Marcus Lemonis, the host of CNBC’s popular show “The Profit”, recently lambasted a struggling business owner by saying, “You can’t spend the revenues, dummy.” Hey, we have to take our truths wherever we can find them. And almost eighty years ago, Benjamin Graham added some elegance to that notion when he stated that intelligent men often mistake a company’s rapid overall growth for the amount of profits that would actually be someday attributable to the shareholder.
Charlie Munger called high revenue/low profit businesses “good until reached for” because the money you saw reported on paper looked nice until you actually tried to convert it into cash that shows up in your bank account. Buffett, too, addressed this concept tangentially when he stated that his favorite businesses are the ones that permits the owners to extract ever-growing sums of cash each year without threatening the company’s competitive position or ability to self-fund growth. The Berkshire Hathaway investment in See’s Candies has emerged as the Exhibit A for this type of business over the past half-century.
An illusory business that could cause a lot of smart people harm would be one that reports very robust revenue growth but never actually gives you commensurate profits that you could extract from the business.
Take something like salesforce.com. That’s not a typographical error on my part—the company takes pride in its all lower case spelling and .com inclusion in the name to signal social proof to investors about scalability and the ever-popular e-commerce potential. And if you were to take a cursory look at this stock, you would be impressed by what you see.
Since the June 2004 IPO, salesforce.com has compounded at a rate of 29.5% annually. If you were to buy then and sell now, it would have been an investment that changed your life. Every dollar invested into the company eleven years ago would have grown into $17 today. Without having to do anything. No tax forms or payments necessary, as the stock does not pay a dividend. To have a million dollars in salesforce.com stock today, you would have needed to pony up $59,000 in 2004.
The reason for the excitement? The revenue growth has been more than amazing. Over the past ten years, the revenues have grown at a rate of 29.0% annually. You can see, based on the similar total returns in the stock price, that this company is being valued based on revenues rather than profits.
Why? Because there are no profits. Although salesforce.com is valued as a company worth $50 billion, it is expected to lose $135 million this year. It lost over $200 million per year in the two years preceding that. It made $80 million in 2009. That was the most profitable year in the company’s history. There is a huge asymmetry that spells problems for investors when a $50 billion company can only point to an $80 million profit six years ago as the best year of profits in the company’s history.
This inability to grow profits is compounded by the fact that salesforce.com gives out stock-based compensation to key executives like it is Halloween candy that needs to be given away before the expiration date. The CEO gets $39 million per year. The share dilution is outrageous. It added 40 million shares of stock between the full calendar year 2013 and 2014, and increased the share count from 450 million to 650 million over the past ten years.
Even worse, management likes to pretend that this excessive share dilution does not exist. They like to state that the company made $1.2 billion in profits over the past five years. How do they make that claim? They add the works on an adjusted basis to the end of their talk. The problem, though, is that this isn’t Johnson & Johnson telling you about earnings power without product recalls. This is a company that will give you figures that systematically ignores the effects of share dilution—which remain with the company forever as the base upon which profits per share are calculated—and calls inconvenient expenses “non-recurring restructurings.”
There is a reason the company has no dividend. It is because when you factor in the share dilution and so-called restructuring costs, the reported $1.2 billion in profit is actually $700 million in losses. As in, salesforce.com had $300 million in debt five years ago and now carries a $1 billion in debt. While still losing over $100 million per year. This is not the profile of a $50 billion company in my book. The company has not adequately addressed the question “What is going to change between 2015 and 2020 that will give you high profits?” that did not exist between 2010 and 2015.
Even if it somehow made $1 billion in annual profits—and keep in mind this is over 10x the highest profit figure the company ever reported in its corporate history—it would still trade at 47x earnings. When people talk about market bubbles, these are the kind of stocks they have in mind. It’s all about future projections and profits that have not yet arrived, and that is not how you get rich using margin of safety principles.
The reliable way to build wealth is to find companies offering valuations with tight relationships between profits and market valuation, and then give you some kind of indication that those profits are sustainable. And then you hold and compound. That’s it. You want to acquire partial ownerships in companies like Nestle that trade at 18x profits, knowing full well that those profits are sustainable because they are funded by 31 different billion-dollar brands that have been around for decades.
You don’t want to rely on companies that are, as the Texas ranchers of old would put it, all hat and no cattle. Sure, salesforce.com can talk about 29% revenue growth over the past decade. And yes, that is an impressive feat. Growing something like that does deserve praise. But it does not deserve your investment dollars, especially when you have to establish an ownership position as if each piece is part of a $50 billion pie. And what does that piece get you? Heavy shareholder dilution when executives get paid and no current profits to speak of. When you buy stock in billion-dollar companies with no profits, you’ve left the dock of conservative investing for the waters of speculation, and there is no telling where you will land.