The Numbers Game: Risks hiding in plain sight

Adam Chandler

Claremont Global

Are earnings estimates too high? It’s a question being repeatedly asked, as the market speculates about the economic outlook. But perhaps the first question should be: are historic earnings too high?

It isn’t uncommon for management teams to systemically overstate their company’s profitability and skew the starting point for evaluating a company’s outlook. In recent years, short-term narratives have often trumped financial reality.

We wrote about the practice of adjusting earnings on Livewire in March last year, but the gradual erosion in the quality of earnings isn’t new. Back in 1998, the Chairman of the SEC announced initiatives to combat earnings management when he said: 

“A gray area where the accounting is being perverted; where managers are cutting corners; and, where earnings reports reflect the desires of management rather than the underlying financial performance of the company”(1).

It was a formidable task. As Warren Buffett noted at the time, once an everybody’s-doing-it attitude takes hold, ethical misgivings vanish, and a form of Gresham’s Law takes hold; where bad accounting drives out good(2). As we’ll discuss, while some of the methods have changed, almost a quarter of century on the gamification of financial reporting continues.

The odds of regulation successfully addressing these issues anytime soon seem low. But, unlike the Quantitative Easing years ― where liquidity and a bull market covered a lot of sins ― we believe in the current environment investors will be increasingly rewarded for rolling up their sleeves and doing the fundamental work of separating business fact from financial illusion.

In this piece, we discuss why the current environment is leading to a more realistic appraisal of companies’ financial performance, the ongoing use of adjusted earnings to boost profitability, how this may unravel (in the short-term at least), and why parts of non-profitable tech could be unlikely to bounce back and how we’re navigating these waters.

Why today’s market may be a better reformer

Rising stock prices fuel investor belief and generate a few tough questions. The recent era of free money suspended financial reality across swathes of the market.

Take the IPO market. Since 2017, the proportion of all companies listed that were unprofitable ranged from 75 per cent to 81 per cent. Since 1980, the only two years with such a high proportion of unprofitable companies being listed were in 1999 (76 per cent) and 2000 (81 per cent)(3), at the peak of the Dotcom boom. Conditions presented an opportune IPO environment, at least for sellers.

Falling share prices led to reappraisals of companies’ profitability and prospects. The dearth of IPOs in recent months highlights how quickly investor appetite can wane. The perception shift is also apparent in hyper-growth tech. Compressed valuation multiples reflect more scepticism, and an increasing prioritisation of profitable growth over spare-no-expense growth.

At the same time, a large proportion of S&P500 companies continue to present “adjusted” earnings numbers. Last year, we discussed how the market still appeared to be ― for the most part uncritically ― accepting these adjusted earnings numbers.

In our view, certain management teams had successfully refocused analysts on inflated earnings numbers that no longer even vaguely approximated the underlying businesses’ economics. Adding back a large portion of employee expenses (by ignoring stock-based compensation expenses) remains a common adjustment to materially boost earnings.

With recent share price falls we’ve seen greater discussion of these adjustments, by both analysts and the media. Andy Fastow, the Former CFO of Enron, and a modern-day financial villain, summed-up the sudden shift in financial perception that can occur when he said: 

“One day the market woke up and said, yeah but these numbers don’t make any sense.”

As capital and bull market confidence deteriorates, we thought it timely to revisit some of the risks hiding in plain sight.

In a less credulous environment, the market may not take the ever increasing, adjusted earnings numbers at face value – potentially leading to an effective rebasing of earnings, further share price declines, and more threatening prospects for marginally profitable companies.

Augmented reality 2.0

Tech investing over the five years to 2021 was characterised by the willingness to throw ever increasing amounts of capital at the promise of rapid revenue growth, with the bottom line largely ignored.

In recent months, shareholders have begun to prioritise profitable growth, over spare-no-expense-growth, across the public (and private) tech space. This is reflected in the plunging share prices of non-profitable tech, as well as recent announcements of moderating spending intentions by many tech companies and venture capitalists.

Yet the use of earnings adjustments, and specifically adding back stock compensation to flatter margins and earnings continues to escalate, with many prominent examples within the tech space. We discuss two below.

Example I – An IPO barometer

Large revenue multiples were awarded to many loss-making entities, so long as revenue growth was at rates running well into the double digits. Software company HashiCorp (NASDAQ:HCP) is just one notable example.

