The Curious Case of CRM As Kyle Bass has stated in regards to his negative bet on Japan, he does not

know the specific timing when Japan falls apart, but the ingredients are there for an explosion to the downside. An investor can use this reference to CRM as well all of the ingredients are now finally here. CRM has been written about extensively by both bulls and bears. This write-up very briefly identifies the current points to the bear thesis, and then discusses 3 very incremental points (and untalked about) that the market is missing. The bears constantly focus on things such as: Increased competition from larger tech giants (i.e. Oracle, Microsoft) and increased competition from smaller rivals (i.e. SugarCRM) this has not dented reported topline growth as much as some have anticipated, but clearly has negatively impacted profitability through severe price discounting and increased spending (expense growth higher than sales growth). Salesforce.coms core product is becoming commoditized - SFA (Salesforce Automation) functionality is not materially different than other SaaS CRM products. In fact, in many areas it has fewer feature sets than several competitors crmsearech.com Significant price discounting to gain new business (Seeking Alpha: Salesforce.com's Incentive Pricing Will Stick, 12/19/11) creating structural pricing issues for the company long-term Significant deterioration in GAAP profitability large increases in subscription, sales, marketing costs as a percent of revenue Weak free cash flow quality driven by high non-cash stock compensation which has nearly doublesdyear-over-year and CRM is stretching out payables Sizeable unexercised options and restricted shares nearly 36mn shares out there waiting to dilute shareholders (for what it is worth, all my contacts at the company (who are rational and objective and have a basic level of a financial background), cant believe how high the stock is and sell their stock every chance they get) Accounting revenue gimmicks - changing in invoicing terms from quarterly/semi-annual to annual contracts to boost deferred revenue (hence artificially increasing deferred sales/billings growth) Unusual changes in accounting changes in revenue recognition in FY12 10K (recognition policy of sales when the service has been or is being provided from when the service has been provided) Aggressive accounting - increases in depreciable life of assets, large increase in capitalized costs (i.e plant, property, software costs) on its balance sheet over the last several years, large increases in deferred commission expense on its balance sheet (Forbes.com: Salesforce Boosts Profits With Aggressive Accounting, Bernstein Says, 8/25/11) High attrition rates relative to other software/cloud tech companies Salesforce.com has double-digit attrition vs established peers mid-single digits, with sales over $3bn attrition is going to become a largely problem to overcome given the magnitude on a dollar basis Deterioration in the balance sheet sizeable increase in capitalized software and PP&E (absolute and as a percent of sales), increase in deferred commission expenses (i.e. pushing out expenses), increase in payables to benefit reported cash flow from operations (masking deterioration in underlying cash generation) No competitive moat - customer exit costs are low compared to prior software publisher models, the market is fluid and the company faces significantly increased competition Excessive insider selling Egregious valuation on any metric

Slowdown in core organic subscription growth For a $23bn company, CRMs disclosure around sales and billings growth is relatively opaque which has led many investors and analysts to analyze reported growth rates without taking a deep look to assess underlying (i.e. organic) growth rates.

In an attempt to peel back the onion, so to speak, I have attempted to leverage management conference call commentary, SEC filings, and technology dedicated websites, to assess CRMs organic billings trends for new subscribers over the past five years. In the table below, I detail a build to the growth rate in organic new subscriptions billings a key driver of long-term value for CRM. The math is simple getting all the data is a cumbersome process. First, one needs to calculate reported billings (subscription sales + change in deferred sales). Second, one needs to adjust for the impact of CRM moving many customers to annual billing contracts or multi-year contracts in both cases, it accelerates the amount of deferred sales CRM reports relative to prior periods when contracts where not annual or multi-year. CRM has disclosed the impact on its quarterly conference calls available on their website. Third, one needs to subtract contract renewals in order to derive new subscriptions billings. CRM also gives a percent attrition rate on its quarterly conference calls, so you can calculate the numeric value. Fourth, one has to make assumptions on the impact from acquired revenues, which is generally found on technology related websites and blogs. Fifth, adjust for the positive or negative impact of foreign currency on sales and/or deferred sales.

