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  • chaoranhu commented on Grahamites's article 08-27 10:54
    TransDigm: The Contemporary Doppelgänger of Capital Cities
    Transdigm is probably one of the largest companies in Cleveland that no one ever heard of. --Nick Howley, CEO of TransDigm At the end of Chapter...
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    chaoranhu 08-27 11:54
    • Grahamites – I do remember reading about the controversies around Coca’s compensation plan and thought Warren Buffet was quite convincing in his assessment of the situation and his rebuttal to David Winters (Trades, Portfolio). I revisited Buffet’s calculation and it made total sense to me.  I’m also aware about the fact that the shares granted in Google’s SBC programs have a vesting schedule. But if you read their financial releases, you will see that “In the fourth quarter of 2014, the total charge related to SBC from continuing operations was $1,201 million, compared to $873 million in the fourth quarter of 2013. We currently estimate SBC charges for grants made to employees prior to December 31, 2014 to be approximately $4.3 billion for 2015…” So roughly speaking, Google’s SBC charge is at a run rate of around 4 to 5  billion dollars per year, on a base of GAAP operating income of around $17 billion. Without the SBC charge, its operating income would have been 21 to 22 billion. The SBC hit is around 25%. If you think about it, GAAP accounting is saying Google is transferring away 25% of the company from existing shareholders to its employees every year. How insane is that! While in reality, the share dilution has only been about 1.5% a year in recent years. Back in the late 90s of the tech & dotcom boom, option grants ran wild and there was no accounting charges for them. After so much crying foul in the financial press, I feel GAAP accounting has now completely gone insane to the other extreme, from total under or zero expensing to over expensing. Nowadays we often find ourselves reading a lot of criticisms in the press about how companies like Google or Facebook are trying to sugar coat their numbers by presenting non-GAAP results adjusted for employee compensation expenses. The truth is, in my opinion, as long as the non-GAAP adjusted EPS is calculated with the diluted share count, I think it properly reflects the economic reality, better than the GAAP EPS. For the future growth of EPS, investors just need to take into account the growth of outstanding shares and discount that accordingly. In my opinion, SBC expenses should not be charged to income. Why? It’s effectively accounted for in the increased share count. Charging it to the income is double punishment and creates the insanity that’s far from reality (e.g. Google is giving away 25% of the company every year). Please let me know if think I'm mistaken.
  • chaoranhu commented on Grahamites's article 08-26 09:15
    TransDigm: The Contemporary Doppelgänger of Capital Cities
    Transdigm is probably one of the largest companies in Cleveland that no one ever heard of. --Nick Howley, CEO of TransDigm At the end of Chapter...
    View all 7 comments
    chaoranhu 08-26 10:15
    • Hi Grahamites – Thanks for your comments. In the case of Google, not so much in the way of judging by the outcome, my hesitation to commit more was in fact caused by a lack of conviction in my understanding of employee compensation. Did try to read up more in this area, but found most of stuff out there not entirely helpful. The definitive answer has got to be in one of those 300-500 pages of FASB documents. I just have not been able to gather myself and take the punishment. Anyway, Google breaks out their GAAP and non-GAAP numbers very nicely. Use rough numbers, I remember its stock based compensation (SBC) expenses are on the order of 4 billion dollars on an annualized basis. That is a large number relative to the GAAP income of around 14.5 billion last year. For anyone considering buying Google shares, they need to have an honest assessment of (1) what the true earnings are at the present and (2) how Google will grow from the current earnings base. People can have different views about Google’s growth prospects, but it should have been much easier to determine its current earnings. With SBC involved, even the latter becomes controversial. Here is my understanding of how GAAP reporting works. Please correct me if I’m wrong. Let’s just assume Google gives away N number of shares and causes 1% dilution a year. For simplicity we further assume the shares are vested immediately. I think GAAP would simply say Google’s SBC expenses are N x price per share and all that gets charged to its income for the current year (neglecting the tax benefit for now). So quite ridiculously, what should have been a mere 1% share dilution causes a gigantic hit in net income, to the order of 20-25%! Here I do have a specific question, since you seem to have a very good grasp of this and most other accounting issues: in the calculation of diluted earnings per share, how is the total number of shares determined with respect to employee stock and option based compensations, and with respect to vesting schedule? For EPS calculation, if all SBC are settled in stocks and result in eventual share dilution, it makes sense to me to account for them with the share count in the denominator. For SBC settled in cash, it would make sense to charge them to income in the numerator. But I’m just not sure what the rules are from GAAP. Any comments would be appreciated.
