Porter’s probably right about the negative prognosis, but when you sell a stock short you have to see a reason why that negative prognosis will happen sometime soon — you can lose an incredible amount of money if you’re patient with a short and the stock rises quickly.
If you do want to bet on CRM imploding you could also use put options, which limit your downside potential (you can’t lose more than 100% when you’re buying an option, you can lose more than 100% if you’re selling short) but make it more likely that you will lose that 100%. It would cost you about $4 a share, for example, to bet that CRM will fall below $30 by January 2015, so that bet would only work in your favor if CRM falls below $26 to generate a profit for you. Alternatively, if you short CRM now you get a straight line of profit if the shares move down by even a couple dollars so you wouldn’t have to see a 30% decline in the stock before your made money. Of course, if you short CRM on margin at $36 and the stock explodes to $50 and takes out its old highs, you’re out a lot of cashola and your broker may not let you be patient and wait around for the shares to come back down before issuing a margin call to make you cover at $50. I didn’t just make that number up, $50 is roughly the average price target among the army of analysts who cover Salesforce.com.
All that is just “for example,” of course — as noted above, I have no idea whether Porter actually recommended selling CRM short in his newsletter, I just followed the clues in his article and concluded that Salesforce.com is the value-destroying tech company he hinted at, and Marc Benioff the next “may be a psychopath” CEO. I’m not buying or selling this one, how about you? Ready to join the short-sellers with the conviction that this kind of money-losing can’t continue forever? Or do you think this industry titan is building a dominant company that (like Amazon, perhaps) needn’t worry about current profits as it builds its customer base and revenues, but will eat Oracle and IBM’s lunch and turn that tremendous sales growth into real profits someday? Let us know your opinion with a comment below.
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