As you can see from the table below, after making the proper adjustments, CRMs core organic new subscriptions billings has been declining notably for over the past 2-years. However, an average investor (or analysts) would not realize this based on reported sales and billings given CRM has done an amazing job masking the deterioration through many acquisitions and significant changes in invoicing terms (moving customer to annual and multi-year contracts). Peel back the onion, and you get a $23bn money losing company with slowing underlying growth.
FY2010 a.) Subscription b.) Chg. in deferred revenue c = a + b Reported billings e.) Less: renew als f.) = c - e New subscription billings a.) Subscription b.) Chg. in deferred revenue g.) Impact of move to multiyear contracts & longer invoices h.) = a +b +g Adjusted billings e.) Less: renew als i.) = h -e Adjusted new subscription billings j.) Less: Acquired sales k.) Adjust for impact of foreign exchange on sales l.) Adjust for impact of foreign exchange on deferred sales m.) = i - j + k + l Organic new subscription billings n.) y-o-y % change = m .)/ f.) $1,209 $110 $1,320 -$915 $405 $1,209 $110 $0 $1,320 -$915 $405 $0 $0 $0 $405 FY2011 $1,551 $231 $1,782 -$1,122 $660 $1,551 $231 $0 $1,782 -$1,122 $660 -$15 $4 $0 $649 60% FY2012 $2,126 $445 $2,572 -$1,532 $1,039 $2,126 $445 -$156 $2,416 -$1,532 $883 -$70 -$35 -$13 $765 16% FY2013E $2,862 $362 $3,224 -$2,237 $987 $2,862 $362 $61 $3,285 -$2,237 $1,048 -$100 $40 $3 $991 12%

Note: For n.), calculation for FY13 & change, denominator adjusted $156mn to reflect change invoicing in FY12 base

Conclusion: Core underlying new subscriptions billings growth has continued to slow meaningfully over past two years. SEC forcing increased disclosure Several weeks ago, rumors swirled around SEC related correspondence with CRM. This is not the first time that CRM has dealt with increased scrutiny from the SEC. As CRM prepared for its IPO in 2005, the SEC delayed the IPO due questions over accounting. The most recent rumbling of SEC correspondence is not new information as the correspondences has been ongoing for several months. In addition, the

correspondence has to deal with mundane issues, outside of more disclosure on cash flows from operations. However, what the market and investors have failed to realize, is that this is likely just the beginning of increased focus by the SEC for CRM to begin disclosing more information about the business. Increased disclosure will be good for investors in assessing the fundamental position of CRM, however, it will be bad for the company as it will exposure significant cracks in the business model and growth profile. I believe there is an increased likelihood CRM will be forced by the SEC to begin disclosing any or all of the following metrics overtime which will shed light into the deteriorating in the fundamentals of the company broadly. Number of customers (which the company used to disclose) essentially allowing investors to calculate revenue per customer, profit per customer Average weighted contract terms (i.e. average contract was 6-months and now it 18-months? 24months?) increased deferred sales growth is impossible to gauge considering prior years are mostly 6-month to 1-year contracts, now CRMs is now increasing contract lengths (some over 5-years) and fronted loading sales in deferred revenue line. I believe the average contract length has increased significantly, which has distorted the apples to apples growth rate in deferred revenue growth. Segment revenue data (i.e. Salesforce automation, Force.com, Service Cloud, etc) More detailed disclosure on the impact from acquisitions (on sales and deferred sales) or reported organic sales/billings/deferred sales growth Increase disclosure on deferred commission expense on the income statement and balance sheet (i.e. length of deferral disclosure)

Conclusion: SEC will begin to force Salesforce.com to increase disclosure on more key metrics, which will show decelerating trends. $3bn-plus in sales + low double-digit attrition + high incremental margins on recurring biz = deteriorating profitability? Arguably, one of the most perplexing issues surrounding CRM is that fact they make no money despite being a $3bn sales company, with low-double-digit attrition, and what should be highly profitable reoccurring business. The analysis in the table below breaks down CRMs business by recurring business and newly acquired business (i.e new contracts/customers). For simplicity purposes, I assume a 15% attrition rate. For example, in 2007, I assume $236mn of $281mn in sales in 2006 is recurring in 2007 ($281mn * (100%15%)) and $213mn is new subscriptions. This exercise is repeated for the remaining years. Lastly, I assume on all recurring business CRM is achieving a 30% operating margin in line with company commentary on what they believe the margins are post initial costs of getting a subscription which can be costly. This exercise showcases that CRMs new business is very unprofitable. For perspective, this analysis implies CRM is losing nearly 65 cents for every dollar of new business. How can CRM be so unprofitable with $3bn in sales and what is considered to be very high margin business on recurring sales? I offer a few thoughts. (1) CRM is really losing that much money on new business as it discounts new products very aggressive to maintain sales growth. It has been written/talked about how CRM is highly focused on trying to bundle its product offerings. However, in order for the customer to accept the new offering, they are asking for severe discounts on products such as Marketing Cloud, Service Cloud, Force.com, Chatter, etc. This is unsustainable to say the least. (2) Recurring business is nowhere near as profitable as CRM say it is and they are not achieving 30% margins years have the business has been one, but are forced to discount products on renewal and/or aggressive pitch to retain the old business which can be costly.

