Ac­coun­tants at Face­book and Ama­zon fac­tor in all those em­ployee stock grants

At a mo­ment of strength, a switch to less fa­vor­able ac­count­ing “There’s no bet­ter time to change your be­hav­ior”

Bloomberg Businessweek (Asia) - - CONTENTS - Alistair Barr, with Sarah Frier

For more than a decade, many of the largest tech­nol­ogy com­pa­nies have danced around the cost of pay­ing work­ers, re­leas­ing profit num­bers that don’t ac­count for the heaps of stock they dole out. In­stead of con­form­ing to the U.S. stan­dards known as Gen­er­ally Ac­cepted Ac­count­ing Prin­ci­ples (GAAP), which in­clude eq­uity-based pay costs, roughly four in five of the 70 tech com­pa­nies in the S&P 500 in­dex use hand­picked profit mea­sures that make their earn­ings look bet­ter, ac­cord­ing to data com­piled by Bloomberg for their lat­est fis­cal years. The non-GAAP mea­sures raised the busi­nesses’ col­lec­tive earn­ings 23 per­cent, to $239 bil­lion.

In their lat­est quar­terly earn­ings re­ports, Ama­zon.com and Face­book stopped elid­ing their stock-based com­pen­sa­tion, join­ing ex­cep­tions such as Net­flix and In­tel. “We view it as a real ex­pense,” Face­book Chief Fi­nan­cial Of­fi­cer David Wehner said on his April 27 earn­ings call. Un­like in pre­vi­ous re­ports, the CFO fo­cused on GAAP num­bers and said he would do the same on fu­ture calls. A day later, Ama­zon re­ported stock-based pay for its dif­fer­ent busi­nesses for the first time.

Dur­ing the first dot-com boom, fast-grow­ing tech star­tups ar­gued that the op­tion grants they were hand­ing em­ploy­ees were too dif­fi­cult to re­li­ably value for the pur­poses of quar­terly re­ports. That’s still the de­fault po­si­tion in an era when most eq­uity grants come in the form of re­stricted stock with a straight­for­ward vest­ing sched­ule. The re­sult: Some se­ri­ous money is fac­tored out of the bot­tom-line re­port­ing. The av­er­age pub­lic U.S. com­pany has a price-earn­ings ra­tio of 17—mean­ing its stock price is 17 times greater than its es­ti­mated 2016 earn­ings per share— or 18, when you count stock com­pen­sa­tion, ac­cord­ing to San­ford C. Bern­stein. Face­book’s p-e’s are 35 and 50; Ama­zon’s are 63 and 122.

So why make the change now? “If you can act from a po­si­tion of strength, which Ama­zon and Face­book clearly are, there’s no bet­ter time to change your be­hav­ior,” says Denny Fish, a port­fo­lio man­ager at in­vest­ment firm Janus Cap­i­tal Group. Face­book just re­ported one of its best quarters, and Ama­zon nearly dou­bled an­a­lysts’ al­ready bullish profit es­ti­mates. “They look more re­spon­si­ble, and it makes them ac­count­able for how they is­sue stock for com­pen­sa­tion,” says Fish.

While in­vestors rarely pun­ish the in­dus­try for its cre­ative ac­count­ing, Face­book’s and Ama­zon’s shifts also follow mount­ing crit­i­cism about overuse of non-GAAP num­bers. In

his lat­est share­holder letter, War­ren Buf­fett called the omis­sion of pay “the most egre­gious” ex­am­ple of non-GAAP ac­count­ing. James Sch­nurr, chief ac­coun­tant for the U.S. Se­cu­ri­ties and Ex­change Com­mis­sion, said in a March speech that ex­ec­u­tives and di­rec­tors should chal­lenge use of the non-GAAP num­bers.

An in­vestor in Face­book and Ama­zon says both com­pa­nies have pri­vately ac­knowl­edged chang­ing their ac­count­ing for com­pet­i­tive ad­van­tage as well as to soothe share­hold­ers. A looser ac­count­ing ap­proach made strug­gling com­pa­nies look fi­nan­cially stronger than they re­ally are and bet­ter able to com­pete for top tal­ent. Twit­ter trades at about 36 times its es­ti­mated 12-month profit, but add in eq­uity com­pen­sa­tion and the com­pany is ex­pected to lose money. Its stock­based pay last year was more than twice its non-GAAP profit, ac­cord­ing to Bern­stein re­search. (Twit­ter didn’t re­spond to an e-mail seek­ing com­ment.)

Fish cited LinkedIn as a com­pany that should keep a tighter rein on its eq­uity grants. An­a­lysts es­ti­mate the busi­ness-fo­cused so­cial net­work will make $591 mil­lion in 2017, or a loss of $36 mil­lion when stock-based com­pen­sa­tion and other costs are in­cluded, ac­cord­ing to data com­piled by Bloomberg. LinkedIn cut growth fore­casts ear­lier this year, draw­ing more at­ten­tion to long-term com­pen­sa­tion costs. “When fun­da­men­tals de­te­ri­o­rate rel­a­tive to high-growth ex­pec­ta­tions and stock-based comp is high as well, com­pa­nies can be dou­bly pe­nal­ized,” Fish says. LinkedIn’s stock price is down 45 per­cent this year, while Face­book’s is up 12 per­cent.

LinkedIn spokesman Hani Durzy says that while the com­pany doesn’t plan to change its re­port­ing prac­tices, it’s try­ing to re­duce stock-based pay to 10 per­cent of rev­enue from 17 per­cent. Eq­uity grants aren’t go­ing away, though. Says Durzy: “Tal­ent is crit­i­cal in this in­dus­try, and we want to make sure that we’re bal­anc­ing the trade-offs ap­pro­pri­ately.”

The bot­tom line Prof­its for most pub­lic com­pa­nies don't shift much when ac­count­ing for stock plans. Tech com­pa­nies are dif­fer­ent.

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