Tuesday, June 30, 2015

Earnings Inflation: Why Some Tech Companies Earn Less Than You Think

This Barron's article covers what it calls the "weird world where a wide range of technology companies...encourage investors to ignore the large and very real cost of stock compensation when calculating expenses and earnings."

Remarkably, this kind of "inflated and distorted earnings figure...is widely embraced by analysts and investors in valuing tech companies."

This, in part, reminds me of what Jeremy Grantham once said:

"Career risk drives the institutional world. Basically,everyone behaves as if their job description is 'keep it.' [John Maynard] Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay."

Well, if that's the case, then maybe this bodes well for those less influenced by "the institutional world."

Barron's estimates that a dozen large tech companies are not including roughly $ 16 billion of stock compensation expense in their non-GAAP earnings. A table in the article provides a detailed look at the relevant numbers for the twelve companies.

Some things to consider:

- Stock compensation is usually the major difference between reported GAAP earnings and non-GAAP earnings.

- Profit projections from analysts often ignore stock compensation.

- The likes of Microsoft (MSFT), Intel (INTC), Apple (AAPL), and IBM (IBM) are tech companies that report GAAP numbers only with stock compensation included.

- Some companies prefer non-GAAP earnings because they're highly dependent on stock-based compensation and, well, it makes their numbers look better. Analysts, in enough cases for it to matter, tend to use whatever approach the company thinks makes more sense. So, basically, those that don't offer much in the way of stock compensation don't mind reflecting the cost; those that do rely extensively on stock compensation, not surprisingly, choose the non-GAAP approach.

Here's three examples of how much of a difference it can make:

Google (GOOG)
2015 GAAP Estimated EPS: 22.70
2015 non-GAAP Estimated EPS: $ 28.35

2015 GAAP P/E: 24.7
2015 non-GAAP P/E: 19.8

Amazon.com (AMZN)
2015 GAAP Estimated EPS: 0.37
2015 non-GAAP Estimated EPS: 4.14

2015 GAAP P/E: 1,193
2015 non-GAAP P/E: 106

Salesforce.com (CRM)
2015 GAAP Estimated EPS: -0.05
2015 non-GAAP Estimated EPS: 0.71

2015 GAAP P/E: Not Meaningful
2015 non-GAAP P/E: 104

More from Barron's:

"Various justifications are offered for excluding equity compensation from expenses, but none hold up to scrutiny."

The argument that stock compensation isn't a real expense is a weak one at best.

If stock-based compensation expense is generally ignored by analysts and investors guess what's going to happen?

It seems rather probable it will encourage the use of stock-based compensation.

Some will no doubt continue to argue that stock compensation expense can be ignored. Arguments include that it's a non-cash expense and the additional share count captures the cost.

Well, in this case, it's a real expense even if it happens to be a non-cash expense: unless the strike price of an employee stock option fully reflects per share intrinsic value, the company is, when options are exercised, effectively selling shares at a discount (with tax implications fully considered). That discount is a real cost to continuing owners. So, in such a case, the additional share count only partially reflects that expense.*

Another argument essentially is that, since many industry peers ignore stock-based compensation, it makes sense to also ignore it for comparison purposes. Well, it's a real expense no matter how another company decides to logically present their own numbers.

When a company chooses to repurchase shares to just keep the share count from increasing, those funds could have instead been used for the direct benefit of shareholders in other ways. If the strike price is less than the repurchase price then, effectively, the company is buying high and selling low.

The difference can prove a meaningful cost especially for shareholders who intend to stick around.**

Those funds could be used for reducing share count instead of merely offsetting the dilution that occurs from stock compensation.

Those funds could be used for paying dividends.

Those funds could also be put to many other potential high return uses.

Now, if a company needs to use stock compensation to get the best employees, or to help manage cash flows, it may be very wise to do so.

Just count it as the real expense that it is.***

It simply makes little sense to ignore stock compensation for certain companies but include it for others.

When stock-based compensation is deliberately ignored -- especially for the companies who heavily rely on it -- per share intrinsic value and how it's likely to change over time is likely to be overestimated.

Stock compensation is also a real cost for shareholders even if a company chooses to NOT repurchase shares. In many ways employee stock options -- depending on how the strike/exercise price compares to per share intrinsic value -- partially function like a reverse buyback that quietly (and, sometimes, not so quietly) dilutes continuing shareholders. Keep in mind that, upon the exercise of stock options, a company will receive funds equal to the strike price for each option that's exercised plus, depending on how much the options are in the money, a tax benefit. So, effectively some capital is "raised" in the process but what matters for continuing owners is how reasonable that strike price happens to be.
(If these funds are used to buyback stock then the net dilution is reduced.)

It's hard to completely fault the companies when not enough analysts and investors seem to be forcing the issue.

It's easy to choose to not follow suit and always include stock-based compensation when attempting to estimate, within a range on a conservative basis, per share intrinsic value.

None of this necessarily means some of these tech stocks aren't fine businesses. In fact, some are already extremely valuable and will no doubt prove to be even more so. It comes down to:

Will the value per share increase sufficiently?

Does the price paid offers an acceptable or better risk versus reward against alternatives?

Is there sufficient margin of safety to protection against what might go wrong and/or misjudged prospects?

If nothing else, a willingness to ignore stock-based compensation is fundamentally at odds with the margin of safety principle.

It's worth noting that I'm not referring to the speculative buying at one premium price (premium to per intrinsic value) with the hope of later sell at an even higher price. I'm referring to whether the price paid today offers an attractive outcome compared to what these businesses will be intrinsically worth on a per share basis in 10 or 20 years.

Those who successfully buy shares at a premium to value and exit successfully are likely taking on far more risk of permanent capital loss than they realize.

Risk that's not usually obvious until it is.

Adam

Long positions in MSFT and AAPL established at much lower than recent prices; long position in IBM established at somewhat higher than current prices; very small long position in GOOG also established at much lower than recent prices. No position in the other stocks mentioned.

Related posts:

Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Technology Stocks
Time for Dividends in Techland

* There are exceptions. When, for example, the strike price of employee stock options is well above per share intrinsic business value, then stock-based compensation can actually become beneficial to long-term owners. Of course, for these to be of any value to an employee the stock must necessarily be more than fully valued upon exercise. In this narrow (and somewhat unlikely) scenario, the company would be getting more than full value. The situation functions like capital being raised at an attractive price with a tax benefit as a bonus. This doesn't apply to stock-based compensation that's in the form of restricted stock (which is increasingly favored over stock options).
** The actual cost for shareholders is the difference between the lower strike price and the higher repurchase price. For companies where this kind of buy high/sell low behavior is the norm, this can become rather expensive (depending on the specifics of the stock-based compensation plan) for long-term owners when compounding effects are fully considered. In contrast, these still very real costs might be viewed as mere noise for those with shorter holding periods.
*** It's worth mentioning, as I noted in a previous post, it's not as if the GAAP numbers are always a terrific indication of actual business economics. Accounting can be a very useful tool but has its own real limitations.
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