Tech Companies Fly High on Fantasy Accounting
JUNE 18, 2015
Technology shares have been powering the stock market recently, outperforming the broader stock indexes by wide margins. The tech-heavy Nasdaq 100, for example, is up 19 percent over the last 12 months, almost twice as much as the Standard & Poor’s 500-stock index, which has risen 10 percent. Investor enthusiasm for all things tech is understandable, given the disruptions the industry is bringing to so many businesses and the potential profits associated with that upheaval.
But there’s a more troubling aspect of the current exuberance for technology stocks: the degree to which so many of the popular companies with premium-priced shares promote financial results and measures that exclude their actual costs of doing business. These companies, in effect, highlight performance that is based more on fantasy than on reality.Corporations still must report their financial results under generally accepted accounting principles, or GAAP. But they often play down those figures, advising investors to focus instead on the numbers favored by those in the executive suite — who, it just so happens, stand to gain personally from the finagling.
Among the biggest costs these companies ask investors to ignore are those associated with stock-based compensation, acquisitions and restructuring. But these are genuine expenses, so excluding them from financial reporting makes these companies’ performance look better than it actually is.
This, in turn, makes it harder for investors to understand how their businesses are really doing and whether their shares are overvalued or fairly priced.
Not all technology companies encourage the use of funny figures. Apple and Netflix report only GAAP results. But they are in the minority.
Cooking up funny figures to accentuate the positive at a company is not a new problem. Justifying rocketing stock prices with kooky financial metrics was central to the 1999 Internet mania. We all remember how that ended.
But while today’s creativity in financial reporting is more down to earth than it was during the last boom, the use of performance measures that exclude some basic corporate costs seems to be growing among companies.
Jack Ciesielski, publisher of The Analyst’s Accounting Observer, studied this issue last fall. For the five years that ended in 2013, he found that the number of cost items excluded from the reports of 104 large technology, health care and telecommunications companies had risen to 504 in 2013, up from 365 in 2009.
We’re talking real money. In 2013, Mr. Ciesielski also found that the difference between these companies’ GAAP profits and earnings without the bad stuff was $46 billion in 2013. This was down from 2012, but it was more than double the amount in 2009.
But perhaps the most disturbing aspect of the funny numbers used by companies is the way they serve to raise executive pay levels. That’s because these companies often exclude the cost of stock grants awarded to executives and employees, significantly improving reported performance.
Consider Salesforce.com, a supplier of customer management software and services. In spite of recording a loss from operations of $146 million in fiscal 2015, the company’s stock is a highflier; its market capitalization is almost $50 billion.
Investors may be focusing on the revenue growth at Salesforce.com — up 32 percent last year and up 34 percent on average in each of the last four years. Or that the company’s most recent loss was half that generated in 2014.
But when Salesforce.com computes its executives’ cash incentive pay, its $146 million operating loss turns into a $574 million operating profit. This transformation occurs because the company excluded $565 million worth of stock grants awarded to employees last year.
Investors may be growing concerned about these games of pretend. A sign of the discontent is the increasing support for “say on pay” measures, in which shareholders express views on company pay practices.
For example, at Salesforce.com’s annual meeting this month, 47 percent of the shares voted were against the company’s pay plan. That’s almost twice the 24 percent dissent the company received from shareholder votes at the 2014 meeting.
Chi Hea Cho, a spokeswoman for Salesforce.com, said in a statement: “We describe our pay practices in significant detail in our proxy statement, including our compensation philosophy and the rationale for our executive compensation decisions. We value the opinions of our shareholders and have engaged in an active dialogue with them on executive compensation practices.”
Ms. Cho declined to comment on the company’s decision to exclude stock grants from its performance pay measures. But she pointed me to company filings, which note that “stock-based expense varies for reasons that are generally unrelated to operational decisions and performance in any particular period.”
Brian Foley, an independent compensation consultant in White Plains, questioned any company’s exclusion of stock grants when assessing executive performance.
“One has to be very disciplined about how you measure performance,” he said in an interview. “These companies are paying out real value in option and stock awards every year, and if those awards are such a key component and driver of overall compensation in such companies, why isn’t the cost of that key component part of the mix when it comes to judging annual performance and sizing senior management annual bonuses?”
Some companies are changing their practices after hearing from investors. This year, Broadcom, a supplier of integrated circuits, said it would no longer exclude stock awards from its performance pay measures.
Companies can’t play pretend about the true cost of stock grants in their regulatory filings, of course. And vigilant shareholders know that these expenses often become glaringly evident through the prism of billion-dollar share buybacks conducted by these companies. Many technology companies have to pursue these repurchase programs to limit the diluting effect of their generous stock grants. And they pay handsomely to do so.
Ken Broad is founding partner and portfolio manager at Jackson Square Partners, a money management firm in San Francisco that oversees $30 billion in assets. He said that it was up to investors to stop accepting performance figures and analysts’ estimates that exclude real costs.
“Lots of investors have ever-shorter time horizons and they care less about what’s embedded in the number than whether the company beat the consensus estimate,” he said in an interview on Thursday.
Part of it, too, is bull-market thinking. And when the music stops?
“This stuff doesn’t matter,” he said, “until it does.”