But We're Growing

Posted on April 17, 2013 by Ben Connard

A company growing its revenue and improving operating margins is generally increasing its cash flow. When buying a stock, you are essentially buying its future cash flows (discounted to its present value). Therefore, companies that demonstrate revenue growth and improving margins are generally rewarded with higher stock prices as their future cash flows will be greater. And a company that has a proven track record of generating and growing cash is generally rewarded with a high Price/Earnings multiple.

The opposite is also true. Companies that don’t grow their revenue or have falling margins also have falling stock prices. Growth with little margin improvement is also generally frowned upon. Cisco has had this problem. It’s been forced to cut prices to grow sales but that has caused its margins to deteriorate. This past quarter, the company found a balance of price reduction that spurred growth and cost cuts that helped steady margins. The market rewarded its performance sending that stock up 4.8% after it released earnings.

Other companies get a pass on their margins and are labeled growth stories. Salesforce.com (CRM) and Amazon.com (AMZN) are two examples.

CRM’s cost of revenue and operating expenses both increased during the most recent quarter- and the stock went up 7%. The bulls point to the 35% sales growth and the transformative nature of its “software as a service” business model. We point to the 41% increase in sales and marketing expenses as a sign the company is forced to spend more to grow less. And the increased competition from Oracle, SAP and Microsoft is not exactly adding to CRM’s pricing power. Over the last few years, CRM’s cost of goods sold, sales & marketing, and research & development all have increased as a percent of revenue. CRM management ignores some of these costs when reporting non-GAAP results to boosts its earnings. For example, CRM spent $230M in stock compensation last year, which is a non-cash charge and can be added to the cash flow. But if you ignore stock compensation, you have to include the 11M options outstanding that could dilute the company’s shares by almost 10% if not bought back. And stock buybacks to prevent option dilution do not help current shareholders as cash is reduced but the share count stays the same. CRM also has spent almost $1B over the last 2 and a half years on acquisitions in order to keep the growth rate higher. Growing through acquisitions is not a long-term strategy. It’s hard to leverage one’s current business when management’s time is occupied integrating the latest series of acquisitions.

AMZN is another growth story. It currently is the most expensive company is the S&P 500 with a P/E multiple of 465 (CRM does not have a P/E multiple since its EPS are negative). Last quarter, AMZN’s revenue increased 27%, but its operating expenses went up 28%. AMZN’s latest expense is opening 19 fulfillment centers around the country to offer faster delivery to customers for the holiday season. It’s also spending money on servers for its Web Services and media business—providing infrastructure to web-based businesses and streaming movies.

Amazon is rolling out more Kindles which are sold at or near cost in the hopes that AMZN will make money on purchases through the devices. This strategy works in theory as eventually AMZN pulls back spending and generates more and more cash, but that assumes spending will stop. Some think AMZN wants to eventually offer same day shipping for certain items, which means more spending on warehouses and shipping centers. AMZN also plans to expand its streaming business which means paying more studios for movies and increased spending on streaming infrastructure. AMZN’s never going to be able to say, “OK, we’re done spending, now we’ll just sit here and generate cash.” It will continue to face competition in retail from Wal- Mart and others, in streaming movies from Netflix and iTunes, and in tablets from Apple, Google, Microsoft, etc.

Both Salesforce and Amazon have failed to prove that they can generate cash using their current business models. Until that happens, we find little reason to be impressed with their growth and no reason to invest in their stock.