Marc Benioff, chief executive officer of stock-market superstar Salesforce.com, says the story of his company is not about earnings, but about revenue. “This is a growth company, and this is a growth story … the ultimate number and the most important number is the top line.”
But if that is the case, then why is the vendor of customer-management software trying so hard to boost its bottom line through a set of aggressive accounting choices that are adding millions of dollars of profit?
We have analyst Mark Moerdler of Bernstein Research to thank for identifying these issues in a recent report. To be clear, Mr. Moerdler is not alleging the high-flying company is violating any rules – in fact, a number of other software companies he examined have similar practices. Yet Mr. Moerdler believes that investors should pay close attention to the decisions Salesforce.com has made in arriving at its net income figure.
One issue: Salesforce.com’s policy toward the sales commissions it pays employees for selling subscriptions to its cloud-based software service. Rather than expensing the commissions as the cash is paid out to its sales force, the company capitalizes the costs, an accounting decision that spreads the impact on its income statement over several years by treating the commissions as an asset that can be gradually written down.
Salesforce.com justifies the accounting by saying the company is selling multi-year contracts, with revenue stretching over the lives of the deals, so it makes sense to spread the cost of landing those agreements over the same period. In a letter to the U.S. Financial Accounting Standards Board – which is mulling rules that would bar companies from using this accounting tactic – the company acknowledges that generally accepted accounting principles (GAAP) state that “costs may not be deferred and capitalized unless an asset is created.” It argues, however, that the sales contracts “are a type of intangible asset.”
Mr. Moerdler notes that about one-third of the software companies he looked at capitalize sales commissions. But International Business Machines Corp. and CA Technologies do not. They, like Salesforce.com, derive significant revenue from selling subscription contracts to software.
Salesforce.com is also capitalizing the costs of developing its software. This is a permissible and standard industry practice, Mr. Moerdler says. (About half the companies he looked at do it.) But he also observes that companies that capitalize the costs typically roll out major software releases every couple of years. Salesforce.com, however, puts out new software releases quarterly, a time frame that seems inconsistent with the idea of writing off development costs over the long run.
While not technically an accounting decision, the company has goosed its bottom line by shifting its cash investments into riskier assets. Roughly 75 per cent of the cash and securities on its balance sheet last year were parked in an assortment of Treasuries, money market funds and bank deposits. It now has less than 40 per cent of its cash in those super safe categories, while riskier – but more lucrative – corporate bonds make up half the portfolio and collateralized mortgage obligations represent 7.5 per cent.
The cumulative impact of all these accounting and investing decisions is big. Mr. Moerdler believes that “if the company used the most conservative accounting and investment policies seen amongst software peers,” Salesforce.com’s fiscal year 2011 net income according to GAAP would be 79 per cent lower – 10 cents a share (U.S.), instead of 47 cents – and the so-called “pro forma” net income it prefers to emphasize would drop 30 per cent, from $1.22 per share to 86 cents.
A Salesforce.com spokeswoman declined to comment, saying the company does not address analyst research. But Mr. Benioff, in responding to a question last Thursday at the firm’s “Dreamforce 2011” investor conference, said the company has “the most conservative and most bulletproof accounting practices,” discussed from the beginning with the Securities and Exchange Commission and in place since it went public in 2004.
The idea that Salesforce.com should use the accounting practices of a Microsoft is “ludicrous,” he said, adding that other cloud-computing companies have adopted the company’s accounting model. It is Mr. Moerdler’s analysis, he said, which is “aggressive.” (Mr. Moerdler is one of just two analysts, out of a crowd of nearly 40, that have the equivalent of a “sell” rating on Salesforce.com. His $112 target price on the stock is almost 10 per cent below Friday’s close of $123.61.)
As long as investors continue to buy into Salesforce.com’s top-line story and not worry too much about profits – its trailing price-to-earnings ratio, after all, is 600 – Mr. Moerdler’s concerns may not matter. For investors who eventually want to see sales turn to robust, quality earnings, however, there are plenty of reasons that suggest staying away.