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"It is impossible for ideas to
compete in the marketplace if no forum for
their presentation is provided or available."
Thomas Mann, 1896
The Business Forum
Journal
Don’t fall in
the GAAP in Pro Forma Performance.
By Joseph Vaughn-Perling
Generally
Accepted Accounting Principles
Wall Street wants’ your money.
Let us take a look at one of the ways the fool and his money are parted
using the example of Facebook Inc. (FB).
Facebook’s first earnings report as a public company may serve as a good
example. How? It boils down to accounting and how this is reported to us as
public consumers of the currency they create, namely the stock in their
company. For full disclosure, the author has profited from shorting options
on this equity.
When calculating a company's quarterly profit estimates, Wall Street
analysts who cover technology companies often leave out a certain type of
accounting charge; namely, the expenses a company incurs when it allows
insiders and employees to buy its shares for less than their market price.
This is a common practice and one of the reasons silicon valley companies
like to go public, so they can use their company stock to pay employees.
Most public companies do the
same thing, Facebook is just the most striking recent example because in the
case of Facebook's latest quarterly results, that expense was more than $1
billion. This is larger than ought be expected in forward quarters because
that number was inflated by the company's initial public offering in May.
Chief Executive Mark Zuckerberg and other insiders cashed in big-time on the
largest-ever Internet IPO.
But keep in mind that
stock-compensation charges aren't typically a one-time charge for public
companies that give large amounts of equity compensation to executives,
venture-capital investors and rank-and-file workers. Technology companies
tend to incur such expenses as a large and recurring charge. And for
Facebook's second quarter, the amount was more than enough to offset revenue
and cause the company to report a net loss putting them in the red.
All of this is well and good, except if you are taking your queues from Wall
Street analysts, especially from one of those employed by one of the many
investment firms that received an allocation in return for managing the
public offering. If you had been reading the stock reports any of these
three dozen or so analysts who covered Facebook, you have not likely seen
any mention of this important fact, or how it impacts Pro Forma earnings.
What are 'Pro
Forma' Earnings?
More than a decade ago, the organization that sets accounting rules for U.S.
companies moved to bring the standards for financial reporting here in line
with international rules. The goal was to provide global investors a valid
way to measure the results of rival companies based in different countries
against each other, a good thing generally.
The problem from the point of view of the companies is that computing
exactly what a stock option is worth is difficult and that the proposed
changes would thus result in the reporting of results that wouldn't reflect
accurately the health of a company's underlying business. Put aside the idea
that FB has weekly options and dollar incremental strike prices and so is
one of the most easily valued of all options available on the market today.
Historically this argument
seemed sound due to the complicated nature of option accounting, and the
rules were held up for years as accountants hashed out which arcane formula
should be used to value them. In the meantime, FASB officials defended their
plan at often-hostile Congressional hearings.
But in arguing against the
rules, the tech lobby was, in effect, ignoring a fundamental characteristic
of a public company: when you issue stock at a discount to one class of
shareholders, you dilute the stake of all others. What's left after that
dilution is the number that public investors should have access to when
determining whether to buy a company's stock.
In the end, the dot-com stock
implosion destroyed enough wealth and aroused enough anger to get the FASB
reforms approved and implemented. So while the reasons for the decision are
no longer as valid as they were, the decision has not changed.
As a result,
all of those tech companies that routinely had reported what they called
"pro forma" results--which excluded stock expenses and other charges--were
forced to lead their quarterly press releases and file their SEC documents
using numbers that adhered to the new rules under GAAP, or generally
accepted accounting principles.
'Non-GAAP'
Earnings
There is a loop-hole in this process, through which a long convoy of trucks
are passing filled with investor monies. Because the rules applied to public
companies' financial reports, but not to the stock reports published by Wall
Street, equity research analysts who cover tech companies simply continued
to leave out stock-based charges.
Even worse for retail investors, the firms that compile analyst reports,
such as Thomson Reuters, Zacks and FactSet, had no choice but to use the
estimates they were given when compiling their quarterly consensus
estimates.
Those estimates, of course, are the ones that set the expectations for an
earnings report--even if they reflect so-called 'non-GAAP' earnings which
don't adhere to accepted accounting standards.
That is why retail investors thought that, as of last week, Wall Street
expected Facebook to report "earnings" of 12 cents a share. Yet we now know
that the company posted a net loss of $157 million, or 8 cents a share.
Unless a company is able to guide analyst opinion heavily toward the right
numbers, this problem continues to surprise to the down side because, every
time a Facebook employee or insider cashes in, the company's share count
will go up and the diluted piece of Facebook will get smaller.
That's why investors should always pay attention to a company's earnings
"attributable to common stockholders," which can be found at the bottom of
its quarterly statement of operations.
If you want to see what can happen to the stock of a company that hands out
gobs of equity, take a look at a decade-long chart of Microsoft (MSFT) or
Cisco Systems Inc. (CSCO). There's a reason these stocks have gone nowhere
for 10 years. Essentially, a very large chunk of the per-share profit that
they generated during the past decade already had been given away, in
advance, to its insiders, executives and employees during the 1990s.
Similarly, with Facebook, much of the company's future profits already have
been extracted from it.
In the case of Facebook, the company's quarterly stock-compensation charges
may be at least $100 million for the foreseeable future, as more insiders
cash in. There is no way to know for sure, though, because Facebook didn't
provide a financial forecast.
So now you know one of the reasons why Facebook's shares have kept plunging.
Investors had been surprised that the company posted a net loss in its first
publicly reported results, but the surprise was one that the attentive
investor has, or should have, expected.
Joseph Vaughn-Perling
is a Fellow of The Business Forum Institute and
is currently the Security and Authentication Capability Manager for
British Telecom Global Services. He holds a B.S. degree in
Psychology & Cognitive Science from the University of California Los
Angeles and studied Law at the University of San Diego Law School. Prior to
joining British Telecom he was
LAN/WAN Technologist for William O’Neil & Co.
publisher of Investors Daily; and was Senior Consulting Engineer, (Global Security, Security Development &
Legal Dept) at Infonet Services Corporation. Joseph is a Certified
Information Systems Security Professional (CISSP) and a Certified
Checkpoint Systems Engineer (CCSE) He is a recognized Network Design
Architect for fault tolerant globe spanning networks and applications
and Member of the Board of Directors for International Networking
companies.
Contact
the Author:
~
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