HashiCorp was listed on NASDAQ in December 2021, on a forward EV/Sales multiple of c.50x. Even at a 100 per cent profit margin, that sounds expensive. In the words of the former CEO of Sun Microsystems Scott McNealy: “What were you thinking?”(4)

However, in FY22, before accounting for a single dollar of cash payments, HashiCorp then paid away 62 per cent of their revenue to employees in equity-based compensation. Prior to this adjustment, the company’s operating margin, on a generally accepted accounting principles (GAAP) basis was negative 90 per cent – you read correctly, HashiCorp lost 90 cents from every dollar of sales.

Following the add back of stock compensation, the company’s adjusted operating margin was greatly improved, to -28 per cent. But even this large adjustment couldn’t create the appearance of breaking even.

While HashiCorp’s technology is highly regarded, the IPO valuation was certainly not supported by the underlying financials. And the market’s appetite to buy revenue growth at any price, has since disappeared.

HashiCorp was listed at $80 per share, and at the time of writing its share price has more than halved in just over six months.

Example II – Snap Inc.’s latest earnings filter

In our March 2021 piece, we discussed Snap Inc (NASDAQ: SNAP)., which in 2020 added back $770 million of stock compensation to adjusted earnings (or 30 per cent of revenue).

Since then, Snap Inc. has announced 2021 results, and that adjustment increased to well over a billion dollars (or 27 per cent of revenue). The ignoring of this, and other expenses, transformed a net loss of $488 million (on a GAAP basis) to a profit of $775 million.

Snap Inc.’s just released, second quarter 2022 result, revealed a deteriorating set of financials, even the add back of stock compensation, equating to almost 30 per cent of revenue, couldn’t return the company to break even.

Consistently ignoring a major portion of your expense base is deceptive and doesn’t change the underlying economics. In a sustainable business, employees must be paid appropriately.

Since we wrote the last piece on this topic, Snap Inc. has fallen from over $50 per share to c.$10, a decline of over 80 per cent.

Employees ― or ex-employees ― a catalyst for change

The market and vocal shareholders are one potential mechanism for a change to stock compensation practices. Another is employees who receive scrip or options.

Equity-linked compensation is often a key piece to attracting and retaining the best talent. This is particularly true for tech companies, which are often founded on belief, engineering talent and hustle. And this engineering talent is typically incentivised by equity-linked compensation, which offers the potential for a huge payday. At a minimum, there is the expectation of share price appreciation.

Declining stock prices and the value of restricted stock units, or options expiring out-of-the-money (worthless), result in potentially significant wealth impacts on employees(5). Prices affect fundamentals. A falling share price may reinforce a negative feedback loop ― impacting employee compensation, motivation, retention, hiring, and ultimately the company’s core capabilities ― which in turn, further impacts the share price.

If employee belief begins to dissolve and enough pessimistic engineers jump ship, the prospects of a technology company falter. This makes employee credulity just as important as that of investors. Especially within Silicon Valley, where despite the headlines, the competition for the top engineering talent remains high.

Of course, if a company ― or its owner ― has the resources available, they may choose to address employee dissatisfaction with a falling asset price, through an improved compensation package.

For example, via a compensation mix more tilted to cash than equity. Such a mix shift would reduce the adjusted earnings boost ― decreasing the amount of stock compensation, and the expense added back to earnings, hence reducing: 1) adjusted margins; 2) adjusted earnings; and 3) cash flow, while leaving GAAP earnings unaffected.

By increasing the cash weighting within total remuneration, the true cost of labour to companies becomes more transparent within adjusted earnings, as does real profitability.

Conversely, companies may look to make employees whole by awarding more shares or options (or give away more value through lower exercise prices) to support the same dollar value remuneration. While this may enable the stock compensation/adjusted earnings charade to be perpetuated, it can result in greater earnings per share dilution to existing investors and can be a stopgap (or perhaps delay-GAAP?) measure.

There’s more to the collapse in non-profitable tech share prices than higher interest rates and lower multiples. A falling stock price, reliance on a highly skilled workforce, a substantial proportion of compensation in equity and accruing losses, is a shaky foundation for any business. This brings to mind economist Herbert Stein’s observation: “If something cannot go on forever it will stop”.

The recent value destruction won’t be easily reversed for many companies.

