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Google & Non-GAAP Earnings

The Science of Hitting

The Science of Hitting

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In Google’s (GOOG) initial filing before going public in 2004, Larry Page and Sergey Brin included “An Owner’s Manual for Google’s Shareholders”. The title included a footnote, which stated the following: “Much of this was inspired by Warren Buffett (Trades, Portfolio)’s essays in his annual reports and his ‘An Owner’s Manual’ to Berkshire Hathaway shareholders.”

The letter’s intent was clear, starting with the following: “Google is not a conventional company. We do not intend to become one.” It continued with a discussion on their long term focus for the company, as well as a disclaimer that they had no interest in taking part in the quarterly earnings game that ensnares many companies. For the most part, the manual rings true today: Google continues to seek the “high-risk, high-reward projects” discussed in that letter. A decade later, the company has been a fantastic success story while largely sticking to these principles.

Despite their success, I think there’s one area that Google’s founders deserves criticism for, as compared to the standard they set for themselves: stock based compensation (SBC). The company’s first quarter results, reported earlier this month, included the following disclosure:

“Non-GAAP operating income and non-GAAP operating margin exclude stock-based compensation (SBC) expense… In the first quarter of 2014, the expense related to SBC and the related tax benefits were $839 million and $190 million compared to $655 million and $141 million in the first quarter of 2013.”

The $839 million in the first quarter, after backing out the $190 million in tax benefit, comes out to a net expense of $650 million that was excluded from the reported results. A further disclosure in the 8-K shows the extent of this expense: “We currently estimate SBC charges for grants to Google employees prior to March 31, 2014 to be approximately $3.22 billion for 2014. This estimate does not include expenses to be recognized related to employee stock awards that are granted after March 31, 2014 or non-employee stock awards that have been or may be granted.”

To put this in perspective, the company’s non-GAAP operating income in the quarter was 20% higher than the reported GAAP operating income (and 17% higher a year ago); we’re not talking a round error – these are big numbers. To be clear, Google’s primary competitors, like Apple (AAPL) and Microsoft (MSFT), use similar compensation practices (both had stock-based comp expenses in excess of $2 billion in their most recent fiscal year); the difference is that neither of those companies back out the expense when reporting quarterly results to investors.

Why does management believe it is appropriate to remove stock based compensation expense from the reported results? They offered the following explanation in the 8-K:

“We use these non-GAAP financial measures for financial and operational decision-making and as a means to evaluate period-to-period comparisons. Our management believes that these non-GAAP financial measures provide meaningful supplemental information regarding our performance and liquidity by excluding certain expenses and expenditures that may not be indicative of our recurring core business operating results, meaning our operating performance excluding not only non-cash charges, such as SBC, but also discrete cash charges that are infrequent in nature. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance and when planning, forecasting, and analyzing future periods. These non-GAAP financial measures also facilitate management's internal comparisons to our historical performance and liquidity as well as comparisons to our competitors' operating results. We believe these non-GAAP financial measures are useful to investors both because (1) they allow for greater transparency with respect to key metrics used by management in its financial and operational decision-making and (2) they are used by our institutional investors and the analyst community to help them analyze the health of our business."

That brings up an interesting question: is stock based compensation “indicative of Google’s recurring core business operating results”?

Well, one way to find out if something is recurring is to look at how long it has been going on for; in this instance, the answer is many, many years (from what I can see, Google has backed out this expense from quarterly results since they went public; years ago, they used to offer the following line early in the press release: “Some Wall Street analysts use non-GAAP measures to analyze our operating results”). Here’s another question that might offer some insight: if they eliminated this practice tomorrow, would it hinder their ability to retain talent? Would they be able to retain and motivate the employees needed to keep running the company?

This statement from the most recent proxy filing doesn’t mince any words:

“As with the compensation of our named executive officers, a substantial portion of the compensation for employees generally is delivered in the form of equity awards that help further align the interests of employees with those of stockholders.”

The company continued along these lines in the risk section of their 10-K:

“Our performance largely depends on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees.”

I don’t think there’s a strong argument for backing out a line item that accounts for a “substantial portion” of employee compensation, and is critical for attracting new employees and retaining and motivating existing employees.

In the past three years, Google’s total stock based compensation expense (as shown on the cash flow statement) has exceeded $8 billion; in the most recent fiscal year, the total was in excess of $3.3 billion. Management is arguing that this (gross) expense – equal to 5.5% of the company’s reported revenues for fiscal 2013 – is not indicative of recurring business results; meanwhile, the dollar amount related to stock based compensation moves higher and higher, year after year (the total expense for 2013 was 3X greater than the amount reported five years earlier).

I’ll close with a quote from Warren Buffett (Trades, Portfolio)’s (BRK.B) 1992 shareholder letter that hits the nail on the head:

“It seems to me that the realities of stock options can be summarized quite simply: If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?”

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 5.0/5 (3 votes)

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Comments

gary_doan
Gary_doan - 2 months ago

Non-conventional is an understatement. They are irresponsible and never held accountable. As the worlds largest propagator of viruses and bugs, they don't even accept responsibility for the risk that open source inflicts on Android users. This was very apparent with the OpenSSL bug, which was implemented, managed an in Linux and Android by two volunteer developers, who were solely responsible for code review. The constant hype that the press gladdly propagates and the glowing reviews by analysts, who's blind lust for open source, has fogged their preceptiomn reality, should take a breathe and actually do a risk analsis. The press and analysts are now activly trying to stop the slide of Google's stock, even though the reality of falling profit margins, falling cash flow and falling stock prices, are all to apparent.

The Science of Hitting
The Science of Hitting premium member - 2 months ago

Gary_doan - I don't know too much about the tech details so I'll have to take your word for it; thanks for the comment!

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