Opinion

James Saft

Mature tech companies make you want to GOSOBB

August 6, 2014

Aug 6 (Reuters) – 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 startup.

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 buybacks 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 by
telephone.

“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 emphasize that the
money is actually traveling 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 percent over five years rather than the 9
actually recorded. Or look at IBM which over a five-year period
saw a decline 17.1 percent 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 percent of IBM operating expenses during the
period, according to Lombard Odier.

For Qualcomm the numbers are even more stark, with
a $5.8 billion buyback over five years but so many shares issued
that $9 billion would have been required to offset the impact,
leaving it with nearly 5 percent more in outstanding shares. Had
Qualcomm offset dilution with a buyback it would have equaled 45
percent of operating expenses.

ONE MAN’S GROWTH COMPANY …

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 buyback 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 cash flows 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 labor 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.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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