Tech Companies Challenged For Paying Employees in Stock During Down Year

When times are good, everyone gets to share, at least to some degree. But when times are bad, if I get cut, you bleed. JL

Katie Benner reports in the New York Times:

Investors are paying more attention to stock-based compensation at many tech companies. The scrutiny means examining earnings with stock-based compensation expenses included — and certain financial measures, like earnings and margins, invariably look worse when that expense is factored in.

For the last few years, LinkedIn, the professional social networking company, has doled out increasingly large amounts of stock to pay its workers.

In 2014, LinkedIn paid employees $319 million in stock, or 14 percent of revenue; in 2015, that rose to $510 million, or 17 percent of revenue. At the time, those figures were largely met with shrugs from Wall Street.

Now that attitude may be changing.

As LinkedIn prepares to report its latest quarterly earnings next week, Wall Street is increasingly scrutinizing the number of stock grants that the company pays employees — especially after LinkedIn projected lower growth for this year and its stock price has fallen.

The Silicon Valley company’s stock-based compensation “provides additional reason to remain cautious” on LinkedIn, Mark May, an Internet analyst at Citigroup, wrote in a research note.

The issue is not limited to LinkedIn. With tech earnings season kicking off, investors are paying more attention to stock-based compensation at many tech companies.

Paying employees with stock is largely unquestioned when times are good, since the move theoretically aligns the interests of the workers with company performance. The practice is technically a corporate expense, but during boom periods, Wall Street typically focuses on a company’s operating results that exclude that expense.

Yet public tech companies have had a rockier time in the stock market this year. That has led investors to begin looking more closely at the quality of the companies’ financial results. The scrutiny means examining earnings with stock-based compensation expenses included — and certain financial measures, like earnings and margins, invariably look worse when that expense is factored in.

Tech companies stand out as some of the most generous givers of shares to employees. While the median number of restricted shares granted at Standard & Poor’s 1500 companies to executives and employees in 2014 equaled 450,198 shares, tech companies granted a median 798,000 shares of restricted stock to workers, according to data from Equilar, a research firm that provides data on executives, boards and compensation.

As a result, there has been a “heightened investor focus on the level of stock-based compensation among the Internet companies,” Mark Mahaney, an analyst at RBC Capital Markets, wrote in a recent note.

In an interview, Mr. Mahaney said stock-based compensation could “distort the quality” of a company’s earnings and “make them look stronger than they are.”

Mr. Mahaney has identified Twitter, LinkedIn, Yahoo and Alibaba as among the tech companies that are highly dependent on stock to pay their employees. In a report, he wrote that Twitter’s stock-based compensation over the last two years accounted for 39 percent of the company’s revenue, on average, the highest percentage of any Internet company.

LinkedIn, whose share price is down about 48 percent this year, did not respond to requests for comment. Twitter, whose stock is down more than 20 percent this year, also did not respond to a request for comment.

Another tech company that Wall Street analysts are examining for its stock-based compensation expenses is Workday, which sells human resources and financial management software. The company is expected to increase its stock compensation about 48 percent in its 2017 fiscal year, which is faster than its revenue is projected to grow, according to Sarah Hindlian, an analyst at Macquarie Group.

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In an illustration of how stock-based compensation expenses can affect a company’s results, Ms. Hindlian says Workday’s margins are projected to be around negative 25 percent for fiscal year 2017. But when the company’s $370 million in stock-based compensation is excluded from results, its operating margins are much better, coming in around zero.

Workday’s heavy reliance on stock-based compensation has been a factor in Ms. Hindlian’s projections for the company’s share price. Last month, she forecast that Workday’s stock would trade at $49, down from its current price of about $77. She has a sell recommendation on the stock.

Ms. Hindlian says that while it can be reasonable for companies to pay workers a lot in stock, the practice can become scary when the stock starts to fall. “Particularly with software companies, you run the risk of losing your leading salespeople, engineers and developers when the stock falls, because employees feel like they’re getting a pay cut,” said Ms. Hindlian, who also rang the alarm on LinkedIn’s use of stock-based compensation over a year ago.

“Somewhere along the way a management team may feel pressure to increase their share price to avoid loss of employees,” Ms. Hindlian said, “which can ultimately mean management goals and shareholder interests become misaligned.”

Workday declined to comment.

When companies authorize additional shares to pay employees and management, that also creates “dilution,” or a decrease in how much of the company a shareholder owns when new stock is issued. That effect is starting to push others on Wall Street to lower their price projections for tech company stocks. Mr. May of Citigroup lowered his price targets this month on Google, Facebook, Amazon, Netflix, eBay, Yahoo and Twitter to “fully capture the likely ongoing dilution from future share grants as part of employee compensation,” he said.

The increased scrutiny of tech companies that rely heavily on stock to pay employees is just one of many places where investors are taking a harder look as markets soften, said John Roe, a managing director at ISS Corporate Solutions, a group that advises shareholders on corporate governance issues.

He noted that some shareholders had also submitted proposals asking companies to consider the impact of share buybacks on earnings, to figure out whether executives delivered better earnings by improving performance or by reducing the number of shares outstanding.

“You see a brighter focus on certain practices when there is more volatility and markets are going down,” said Mr. Roe. “The reliance on equity compensation is one of those things that you might always worry about, but recent events have amplified that concern.”