(3) CRM is offering customers sizeable price discounts on its products, and booking some of these discounts in its costs lines instead of against gross sales. This clearly would be a huge red flag as it would essentially allow CRM to inflate sales.
2006 281 29 310 0 281 15% 2007 452 45 497 0 452 15% 2008 681 68 749 5 676 15% 2009 985 92 1,077 15 970 15% 2010 1,209 96 1,306 5 1,204 15% 2011 1,551 106 1,657 10 1,541 15% 2012 2,126 140 2,267 35 2,091 15% 2013E 2,862 183 3,045 100 2,762 15%

Subscription and support Professional services Total Sales Acquisitions Subscription (ex acquisitions) Attrition

2006 2007 2008 2009 2010 2011 2012 2013E

281

239 213

203 181 292

172 154 248 395

146 131 211 336 380

125 111 179 286 323 517

106 95 152 243 275 440 781

90 80 129 206 234 374 664 985

Reccuring business EBIT New subscription business EBIT Total EBIT (GAAP) Recurring EBIT margin New subscription margin
Memo: Recurring sales 2012 = 2006-2011

72 (75) (4) 30% -35%

115 (95) 20 30% -33%

172 (109) 64 30% -27%

247 (132) 115 30% -35%

307 (210) 97 30% -41%

393 (428) (35) 30% -55%

533 (653) (119) 30% -66%

Conclusion: It is largely unexplainable how Salesforce.com can be so unprofitable given recurring revenues. Valuation Working through the math Aside from looking at CRM lofty valuation metric, lets value CRM based on a very optimistic bull case scenario. CRM management has constantly recited their goal to be a $10bn sales company. Lets assume CRM generates $10bn in sales by 2017 (30% sales CAGR), applying a 4x EV/sales multiple (similar to GOOG) equals $40bn enterprise. If we discount that back to todays value at a 15% discount rate it equals roughly $23bn, about the enterprise value today. Lets take it another way as well, assume CRM generates $10bn in sales by 2017 and achieves 30% margins and has a 35% tax rate this equals about $13.75 in EPS (using current share count) - apply 20x P/E = $275, discount back to todays value at 15% discount rate it implies a value of around $155$160, below the current share price. Lastly, let me break out my textbook and look at valuation from a discounted cash flow analysis perspective. In FY13, CRM is going to generate roughly a negative $350mn in cash flow to the enterprise (defined as cash flow from operations capex building improvements acquisitions lease payments). Based on research reports I have viewed, analysts forecast this number to be about $550mn in FY14. Lets assume this is the number. Lets assume CRM can grow 30%/ year until 2017 off $550mn but stock comp eventually become a headwind by 2015 to the tune of $300 (about $400mn benefit this year) eventually employee compensation will move to higher cash payments vs massive stock comp. Under this rosy growth scenario, assuming a discount rate of 15% - it implies a sub $100 stock. Nearly every

analyst note with a DCF is massively flawed because it assumes stock comp remaining a huge cash flow positive even in the out-years when growth with eventually slow and employees will want less stock comp, but more cash comp.

Conclusion, even in the most bullish scenario where everything goes right from CRM, the stock can be considered overvalued. As Warren Buffett would say, where is the margin of safety if the rosy forecasts dont work out?

Key flaws in the bull thesis The core CRM market is growing significantly The total CRM (customer relationship management) market continues to show strong growth. However, Salesforce derives 75%-80% of revenue from the Sales CRM market, which was the first segment to move to the cloud and will continue to see growth slow given it was the first out of all the sub-CRM markets. Based on my research, the Sales CRM market is now growing in the high-single-digits, from rapid double-digit several years ago. Lastly, it is increasingly evident CRMs management manages the billings number through acquisition and revenue tricks (on a side note, why are management and investors so focused on 30% number for billings growth, is that the magic number?). For perspective, for CRM to hit revenue expectations next year, based on the assumption 75%-80% of sales are the core sales CRM product which is growing mid-teens, CRM essentially needs to grow its other products (i.e. Service Cloud, Marketing Cloud, Force.com, Chatter) 100% - I think this is very unlikely based on all my research. Service Cloud and Marketing Cloud will be huge growth drivers This is highly unlikely. First, based on independent reviews, the overwhelming consensus is that Salesforces Service Cloud and Marketing Cloud have weaker positions relative to Salesforces core SFA offering. I find it of interest that at the latest Dreamforce event, CEO Benioff acknowledged that enterprise social media has perhaps not yet yielded as solid a return on investment as enterprises might like to see for a new business model. Further, it is widely viewed in the tech community that CRMs Service Cloud is nowhere near capable of handling large scale operations, and core market will be focus on small to mid-tier companies that need less complex services. Based on my research, even people at the company question the success of CRMs offering outside of the core SFA product given they are inferior products based on many of my channel checks and CRM is not the first mover in marketing cloud, service cloud, etc very different from its core offering, which led CRM to have a first mover advantage.

