The Hidden Tech Headwind

Rising stock compensation as a percentage of sales threatens to set in motion a vicious cycle

All eyes are on tech. The initial wave of AI hype has cooled off and the threat of more interest rate increases is deflating the present value calculations analysts use to discount the generous earnings some of these young companies promise to eventually report. The Technology Select SPDR Fund is down roughly 10% from its July peak and investors seem to be in “wait and see” mode. While we are by no means predicting another dot.com crash, we will observe that many of these companies are still selling for sky-high multiples, and more importantly, we believe many investors are not seeing the recent hidden boost to earnings growth that many tech companies have received by growing their stock compensation at a faster pace than revenues.

Note that we are not referring to just the general distortion of non-GAAP earnings from adding back stock compensation. That’s bad enough, but adding back stock compensation becomes even more of a distortion when  it is rising as a percentage of sales and artificially inflating non-GAAP margins and profit growth. Think of it this way- if a company ignores expenses amounting to 20% of sales this quarter, and that same expense item rises to 22% in the next quarter due to an increase in the expense amount, adjusted margins will benefit by 2%. Exposure to this trend stalling or even reversing puts these companies at even more risk of an earnings disappointment if wavering stock prices prompt employees to demand higher cash wages which can’t be added back to non-GAAP results. (We promise you that the employees are aware of the Technology Select SPDR Fund’s recent performance too.) An earnings miss can set in motion a vicious cycle where the stock price is pushed down, driving employees to demand more cash compensation. Higher cash spending crimps cash flow (which some of these companies are already low on) and can pressure earnings and non-GAAP PE ratios which pushes the stock even lower. Finally, pressure on cash flow may stunt investing in R&D and marketing and penalize future revenue growth in the longer term.

The pre-Elon, pre-Covid history of Twitter is a great illustration of this dynamic at work. Twitter went public on Nov 7, 2013, at an IPO price of $26 and quickly rose to over $70. In 2015 and 2016, Twitter’s non-GAAP EPS was only about 30 cents, so the valuation was still 120x adjusted EPS even with the stock in the mid-$30s. By 2015, it was clear the revenue growth was slowing rapidly which took the stock price down further. As the stock reached $14 in 2016, Twitter couldn’t use its stock as currency as easily as it had in the past and stock compensation began to decline. It fell from 90% of revenue in 2013 to 11% in 2018. Notice also that Twitter began investing less in R&D and sales and marketing both in terms of cash and stock compensation:

With Twitter’s rapid revenue growth early on, it saw stock compensation decline as a percentage of sales. 100% revenue growth can drive some serious leverage on the cost side.

To find the companies most vulnerable to this phenomenon, we began looking for companies with market capitalizations greater than $5 billion and non-GAAP PE ratios of at least 40. We dug through their financials looking for the following characteristics:

• Slowing or non-stratospheric revenue growth

• Without adding back stock compensation, earnings would be negative and cash flow would be materially lower.

• An increase in stock compensation as a percentage of sales has resulted in a material tailwind to non-GAAP EPS growth in recent quarters creating more froth that could unwind and hurt the stock price.

• We highlight instances of companies that fit the above traits but have peers that are less aggressive.

• We also include some more established companies that have benefited from stock compensation rising as a percentage of sales which makes them more at risk of an earnings miss.

We provide a list of 34 at-risk companies and look more closely at 8 which stand out as strong illustrations. Note that these include some of the most popular growth names in the market today from both the tech and non-tech arenas as well as some large, established tech companies you might not expect to show up on the list.

Let’s go “Behind the Numbers.”