Shame on Silicon Valley's Stock Expense Stragglers
I wrote a year ago about tech companies' addiction to "adjusted" measures for earnings that made profits look better than they really were. It's true that generally accepted accounting principles, or GAAP, can't capture all the nuances of a business. But too many tech companies were abusing GAAP to the point of absurdity.
Since then, there has been much progress. Several tech companies, notably Facebook, Amazon.com Inc., Google and Electronic Arts Inc., have started or plan to disclose by-the-book earnings more prominently in their financial reports. The biggest sea change is a move away from non-GAAP earnings disclosures that exclude the non-cash but real costs of stock issued to employees as part of their compensation.
It's as though Silicon Valley suddenly got religion about these expenses. Can I get a hallelujah?
Facebook Inc. still reports a net income figure excluding stock pay, but it was buried on page 11 of its most recent earnings disclosure. In the same financial report card one year earlier, Facebook's net income excluding its stock compensation and other items was on the first page. The difference, as with many other tech companies, was stark. The earnings adjustments boosted Facebook's 2015 net income from $3.7 billion under GAAP to $6.5 billion -- an increase of 78 percent.
Google parent company Alphabet Inc. is going a step further than Facebook, and won't even disclose a net income metric stripping out equity pay. 1 Listen to Ruth Porat, Alphabet's chief financial officer, from a January conference call with analysts: "Although it's not a cash expense, we consider [stock-based compensation] to be a real cost of running our business because SBC is critical to our ability to attract and retain the best talent."
I never would have imagined that a senior tech executive would sound like Warren Buffett, a longtime critic of companies' habit of pushing stock-compensation costs under the carpet. 2
Whether these tech companies found GAAP religion because of prodding by regulators, pressure from investors, or a zeal to embarrass less profitable rivals, the end result is a welcome dose of nonfiction in Silicon Valley financial statements. Still, there remain tech stragglers who are still excluding stock compensation from their earnings, and analysts who enable this behavior. Consider this my attempt to name and shame some of the outliers.
A perfect example is Twitter. The average of analysts' estimates for Twitter's 2017 Ebitda is $579.5 million, according to estimates compiled by Bloomberg. This implies most of them are basing their estimates on the company's preferred earnings measure excluding stock compensation. On that basis, Twitter trades at a reasonable 15 times the average Ebitda estimate for 2017, not far off Facebook's multiple of 16.
But if you use the $19 million 2017 Ebitda estimate from RBC Capital analyst Mark Mahaney, who includes about $502 million of stock compensation in his analysis, then Twitter's multiple jumps to 464 times expected 2017 Ebitda.
Yes, Twitter's outsize stock compensation costs are no secret, and investors can do simple math to calculate the company's true Ebitda inclusive of these expenses. But it's clear that these cherry-picked earnings excluding the bad stuff obfuscate how expensive Twitter shares are relative to more standard income measures. And the Wall Street stock analysts aren't doing investors any favors by enabling the company's non-GAAP fiction.
Then there's Netflix Inc.: It trades at 100 times its preferred 2016 Ebitda measure, which excludes stock pay. Including those expenses, the multiple is 142 times trailing Ebtida.
At first glance, ServiceNow Inc. and Veeva Systems Inc. are similar business software firms, each with an enterprise value of roughly 10 times revenue for the most recent fiscal year. But Veeva's stock compensation costs amounted to about 7.5 percent of its revenue last year, and at ServiceNow it was 23 percent -- which dragged the company to a loss. That means the companies' comparable valuations based on revenue don't effectively measure the true health of their earnings. 3
A non-GAAP earnings metric is supposed to give investors a clearer picture of the company's business. But instead, the tech firms that ignore equity pay in their earnings are making investors see a company through a fun-house mirror. It's time for the tech industry's stock compensation deniers -- and their enablers on Wall Street -- to get real.
Of course it will still be possible to figure Alphabet's earnings excluding stock compensation expenses, which are a line item in the cash flow statement.
Here is what Buffett wrote in his annual Berkshire Hathaway shareholder letter last year: "If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?"
Not that their adjusted earnings figures do either. ServiceNow's GAAP net loss was $452 million in the latest year, while on a non-GAAP basis it had net income of $122 million! Mostly the difference was stock compensation and a big legal settlement. Veeva reported GAAP net income of $69 million, and non-GAAP net income of $108 million.
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Shira Ovide in New York at email@example.com
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