Salesforce Service Cloud lacks next-best-action and real-time analytics capabilities commonly requested for agent support. Also, because the Service Cloud is only available from the cloud, it is rarely deployed in larger, high volume B2C contact centers. CRMSearch.com The marketing software is competitively weak in the cloud CRM industry crmcafe.com, referring to Salesforce.coms marketing cloud product Salesforce becomes less competitive when looking beyond CRM. crmcafe.com Andy Lark, CMO Commonwealth Bank of Australia made the telling point: "The role of the CMO is vastly over-stated." He then went on to say that Facebook advertising accounts for less than two percent of his company's ad spend. That runs counter to Salesforce.com's assertion that 'all business software of the future will need to be lie Facebook' - a statement that drew a loud raspberry from colleagues in the Twitter peanut gallery. CRM will be a leader in the PaaS (platform-as-a-service) market CRM may generate sales from app development. However, almost anyone in the industry does not expect the company to be able to monetize this year long-term.

GAAP profits a negative, CRM is growing free cash flow CRM free cash flow growth has been a modest 5% annual growth rate since 2008, including stock compensation. This calculation excludes over $1bn in acquisitions. CRM has poor free cash flow quality in regards to lagging revenues, combined with stretching out payables and having non-cash stock compensations becoming meaningful drivers of cash flow is unsustainable, in my view. Margins will grow at the company matures Further, both Oracle and Microsoft, were actually growing faster than CRM at the $3bn sales level, had higher margins in the mid-20%s, and deployed meaningful less capital to grow sales. The idea to compare a company like Salesforce.com to Microsoft or Oracle is laughable considering both MSFT and ORCL where unique in size and offering and did not face not larger scale competitors and, generated high cash flows and margins at the $3bn run-rate. CRM currently loses money, generates little core free cash flow, and has large-scale competition. CRM will continue to grow by acquisitions CRM may engage in more acquisitions, but given CRM size, it will need to do larger scale acquisitions which will likely be highly dilutive considering CRM will try to issue share to pay for deals. A growth by acquisitions almost never succeeds over the long-run when technology is changing so rapidly. Also, I believe greater detail around the impact of acquisitions will be forced by the SEC and will make investors focus more on core organic revenue growth vs reported which includes deals. Salesforce offer one of the most differentiated products in the cloud space If CRM has such unique and non-commoditized products, then why do they offer such massive pricing discount in order to win new business? CIO feedback, across the board, highlights that the majority of CRMs largest customers want implicit quid pro quo on any new feature the CRM sales forces tries to push this almost always results in dramatically lower pricing and favorable contract terms for customers. At the end of the day, CRMs core salesforce automation product is becoming more and more commoditized. Lastly, software-as-a-service has real benefits. However, a huge negative is that switching costs are materially lower versus traditional software (which requires installation onpremise). Attrition rates at CRM run well above more traditional tech companies and it is higher than offer cloud based companies (i.e. ATHN has 5% attrition). The ease for customers to switch from salesforce.com product is high and limits any type of competitive moat long-term.

Conclusion: Key parts of the bull thesis are materially flawed. I understand it is nearly impossible for sellside analysts and investors to go against the grain because it is uncomfortable at times (and sell-siders want banking biz from acquisitive companies such as CRM and analyst have to write favorably in order to get access to management for investor field trips which then helps analyst get paid by clients and get broker votes). That said, the lack of objectivity never ceases to amaze me. I find it very interesting that the majority of well-known growth investors from the tech bubble who are still managing money almost none own CRM. Variant view and How do I make money? I believe that CRMs core underlying sales growth has slowed materially. This has gone largely unnoticed due to management pulling forward sales/deferred sales through moving customers to annual invoicing and multi-year contracts, hence boosting reported revenue growth. The core business for CRM is slowing and share gains are slowing, meanwhile all of its newer product offerings are inferior to peers and CRM has no first mover advantage in the end, these product are unlikely to make CRM money. Due to the lack of visibility into CRM revenue profile and profitability profile, I believe the SEC will force the company to increase disclosure on key metrics which will show deterioration in trends and force bulls to reassess the future growth prospects and profitability on this entity. Why now? CRM is out of levers to pull in regards to accounting trickery, core trends are decelerating, competition is more intense than ever, underlying cash flow generation is deteriorating rapidly, and sales growth expectations for FY2014 are unrealistic given the implication would be for CRM to gain massive share in their core market and/or a

doubling of revenue outside its core sales automation product again, highly unlikely based on channel checks and survey work. Warren Buffett is quoted for saying, Price is what you pay, value is what you get. So, for $171 what do you get? You can buy a company valued at over $20bn, whose main product offering is 80% of sales and is becoming increasingly commoditized, earns no GAAP profits, has no pricing power, engages in aggressive accounting and revenue gimmicks, generates little cash flow ex non-cash stock comp, insiders continue to sell rapidly, offers inferior products outside its core, and the stock trades at an egregious valuation. All I can say is (and likely Warren Buffett is thinking).good luck!