Monday, 31 July 2017

Seeing through the stock-based compensation ruse

A large and perennial frustration I have when researching companies in the US is the propensity of many companies to add back stock-based compensation to headline 'adjusted earnings'/'adjusted EBITDA', coupled with the propensity of many analysts and investors to take those adjustments at face value. In many cases, I believe the practice to be contributing to material overvaluation, as headline PE and EV/EBITDA multiples are often meaningfully understated.

It took a long time for accounting standards to be changed to require companies to expense stock/option grants in the first place, but now that the standards have been amended, many companies have elected to bypass the implications by simply reporting headline adjusted earnings exclusive of such charges. In my opinion, the practice is reprehensible and should be outlawed (and it is regrettable that professional investors and analysts are so superficial in their thinking that SEC action is necessary). The SEC has recently already started to clamp down on the practice, but has been slow to act and has still done too little in my opinion.

The dilution is recurring not one-off

The strongest argument I have encountered for adding back stock-based compensation is that it is a non-cash expense where the associated dilutionary impact is already reflected in market forward EPS expectations (which generally factor in a rising share count). Consequently, it would be double-counting to deduct stock compensation expenses from projected EPS.

The problem with this approach is that it implicitly treats stock grants as if they were one-off/temporary in nature, whereas in reality they are recurring. If you ever wish to cease compensating your employees in stock, then you will need to compensate them with additional cash, and if you do not compensate them with cash, they will leave. It really is that simple.

The corrosive impact stock-based compensation has on long term valuations/investor returns is often masked in the short term by rapid growth (it is usually fast-growing companies that rely most heavily on stock-based compensation), but in the long run as the company matures, the impact is apt to become more apparent. Twitter is a pertinent example at present - it has solidly positive adjusted EBITDA but substantially negative GAAP earnings, and if recent trends continue, which suggest the company may be going ex-growth, 'adjusted EBITDA per share' growth will begin to trend significantly negative even if operational EBITDA remains constant. How many investors have included a negative terminal growth rate in their valuations?

It is also sometimes argued that correctly valuing stock-based compensation is difficult. This is a fair concern. However, in the world of accounting, lots of things are difficult to estimate - estimating the correct level of depreciation is sometimes difficult as well. But an estimate that results in an approximately accurate charge is better than no estimate/charge at all.

An example

The issue is best highlighted by example. Suppose that I wanted to hire you to work for my company for US$200k a year, and suppose I offered to pay you in either cash or stock. If you elected to receive cash, US$200k would go through the P&L as employee compensation expenses, as is conventional. However, if you elected stock, my 'adjusted earnings' would be US$200k higher (ignoring taxes) because I have paid you in 'non-cash' stock. But why should my company report higher earnings and trade at a higher valuation under the latter approach than the former?

Furthermore, suppose that you took the first option - cash - but after working for my company for a year, you decided to participate in a new share placement to the tune of US$200k. Now, the share issue would be treated conventionally as an ordinary share placement that increased share capital. In substance, this is exactly what happens when employees are paid in stock, but under the former compensation is expensed in the P&L, whereas under the latter approach, it is not.

Finally, consider the situation where you elect to be paid in stock, and I then decided to spend US$200k a year buying back stock on-market to offset the dilutionary impact. My adjusted earnings are now US$200k higher, as I have compensated you in 'non-cash' stock, but the simultaneous US$200k buyback makes the compensation look very 'cashy' to me. This exact bait-and-switch practice happens all the time, and it is extremely cynical to see such companies nevertheless classifying such employee stock grants as 'non-cash'.

In my opinion the bottom line is simple: Employee stock grants are in substance no different to any other share issue and so should be accounted for in a similar manner, and there is no reason why a company that pays its employees in cash should report lower earnings and receive a lower valuation than one who pays its employees in stock.

Be wary of companies that place a disproportionate emphasis on non-GAAP earnings

In my opinion, as a general rule investors ought be weary of companies that steer investors away from bottom-line GAAP earnings to an unreasonable degree. The excessive propensity of investors to focus on 'EBITDA' instead of bottom-line earnings is also something that many companies exploit which regularly gets investors into trouble. GAAP earnings are not perfect, but they at least capture - over time - all cash that goes in and out of the company, whereas 'adjusted' earnings/EBITDA almost invariably do not.

Cautionary tales abound everywhere. For instance, on Friday, Webjet (WEB AU) announced a disagreement with its auditor that appears to have related to the excessive upfront capitalisation of costs relating to its recent Thomas Cook hotel supply agreement - presumably so it could report higher EBITDA by converting cash costs into non-cash amortization (see the announcement here). Investors valuing the stock on an EV/EBITDA basis appear to have been duped, and the stock has declined by about 10% since the revelations emerged.

Valeant Pharmaceuticals also bought drugs with - say - only 5yrs of patent protection remaining, and then managed to persuade investors that they could ignore the amortization of the capitalised on-balance-sheet intangible assets resulting from such acquisitions when looking at 'adjusted earnings', even though the acquisition of those intangibles cost the company real cash and had a real finite life. That approach did not end well for investors, including for many high-profile fund managers that should have known better.

Lastly, companies that outsource their R&D by acquiring companies rather than spending (and expensing) the R&D internally, often end up materially overstating their through-the-cycle 'adjusted earnings' as well. Such companies capitalize acquired goodwill, and when - as is often the case - things don't work out as well as originally planned, some or all of the goodwill is written off, at which point management is careful to emphasise that the write-offs are 'non-cash in nature' (ignoring the fact that real shareholder cash was used to acquire the assets in the first place).

The adding back of stock-based compensation is the most transparent of all these accounting ruses, in my view, and yet it continues to be perpetuated in broad daylight with an unusual degree of complicity by investors. I believe it is high time the practice is opposed and discontinued.