Positioning in the current environment

With tightening liquidity, the easy money is gone. And a re-examination of companies’ underlying profitability may lead to negative feedback loops for share prices. For more marginal companies, there’s a good chance recent market valuations won’t be revisited for many years, and some face more threatening existential questions. However, this environment is also presenting some attractive, high-quality, long-term investment opportunities.

Our views and process haven’t changed. A rigorous approach to finding profitable investment opportunities within tech, and more broadly, is required. We have several, genuinely profitable, U.S. tech companies within our portfolio. Today’s conditions may also present opportunities for these companies to further consolidate their position, by acquiring good technology cheaply, or employing outstanding talent.

Over the long-term, financial reality always trumps narratives. While perceptions and markets change, focusing on well established, profitable businesses, management teams with integrity and maintaining a disciplined approach to valuation are all key at Claremont Global. We believe it will continue to hold us in good stead, throughout many more cycles.

Learn more

Claremont Global is a high conviction portfolio of value-creating businesses at reasonable prices. We consider ourselves true stock-pickers and look to avoid owning businesses that depend on a benign or favourable economic environment. Visit our website for more information. 

Managed Fund
Claremont Global Fund
Global Shares

Sources

(1) Arthur Levitt, then Chairman of the Securities and Commission Exchange, quoted in “The Numbers Game” speech, September 1998.

(2) Chairman’s Letter, Berkshire Hathaway Annual Report, 1998.

(3) Initial Public Offerings: Updated Statistics. Jay R. Ritter. Cordell Eminent Scholar, Eugene F. Brigham Department of Finance, Insurance, and Real Estate Warrington College of Business, University of Florida. June 20, 2022.

(4) Scott McNealy’s iconic quote, referencing his time as CEO of Sun Microsystems during the Dotcom years when his stock traded at a 10x revenue multiple. “At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”. In 2021, 50x was the new 10x.

(5) This applies to listed markets and venture capital valuations - which can only defy gravity for so long. A decline in venture capital funding would likely contribute to a decline in valuations. 

The information in this article may contain general advice. Any general advice provided has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, you should consider the appropriateness of the advice with regard to your objectives, financial situation and needs.

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This information has been prepared by Claremont Funds Management Pty Ltd (Investment Manager) (ACN 649 280 142, ABN 38 649 280 142, CAR No. 001289207), as investment manager for the Claremont Global Fund (ARSN 166 708 792) and Claremont Global Fund (Hedged) (ARSN 166 708 407), which are together referred to as the ‘Funds’. Equity Trustees Limited (ACN 004 031 298, AFSL 240957) (“Equity Trustees”) is the Responsible Entity of the Funds. For further information on the Funds please refer to each Fund’s PDS which is available at www.claremontglobal.com.au. The Target Market Determination for the product can be available by contacting your adviser. A Target Market Determination is a document which is required to be made available from 5 October 2021. It describes who this financial product is likely to be appropriate for (i.e. the target market), and any conditions around how the product can be distributed to investors. It also describes the events or circumstances where the Target Market Determination for this financial product may need to be reviewed. Past performance is not a reliable indicator of future performance. This article may contain statements, opinions, projections, forecasts and other material (forward-looking statements), based on various assumptions. Those assumptions may or may not prove to be correct. The Investment Manager and its advisers (including all of their respective directors, consultants and/or employees, related bodies corporate and the directors, shareholders, managers, employees or agents of them) (Parties) do not make any representation as to the accuracy or likelihood of fulfilment of the forward-looking statements or any of the assumptions upon which they are based. Readers are cautioned not to place undue reliance on forward-looking statements and the Parties assume no obligation to update that information. The Parties give no warranty, representation or guarantee as to the accuracy, completeness or reliability of the information contained in this report. The Parties do not accept, except to the extent permitted by law, responsibility for any loss, claim, damages, costs or expenses arising out of, or in connection with, the information contained in this article. The information provided in the article is current at the time of publication. The views expressed herein should be considered as part of a wider portfolio investment strategy applicable to the Funds and should not be considered in isolation or relied on to make an investment decision without seeking further information and/or advice from a financial adviser.

1 fund mentioned

Adam Chandler
Portfolio Manager
Claremont Global

Adam has more than 20 years’ experience in financial markets,having previously worked as an analyst and Portfolio Manager with UBS’s Fundamental Investment Group and at a London-based, absolute return fund. In the earlier stages of his career,...

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