Another quarter and despite it, again, being represented as a solid result, the fundamentals have deteriorated. As usual, I stick mainly to GAAP (Generally Accepted Accounting Principles) results which Salesforce presents to the Securities and Exchange Commission (SEC) rather than the non-standard results presented by Salesforce to the public. There will be one significant exception for this quarter which is a $149 million tax offset but we will get to that in a bit.
As we did last quarter, let us see what is on the minds on Benioff and Smith this quarter.
Key phrases (two words or more) for this quarter included:
It is fair to say revenue and growth are the focus for the CEO and CFO, as they always have been. As usual other key financial measures, such as profitability did not rate. However indirectly, as we will see further on, Salesforce have clearly communicated what they consider their future prospects for profitability are.
The only new topic on the list is ‘mobile’; a hot topic in CRM as people move beyond the laptop/PC.
As was the case last quarter, mentions of social are down about one half from last year. I speculated last time this was due to the backlash against 'Salesforce using the term ‘social enterprise’. Given that phrase was not said once this time around, in keeping with Benioff’s commitment to abandon the expression, this could be the reason.
There is a focus on marketing, whereas this was not mentioned a year ago and is in keeping with their acquisitions of Radian6 and Buddy Media.
Before I get into the financials, there is something that must be addressed. If you look at the numbers, you will see Salesforce has put aside $157m for taxes (a number well outside of historical norms) and this has led to a quarterly loss of $220m and a financial year to date loss of about a quarter of a billion dollars. Given last year’s loss was $11m, there is something clearly out of the ordinary here.
This is how CFO Graham Smith described it:
“Our GAAP results this quarter include the impact of a onetime, noncash charge of $149 million to establish a valuation allowance against our federal and state deferred tax assets.”
“Deferred tax assets on the balance sheet represent the value of tax deductions and credits to offset future tax liabilities. These assets include net operating loss carry-forwards, R&D credits and book/tax timing differences, such as accrued liabilities. U.S. GAAP requires companies to regularly assess the realizability of deferred tax assets by evaluating certain criteria. These criteria include whether the company has a cumulative 3-year historical pre-tax GAAP loss, as well as the timing and likelihood of near-term GAAP profitability.
After performing this analysis in Q3, we determined that a valuation allowance was required as near-term realization of these assets is unlikely. But just to be clear, our deferred tax assets have expiry dates many years into the future. And so we do anticipate being able to use these assets at some point to offset perspective tax liabilities.”
If you are like me, you did not understand a word of it. The best article I can find on deferred tax assets is this one from the Motley Fool. This is my interpretation of the situation. If you make a loss as a company you get a tax credit with the idea being that when you finally make a profit, you can offset the tax you would normally pay with this credit. On the accounting books this tax credit is carried as an asset because, in some ways, it can be thought of as a bag of money standing by to use to pay taxes in the future.
However, what if a company never makes a profit? In this case the asset will never be realised i.e. the credit will never be used and having it on the books is misrepresenting the true value of the organisation. To keep the asset value of a company accurate, the government has put in place certain ‘triggers’ which mean a company must assess the likelihood that such an asset will be used, if one of these triggers goes off. In the case of Salesforce, the trigger was making a net loss over the past three years. Yes, despite all this awesome growth, Salesforce has lost more money than it has made over the last three years.
Salesforce has reviewed the likelihood that they will use this asset i.e. make a profit and determined that $149m of this tax credit will never be realised. This can also be seen in the balance sheet where ‘Deferred Income Taxes’ has gone from $165m down to $21m.
So to make this clear, when Graham says “near-term realization of these assets is unlikely” he is saying “we are not going to make a profit any time soon”. He then makes the plea that at “some point” they will use it but, frankly, if there was a reasonable prospect of using them, they would not take them out of their assets. You can stretch your optimism in an earnings call but the government require you to be practical.
Ultimately though this is a write-down and does not reflect their current business operations (more their future prospect of making a profit) and so I have removed the expense from my financial calculations below. We will see, even with this item eliminated, things are not rosy when we look beyond revenue growth.
Green is cost growth year-on-year and red is revenue growth year-on-year. As Benioff mentioned, year-on-year revenue growth came in around 34%. What he did not mention was that to achieve this, they had to grow expenses by 42%. This is disappointing. In the previous four quarters they had successfully tempered cost growth and brought it back to the same rate as revenues. Unfortunately, it seems to be impossible for Salesforce to reduce the rate of growth of costs to below that of their revenue and therefore head towards profitability. We can see why they needed to write down their deferred tax asset.
In terms of absolute numbers, the only notable change is the larger loss. Excluding the write-off, the loss to the business for this quarter was $70m. This is a larger loss than the previous five quarter losses combined. The largest profit made by Salesforce in a quarter was $21m this time two years ago (and also back in 2009). So this quarter’s loss is more than three times the largest profit ever made in a quarter.
Some of you may remember my log scale graph from last year. While the shape is similar, the difference here is this is not a log scale. nothing is being stretched here. The fact of the matter is, even with the massive $149m write-off removed, margins are plummeting, down to –9% this quarter. In other words, for every dollar they spend on generating a sale, they return around 91c. we are now at a point where Salesforce is selling $10 notes for $9.
Marc mentioned that staff numbers were up 34% from this time last year, which is true. What he did not mention was this is the slowest rate of staff growth in two years. Around 40-50% year-on-year growth has been the norm for the last year or so. In other works, staff growth appears to be tailing off.
Despite a deterioration in profitability, this has not deterred Benioff on his focus on revenue growth at all costs, literally. My hope last quarter was that Salesforce would return to profitability but this is unlikely to be the case any time soon. This deterioration of position is confirmed in the declaration of the CFO that Salesforce will not be making a profit in the near future and the subsequent revaluation of their ‘tax credit’ asset.
As usual I hope Salesforce can turn things around as competition is a good thing. If not they will continue to bleed money and dig themselves a hole that it will become increasingly harder to get out of.
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