  • chaoranhu commented on Grahamites's article 08-21 12:50
    TransDigm: The Contemporary Doppelgänger of Capital Cities
    Transdigm is probably one of the largest companies in Cleveland that no one ever heard of. --Nick Howley, CEO of TransDigm At the end of Chapter...
    View all 5 comments
    chaoranhu 08-21 13:50
    • Grahamites - Thanks for commenting back. Much appreciated. Let me itemize a few thoughts below.

      EBITDA. I understand TDG runs an asset-light and Capex-light business model, as evidenced by the fact that its FCF tends to be quite a bit higher than earnings. So perhaps it's less wrong and yet still misleading for it to use EBITDA as the anchor for valuation. On the other hand, with all the teachings from the likes of Buffett/Munger, I'm not sure why what seems an extremely honest, shareholder-friendly, and keenly return-focused management wants to judge business performance through the lens of EBITDA, which certainly has got quite a bad reputation in the investor land. It's true that almost everyone else in today's world uses EBITDA, much to our dismay. Also true that TDG has very good disclosure. But still EBITDA is not owner earnings, not even EBIT. Honestly, although I understand using EV/EBIT or EV/EBITDA puts companies with different level of debt and tax rates on equal footing, I have never found why that should be a replacement for valuation. You can’t eat EBITDA or EBIT. It’s just not what shareholder can take home, and certainly not what you could plug into a DCF conceptually (I know, I know, many of us never intend to run a DCF, myself included).  Instead of estimating what owner earnings are, people instead resort to this type of lazy and dubious tools. Unfortunately, people speaking this type of language include most of the best and brightest in the investment business (e.g. Joel GreenBlatt).
      Quality of management. In spite of my complaints above, I found TDG management among the most honest, capable, and intensely focused. Really the best combination to go around. I’m most impressed by the thoughtfulness of the compensation philosophy they have laid out in the proxy. It’s among the best designed incentive structure out there, very much on par with or even better than what ValueAct has helped put in place at VRX. I think the interests of TDG management are very well aligned with shareholders. In terms of overall management quality, they are certainly in the same league with the outsider CEOs. In spite of doubts in the market (including, among others, no less than Charlie Munger (Trades, Portfolio)), when all is said and done, I also think Mike Pearson at VRX will belong.
      Accounting and financial reporting. You have written many nice short educational pieces on accounting and reporting issues. I have found them particularly helpful for myself. As Buffett says, accounting is the language of business. Understanding accounting and financial reporting is therefore the very first step towards investment success. This is unfortunately an area in which I find myself still sorely lacking in fluency. It has proven to hurt. Earlier back in January this year, GOOGL traded down to around 500. I thought it was very cheap based on adjusted earnings and consensus growth projection. I also saw Mohnish Pabrai (Trades, Portfolio) bought a 6.5% position in his portfolio. I added some to my existing Google position, but far too light! Instead of a 10% position, I still have 5%, barely.  The deterrence was a lack of conviction in my understanding of adjusted earnings, especially in the area of employee compensations. This was certainly a subject you wrote extensively about. One day, if/when I have time, I’d like to put up a post and hopefully invite some discussions about it. My feeling is there has been a lot written about employee stock/option compensation and how it gets treated in financial statements, but still there are a lot of confusions, perhaps even among the very best.

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