A handful of times over the past few years, I have been openly critical of Alphabet Inc.'s (GOOG, Financial) (GOOGL, Financial) management for the continued reporting of non-GAAP earnings that excluded the cost of stock-based compensation (SBC). As a corollary, I have been critical of Wall Street analysts that accepted this without question, despite including these costs in the EPS for Alphabet’s peers, such as Apple (AAPL, Financial) and Microsoft (MSFT, Financial).
Finally, I have argued that leading investment publications such as Barron’s have also played their part by reporting non-GAAP financials without properly explaining to readers what that actually means – and in some cases, without even disclosing that the presented metrics were non-GAAP.
In an April 2014 article titled “Google and Non-GAAP Earnings,” I said the following:
"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, stock-based compensation expense 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 in 2013 – is not indicative of recurring business results; meanwhile, the dollar amount related to SBC 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 1992 shareholder letter:
'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?'"
Those statements are still accurate today, only more so. As noted, SBC was equal to 5.5% of revenues in 2013. In 2014, SBC climbed to 6.3% of revenues. In 2015, SBC climbed to 6.9% of revenues (exceeding $5 billion). That trend has continued: in the most recent quarter (fourth-quarter 2016), stock-based compensation exceeded $1.8 billion, or more than 7% of revenues.
I am not the least bit surprised SBC has continued to trend higher over time (in both absolute dollars and as a percentage of revenues). In similar circumstances, most of us would choose a similar path. Dan Airley, a leading researcher in the field of behavioral economics, explained why when discussing the power of incentives in a June 2010 Harvard Business Review column:
"Human beings adjust behavior based on the metrics they’re held against. Anything you measure will impel a person to optimize his score on that metric. What you measure is what you’ll get. Period."
Management, which was ultimately judged against non-GAAP EPS, was holding a "get-out-of jail-free" card; nobody should be surprised they used it. Instead of pushing back, analysts willingly accepted the continued exclusion of SBC from earnings (considering how these same analysts treated SBC at other companies, I believe this was inexcusable). What you measure impacts behavior. I think this played a role in the trend of SBC at Alphabet over the past five-plus years.
But the point of this article is not to simply rehash what I wrote few years ago. The purpose is to extend kudos to Alphabet – and specifically CFO Ruth Porat – for a major announcement on last Thursday’s conference call (Jan. 27):
“We are making changes to our non-GAAP reporting. SBC [stock-based compensation] has always been an important part of how we reward our employees in a way that aligns their interests with those of all shareholders. Although it is not a cash expense, we consider it to be a real cost of running our business because SBC is critical to our ability to attract and retain the best talent in the world. Starting with our first-quarter results for 2017, we will no longer regularly exclude stock-based compensation expense from non-GAAP results.”
Conclusion
For years, Alphabet played a game where they acted as if SBC was not a real cost of doing business. Analysts willingly obliged and modeled against non-GAAP EPS. The statement from management’s decision is clear: SBC is a real – and meaningful – cost of doing business.
It will be interesting to see how analysts proceed. As noted above, SBC was equal to approximately 7% of revenues in the most recent quarter. The company has reported non-GAAP operating margins in the low 30s, compared to GAAP operating margins in the mid-20s (%). As a result of this cosmetic change, Alphabet’s EPS will decline by roughly 20% overnight.
Analysts now find themselves in a bit of a quandary: should they stick to the non-GAAP figures they have reported for years or suddenly roll over to GAAP? Doing the latter will require a bit of acrobatics to explain changes in valuation (higher price-earnings multiples, here we come). Here is what William Blair analyst Ralph Schackart had to say about the change:
"We have left non-GAAP estimates in our model for illustration purposes, but note we will likely be unable to update these with precision going forward and expect investors to start focusing more on profitability measures that include SBC expenses - GAAP operating margin and GAAP EPS.”
Presentation matters. Most people do not actually dig through the financials to understand the economic reality of the underlying business. I suspect many investors will likely be surprised when the P/E multiple for GOOGL unexpectedly jumps a few turns in the coming quarters.
For me, what is most relevant about this decision is what it says about management. They have finally accepted the reality of what the Financial Accounting Standards Board concluded more than a decade ago (better late than never). Personally, I am more willing to consider an investment in the company as a result of this change. I think it reflects positively on the people who have been put in charge at Alphabet.
Disclosure: Long MSFT.
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