In the 90s, Warren Buffett made big noise with his simply correct and rational argument
that stock - based compensation is, well, compensation and ought to be expensed as such. This seems so old and obvious for financial market participants that it should not be an article - prone subject by now. Get ready.
In the U.S. it is not unusual for companies, even the largest ones, to grant between 0.5%
and 1.5% of their capital as stock - options and/or Restricted Stock Units (RSUs) annually, even after forfeitures. Each RSU equals one share, without the strike price that makes the older stock option worth less than its underlying share at the time of the grant. RSUs have come to dominate the stock - based compensation arena, because their value is more “predictable”, therefore more palatable to shareholders who had, theoretically, got tired of seeing stock options’ value explode down the road – this sub - topic alone is enough for another article, suffice to provoke your thoughts, though, is to say that the “predictable” argument craters if you substitute one option for one RSU in the overall “share - based budget”, which every individual company would deny they did/do, but seems to be what is happening over time as the competitive and psychological dynamics explored below would foretell – it is just another version of that typical “ one man on its toes to watch the parade”
case. And let’s not forget that usual option grants are also hugely valuable as the strike price is normally fixed for periods longer than five years.
For Brazilian readers, 0.5% to 1.5% is an already eye - catching dilution. This is nothing
though, compared to what is going on in the Bay Area, especially amid the Equity markets’
darlings of the moment, SaaS and other “technology” companies. In this space, annual grants of 3% to 4% of the firm’s capital has become the norm.
Every reasonably careful investor know what is going on when they look at the footnotes on Financial Statements. But with CEOs and CFOs focusing their earnings releases and assessments of the business on adjusted financials excluding GAAP stock - based compensation expenses (already an under estimate in my opinion*), and Equity markets totally overlooking the matter, we got to a point in which some incredible things appear, such as companies that are at “break - even”, but, if one rightly accounts for a reasonable estimate for the true value of share - based compensation, would have minus 10% to 30% operating margins; or even more astonishingly, companies whose grants are worth 30%, 50%, or more of all they spend in cash on R&D and SG&A, excluding advertising.
In prosperous times, accounting shenanigans prosper, later to be headlines and book -themes for years. This is not a case of shenanigans as companies are following GAAP norms on their accounting and managers respecting SEC disclosures when focusing solely on adjusted financials in their communications with the investment community. Nonetheless, the reasons for amazing things like the ones in the previous paragraph to be happening are the same that explain accounting frauds. Equity markets get so in love with gains and so hopeful of their continuance that individual participants opt to close their eyes for the simple reality, which in the case we are discussing here is that these companies are not nearly as profitable (today or in the future) as many believe, and in the old Enron case, that the business model then advertised did not make sense.
Managers pretend RSUs are not an expense; investors pretend they believe it, or at least believe that growth will make any short - term absurdities unimportant; and everyone hopes the situation gets solved “somehow” down the road. The reality is: capitalism is cruel. We cannot overlook the fact that the true human capital cost to develop and run these businesses has escalated tremendously over the last ten years. Furthermore, the more we overlook it, the bigger it gets, as the culture of discounting share - based compensation spreads through the ranks and middle managers dole out more and more RSUs to solve their hiring/retention problems.
All of this is not to argue that SaaS and broader “technology” firms are all fads. To the contrary, the only reason I am writing this is because I am studying many of these companies in depth and have found some interesting ones. We are even shareholders in a couple of them, despite acknowledging the problem here exposed. I have also come to believe, though, that a good chunk of “naked companies” will be exposed when the tide goes out - many investors seem to have forgotten the fact that without true moats, superior economics won’t follow for any high growth company.
To close, the arguments and numbers here discussed must be taken in perspective. Over the last ten years we have indeed watched unprecedented value creation by companies and their richly rewarded employees in the Bay Area and technology hubs all over the world. All this compensation has not been in vain, to the opposite. In addition, part of the RSU grants we see in any given period is to attract new talent to rapidly growing ranks, which by itself, should lead to lower dilution as these firms mature. Anyway, I strongly believe my peers are giving much less weight to the real sums their companies are spending to run their shows than they should. Perhaps all of this will get corrected in the next downturn, with many companies proving unsustainable, less crazy competition for personnel, and some unavoidable permanent capital losses, which I hope to avert by, amid other things, not overlooking what is in front of me.
Final note: with Covid - 19 the next downturn is likely here, sooner than anyone expected, including me when I wrote this piece.
*According to GAAP norms, stock - based compensation is not expensed at the time of the grant, but rather deferred and expensed over the years as the underlying shares vest, but
without adjusting for movements in the actual share price. This creates an ever - delayed expense for any company whose share price advances. In other words, the accounting expense we see, is not the value of the shares being granted in the period. The difference is often substantial. Charlie Munger would say, invert, always invert; employees
being granted these shares know that their value is likely to rise over the vesting period, and I am sure they see current period stock - based compensation as worth the current market value of the shares being granted (rather than the old market value of shares granted years ago now vesting), knowing that they need to achieve some thresholds (usually just staying on the job) to actually put their hands on those shares, and sell them at likely
even higher prices.
Guilherme Partel
Tarpon U.S. Equities
April 2020