It is hard, often thankless work being a mature technology company.
New technology threatens existing revenues, making top-line growth difficult. Employees demand lots of compensation for forgoing a lottery ticket at a start-up.
And investors, they wish you were still young and cute, like Facebook or better yet Uber.
For many, notably Microsoft and IBM, the play to make in response is something Bolko Hohaus of Lombard Odier Investment Managers has called “GOSOBB”, or ‘Giving Out Stock Options and Buying them Back’. This maneuver, which is so common it hardly attracts notice, allows for handsome payments to staff while unrealistically flattering earnings.
Employees get their packet and investors can still imagine that they are participating in a young growth stock.
“Share buy-backs by large tech companies in general have actually not reduced share counts over time by the same proportion of the market cap as they have been buying back,” Geneva-based Lombard Odier fund manager Eurof Uppington said.
“We worry they are indulging in financial engineering rather than being the kind of company people buy tech stocks (to own).”
In essence issuing stock options and buying them back gives companies with less explosive growth a way to control operating expenses, but one which doesn’t actually emphasise that the money is actually travelling out the door and home with employees. That leaves earnings looking better than they would if payment was simply cash.
And most valuation techniques don’t fully pick this up. Take Microsoft, which Lombard Odier argues would have had earnings per share growth of 5 per cent over five years rather than the 9 actually recorded. Or look at IBM which over a five-year period saw a decline 17.1 per cent in shares outstanding at a cost of $52.6 billion, of which almost $18 billion was needed to offset the dilution created by new shares issued to employees.
That cost equals 15.4 per cent of IBM operating expenses during the period, according to Lombard Odier.
For Qualcomm the numbers are even more stark, with a $5.8 billion buy-back over five years but so many shares issued that $9 billion would have been required to offset the impact, leaving it with nearly 5 per cent more in outstanding shares. Had Qualcomm offset dilution with a buy-back it would have equalled 45 per cent of operating expenses.
Now, to be sure, one man’s mature company struggling to maintain momentum is another man’s hot growth company, and so how harshly to judge corporate tactics is a matter for individual discretion. And it is also undeniable that the hot market for tech employees is a reality.
There is real pressure on older tech companies to compensate employees well in order to attract talent and maintain, much less expand, their franchises.
Still, even Generally Accepted Accounting Principles (GAAP) earnings, which were designed in part to address this issue, only do so incompletely. Under GAAP, companies have to chalk up an expense for employee stock options but can do so based on the fair value at the time the shares were granted.
That, as you can see by the numbers above, is often far less than the actual cash moving out the actual door if the buy-back comes when the stock price has moved higher.
None of this is improper, the only questions are whether it is wise and who benefits. From an investor’s standpoint it is important to look through the earnings as presented, keeping a keen eye instead on cashflows and top-line growth.
We all need to make our own decisions about what the future rate of growth and its relationship to operating expenses is going to be, but mature companies, while having a place in a portfolio, need to be appropriately priced.
The market today is placing an extraordinary premium on growth, and so it should come as no surprise that every company is doing its best to portray itself as fitting that bill.
At the same time a series of huge revolutions in technology and a shortage of talent are creating unusual labour conditions. In addition, and this is not unique to technology companies, executives use share options to do a certain amount of nest-feathering.
At some point, and my guess is that this happens when monetary conditions tighten, that premium for hoped-for growth will ebb, and investors will become more discriminating about the quality of growth and earnings they are willing to buy, and at what price.
Expect at that point to hear the gentle sound of sobbing from some tech investors.
Reuters
