Michael Burry: Where the Value Isn't

Investor talks about accounting tricks used by tech companies

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Sep 07, 2018
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I have recently been reading through some of Michael Burry's early Scion Capital letters to investors and stumbled across an interesting passage written by Burry in his first quarter 2001 letter to investors.

At the time, the dot-com bubble had just burst, and the market was spotted with attractive opportunities for value investors. Some of these opportunities were more attractive than others, as Burry outlined in his letter in a section titled, "Where the Value Isn't."

"With many large-cap technology sector stocks falling out of favor, one might be tempted to jump into the fray and find a bottom," Burry wrote at the top of the section. "This is all well and good, but there is a flaw at the first assumption here" he continued. What he went on to explain was the importance of considering the impact stock options have on tech companies' bottom lines, and how this reflects on overall evaluation.

"Following is an outline of a problem that a lot of technology-related companies face -- and that makes their stocks in general overvalued. Unlike nearly every other industry, technology companies, as they are generally grouped these days, compensate their employees in a manner that hides much of the expense of the compensation from the income statement. Of course, the subject here is options compensation."

The letter went on to discuss the topic of "nonqualified stock options." Here the "difference between the price of the stock and the price of the options when exercised accrues to the employee as income that must be taxed because it is considered compensation." This definition was not provided by GAAP accounting standards in use at the time but was based on IRS guidance. So, under GAAP the company could book a benefit of roughly 35% of the total difference between the exercise price and the market price of the stock. As it is not recognized on the income statement, the cash benefit is recorded on the cash flow statements as a positive adjustment. Burry went on to say:

"So cash income is understated by net income, right? Wrong. When evaluating US companies, conservative investors ought to assume that if the IRS can tax something, then it is a real profit. And if they allow one to deduct something, then it is a real cost."

He then noted in the letter that in a rising market, by using this method, companies can gain quite a significant tax benefit. However, it would ultimately cost the company because the company must issue new stock at a severe discount to prevailing market prices or buy back stock at prevailing market prices to provide stock at a discount for employees exercising their options. Existing shareholders are the ones who suffer as they are subject to significant dilution. Burry ave an example of the accounting trickery in action:

"Adobe Systems, for instance, is widely regarded as a good company with a decent franchise. A bit cyclical maybe, but a member of the Nasdaq 100 and the S&P 500. It is widely held by institutions.

Looking at its annual report for 2000, one sees that the income tax benefit for options supplied $125 million, or roughly 28% of operating cash flow. Fair enough. Let's move to the income statement. Divide that $125 million by a corporate tax rate of around 35%, and one gets an amount of $357 million. That's the amount of employee compensation that the IRS recognizes Adobe paid in the form of options, but that does not appear on the income statement.

Plugging it into the income statement as an expense drops the operating income - less investment gains and interest - from $408 million to $51 million. Tax that and you get net income somewhere around $33 million - and an abnormally small tax payment to the IRS. That $33 million is a good proxy for the amount of net income that public shareholders get after the company's senior management and employees feed at the trough. For this $33 million – roughly 1/10 of the reported earnings - shareholders were paying $8.7 billion around the time of this writing. Shareholders of such firms as Seibel Systems, Oracle and Xilinx were paying near infinite multiples on last year's earnings, as a similar exercise shows that these firms paid employees more money in options compensation than their entire net income last year."

All in all, this is a fantastic lesson from the past on the pitfalls of trying to find value in the tech sector and the accounting trickery used by some tech companies to boost their earnings, attractiveness to investors and ultimately share price.

Disclosure: The author owns no share mentioned.