Alphabet’s move to spell out its stock options is a watershed moment
Issuing mountains of stock to employees — Silicon Valley’s favourite financial drug — might be going cold turkey, writes Richard Waters
San Francisco — Google is about to go cold turkey on Silicon Valley’s favourite financial drug. Issuing mountains of stock to employees — then turning a blind eye to the impact on profits — has been a not-so-secret dirty habit of the US tech industry for years.
But the times are changing. In a little-noticed announcement, the internet company’s parent, Alphabet, let slip on its last earnings call that it is about to alter its treatment of stock-based compensation — a $6.7bn cost last year. From this quarter, it will stop presenting a view of its earnings that ignores stock costs.
Had that been applied in 2016, the earnings figure that Wall Street used to judge the company would have been nearly 20% lower. Its trailing price/earnings ratio would be 34, not the 27 seen through more rosy spectacles.
Alphabet’s rethink is a watershed moment in the financial maturity of Google’s parent and the evolution of the Valley. The vast companies that dominate today’s tech landscape are finally feeling the financial self-confidence to deal with mainstream investors on their own terms. What this means for the next generation of up-and-coming tech companies is another matter.
It is more than a decade since Silicon Valley went to war with the accountants over the issue of how to treat stock issued to employees. Tech companies argued that if these were deducted from profits, investors would pressure them to hand out fewer options. Fewer workers, in turn, would be willing to take the risk of joining a tech start-up, and Silicon Valley’s gravy train would come to a halt.
Tech companies lost that fight — at least, when it came to their formal GAAP accounts, the ones that comply with generally accepted accounting principles. But in the years since, most have also published parallel pro-forma numbers that ignore the stock costs, and Wall Street analysts have been happy to treat these alternative non-GAAP numbers as the preferred view of reality.
In theory, the particular gloss that tech companies put on their earnings should not matter. They present GAAP figures as well and there is ample disclosure. But convention is hard to buck. Facebook has relegated non-GAAP figures to a footnote in its earnings reports, but Wall Street still takes this adjusted number as gospel when judging the company’s performance.
Alphabet is not the first to take this step. Amazon, for instance, has already dispensed with non-GAAP figures entirely. Had Amazon deducted its $3bn of stock compensation costs last year, it would have lifted its operating profits by more than 75%. But the e-commerce heavyweight does not live or die by its profits, which often feel like almost an afterthought.
Things are different with Alphabet. It has been one of the corporate world’s most impressive profit machines. So, after taking other steps to come more into line with conventional blue-chip companies — such as paying a dividend — why not play by the same accounting rules as well?
Google’s record of sustained growth and profits should make this a smooth transition. But others will not come out so well.
LinkedIn, before it was absorbed by Microsoft last year, was only able to present itself as a profitable company after deducting its stock compensation costs, which amounted to a hefty 16% of revenues. Salesforce also only looks profitable after disregarding employee stock.
For the struggling Twitter, things look even worse. The stock it handed out to workers in 2015 was equivalent to a hefty 31% of revenue. Greater discipline last year brought this down, but stock pay was still 25% of revenue, and by far the biggest factor in turning a $406m non-GAAP net profit into a $457m GAAP loss.
Many tech companies still in high-growth mode will no doubt continue to argue that they should be given special dispensation on stock pay. But growth does not always have to come at the expense of profits. In the year it went public, Google’s stock costs ate up only 9% of revenue — not that far from the 7% it recorded last year.
Its consistency is a reminder that, for a public tech company, there is no substitute for a solid business model from the outset. Shining a brighter spotlight on stock-based pay might just help investors think a little harder about whether the tech industry’s next high-growth, loss-making darling is as hot a prospect as it seems.
© The Financial Times Limited 2017