Is This Tech Titan a Bubble Play Ready to Burst?

Man bites dog.

Stock of Nasdaq giant declines after weak earnings guidance.

These two headlines seem just as likely these days, but Salesforce.com's (CRM) sharp decline in Friday morning trading shows the market is paying attention to fundamentals.

The market was unhappy with Salesforce management's lowered guidance for earnings for its fiscal second quarter (ending July,) but a closer look at the April quarter shows the signs of slowing growth. Growth is the touchstone for valuation for any of the Tech Titans, and Salesforce's first quarter was a mixed bag in terms of growth and cash flow metrics.

For the April quarter, Salesforce's revenues, EPS and growth in remaining performance obligation (backlog) all came in slightly below the guidance given by the company on Feb. 25. Of course, the impacts of Covid-19 were felt everywhere, and I think the market was willing to give Salesforce a pass on the April quarter as long as guidance for the year was maintained.

Tellingly, that did not occur.

Management lowered guidance for fiscal 2021 revenues to ~$20 billion from February's forecast of $21.0 billion-21.1 billion and for non-GAAP EPS to $2.93 - $2.95 from the February guidance of $3.16 - $3.18.

Most importantly, management lowered its forecast for operating cash flow growth for fiscal 2021 to 10-11% from 20%. That's a huge decrement and, on the surface, would explain CRM's decline in Friday's trading.

I wrote "on the surface," because Salesforce is truly a tech conglomerate, not just your friendly neighborhood purveyor of customer relationship management software. From a financial perspective, CRM essentially operates as a large hedge fund. Incremental growth is driven by acquisition, and earnings per share are driven by realized and unrealized gains in investments in other companies, both public and private.

On the revenue line, Salesforce CFO Mark Hawkins noted on the call that:

"Americas grew 29% with 11 points from significant M&A. EMEA grew 41% with 12 points from significant M&A and Asia Pac grew 28%."

So, if CRM stopped acquiring other companies, the reported growth rates would be much lower. Habitually acquisitive companies often face extra scrutiny owing to the subjectivity involved in acquisition accounting (General Electric (GE) is a classic case of this) but I am not casting aspersions on Salesforce's strategy or bookkeeping here. The company needs to continue to acquire other businesses to maintain its growth rate and keep the equity markets happy. This is not a questionable point.

What is questionable, however, is the amount of Salesforce's net income that comes from gains in its investment portfolio. In the April quarter, Salesforce reported a GAAP operating loss of $140 million, a figure that was more than offset by the recognition of $192 million of gains, both unrealized and realized from its strategic investments in the quarter. Hawkins noted on the call that the gain in this line item was driven by significant realized gains on the sale of public securities, partially offset by unrealized losses within the investment portfolio. So, Salesforce's operating loss became a profit due to the big April bounce in the Nasdaq. This is not a new phenomenon, either, as for the full fiscal years ending 2020 and 2019 CRM's income from investments exceeded its profit from operations.

Yes, this is a tech company, and yes, investors tend to focus on non-GAAP figures, but as the motto of my firm, Excelsior Capital Partners, states, cash flow never lies. For the April quarter, Salesforce's free cash flow (operating cash flow minus capital expenditures) fell by 15% year on year, to $1.54 billion.

Even after Friday's pullback, CRM shares are still trading at about 57x the company's guidance for fiscal 2021 non-GAAP earnings. To own a stock at that multiple, I need to see real, organic growth, not just constant purchases and hedge fund-style investment gains.

So, I avoid CRM here.

For those who own the stock, just remember that a significant portion of the company's valuation is attributable to its ability to purchase assets and for those assets to be given higher valuations by the market.

Make sure you are not on the wrong side of a bubble play. It can be expensive when they burst.

(Salesforce.com is a holding in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells CRM? Learn more now.)

At the time of publication, Collins had no positions in the securities mentioned.