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Amazon, web giants shift to reporting real cost of equity pay

amazon.jpg Inc started breaking out stock-based compensation in the results of its different businesses in the first quarter.

[SAN FRANCISCO] For more than a decade, technology companies doled out heaps of stock to recruit top talent - then pretended this wasn't a normal part of doing business by reporting profit numbers that subtracted the cost. That's changing as the industry grows up and responds to pressure from regulators and investors. Inc started breaking out stock-based compensation in the results of its different businesses in the first quarter. This is "the way we now evaluate our business performance and manage our operations," Chief Financial Officer Brian Olsavsky told analysts after the earnings report last week.

Facebook Inc Chief Financial Officer David Wehner had a similar message. From now on, he said he'll talk about the social network's results and other metrics based on US standards known as Generally Accepted Accounting Principles, or GAAP, which include equity-based pay costs, instead of a mix of GAAP and non-GAAP numbers.

"We view it as a real expense," he said.

Some technology companies, such as Netflix Inc and Intel Corp, already take this approach, but many don't. If the shift to focusing on the real bottom line catches on more broadly, it could slice billions of dollars off the reported profits and official forecasts that underpin the technology sector's lofty market valuations.

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Facebook stock trades at about 35 times estimated earnings over the next 12 months. Add in equity compensation expense and that price-to-earnings ratio jumps to 50, according to a Sanford C Bernstein & Co analysis.

Amazon would trade at 122 times projected profit, rather than a multiple of 63. Using GAAP numbers, Alphabet Inc would trade at 26 times forecast profit, versus 21 times, Bernstein estimates.

The change also highlights the struggles of smaller Internet companies like Twitter Inc and LinkedIn Corp to generate GAAP earnings.

Facebook, Amazon and Alphabet may have high stock valuations, but they are also very profitable by GAAP and non-GAAP measures. Twitter shares trade at about 36 times estimated profit, but including stock-based compensation analysts expect it to have a loss over the next 12 months, Bernstein research shows.

"If you can act from a position of strength, which Amazon and Facebook clearly are, there's no better time to change your behavior," said Denny Fish, who helps oversee US$2.5 billion in technology stocks at Janus Capital Group Inc.

"They look more responsible and it makes them accountable for how they issue stock for compensation in the future."

Amazon in prior quarters disclosed overall stock-based compensation, but didn't tell investors how much went to each business and didn't allocate this expense to these divisions for its own management purposes. In the fourth quarter, the AWS cloud business generated US$687 million in operating income, and investors were left to estimate how much of Amazon's total equity-pay costs of US$606 million went into that division.

Last Thursday, the company said AWS had first-quarter operating profit of US$604 million, including US$112 million in stock- compensation expense.

Alphabet may focus more on GAAP results in the future, while Twitter is unlikely to do so because that would make its numbers look a lot worse, Mr Fish said.

In February, Alphabet started reporting stock-based compensation for its Google business and a group of newer businesses known as Other Bets. The Google unit had US$1.3 billion in equity pay expense in the final quarter of 2015, leaving an operating profit of US$6.8 billion.

Other Bets spent US$498 million on equity awards for the whole of last year, contributing to a US$3.6 billion annual operating loss.

Twitter reported 2015 non-GAAP profit of US$277 million, or 40 US cents a share. On a GAAP basis, including stock-based compensation, the company posted a loss of US$521 million, or 79 US cents.

"Some companies have been egregious with stock compensation," Mr Fish said, citing LinkedIn, which has relatively high equity-based pay compared to its revenue and earnings.

Analysts on average project that LinkedIn will have profit of US$591 million, or US$4.27 a share, in 2017 - a non-GAAP number that excludes stock-based compensation costs. When that expense is included, along with other items, the company is forecast to lose US$36 million, or 29 US cents, according to data compiled by Bloomberg. 

LinkedIn cut growth forecasts earlier this year, making it more important for investors to assess its long-term compensation costs. "When fundamentals deteriorate relative to high-growth expectations and stock-based comp is high as well, companies can be doubly penalized," Mr Fish said.

LinkedIn shares have declined 44 per cent this year, while rival social network Facebook is up 13 per cent.

"Non-GAAP results are the most accurate representation of our operating results," LinkedIn spokesman Hani Durzy wrote in an e-mail. Still, he said the company aims to reduce stock-based compensation to about 10 per cent of revenue from the current 17 per cent, while still using equity as a hiring tool.

"Talent is critical in this industry, and we want to make sure that we're balancing the trade-offs appropriately," Mr Durzy said.

Representatives at Facebook, Amazon and Alphabet declined to comment. A Twitter spokesman didn't respond to an e-mail seeking comment.

Facebook and Amazon's new approach follows mounting criticism about many companies' overuse of non-GAAP numbers, especially in technology, where big equity awards are common.

In his latest shareholder letter, Warren Buffett disparaged the omission of pay as "the most egregious" example of non-GAAP accounting. "If compensation isn't an expense, what is it? And, if real and recurring expenses don't belong in the calculation of earnings, where in the world do they belong?" he wrote.

Companies have taken note. The Society of Corporate Secretaries and Governance Professionals, which represents company executives and other managers, sent a memo to members last month highlighting comments on this issue by officials at the US Securities and Exchange Commission and the Public Company Accounting Oversight Board.

SEC Chief Accountant James Schnurr said executives and directors on boards' audit committees should ask why non-GAAP numbers are an appropriate way to measure performance and probe whether they're really useful to investors.

Shareholder pressure may also have had a big impact at Facebook and Amazon. The companies recently told one large technology investor that they made the change in response to investor requests and for competitive reasons.

When large, profitable technology companies exclude stock-based compensation, they promote an accounting concept that lets smaller rivals appear more profitable than they actually are. This helps these same rivals compete better for talented employees, who are looking to work at the most successful firms, said this investor, who asked not to be identified because the conversations were private.

If the tech industry keeps shifting toward treating share-based pay as a real expense, Twitter may be most exposed, according to Carlos Kirjner, an Internet analyst at Bernstein. The social-media company has to compete with Internet behemoths Facebook and Alphabet and venture-backed startups to hire talented product and engineering employees, and issuing stock as part of a job offer is a good way to lure candidates.

Yet these expenses will eat up a "very large portion" of Twitter's future free cash flow, and long-term investors should consider this when deciding whether to back the company, Mr Kirjner said.

"Some companies like Twitter that pay their employees generously with hundreds of millions of dollars in equity grants will say they are free-cash-flow positive before expensing stock-based comp," the analyst wrote. "Maybe they should define free cash flow before any expenses, which would look even better," he joked.


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