A Case For Adding Back Stock-Based Compensation

| About:, Inc. (CRM)

A few days ago, after (NYSE:CRM) announced its $2.5 billion cash acquisition of Exact Target, Inc. (NYSE:ET), Jim Cramer asked a question to CEO Marc Benioff about the concept of adding back stock compensation to CRM. I would have asked the question a little bit more directly by simply asking "Why do you add back stock-based compensation to your GAAP EPS?" Jim took a different approach but at least he brought up the subject:

Cramer's Question:

I want to point out, stock down 20% from its high, hit badly today. Barron's article saying that if your company was not to use stock-based compensation, you would actually be losing money. 29 cents gaap estimate. If you are able to grow the company and a stock goes higher, you can attract really good people with stock. What happens if this ends, the stock goes down, people don't want stock compensation, you suddenly have to pay with cash. is that something that sales force is equipped or can handle?

The Answer, If You Can Call it That (I've emboldened all the superlatives):

Look, Jim, Sales Force is a phenomenal company, and you have seen the massive cash generation of the business and the tremendous revenue growth and would what we're focused on, Jim, is building a phenomenal, highly valuable, critical asset for our customers. We are customer first and we want to have the organization that customers turn to manage the relationship with their customers and that's the value and then from that value, everything else gets monetized. All cash flow, all the profit realty, all that comes out of that and we have proven that over 14 years of our operating history. And today we're a growth organization. We just put up, as you know, a 30% growth quarter in costs and currency, Jim. 30% operating cash flow growth and also 30% deferred revenue growth. and I think we're the only ones who did that this quarter for you at our size and scale. No, you are the only one and that's why I always tell people, pure growth, sales force is the best pure growth. I just wanted to check on that point because, Jim, we're delivering and my job as the CEO of is to get on your show and to accurately predict the future, to be mindful and thoughtful about what's coming to align our organization and our customers and to make this happen and that's what we're doing and at some point, if that changes, I'll be the first to come on and tell you that, just as I did, for example, in 2008.

Adding back stock compensation to GAAP EPS is a ludicrous exercise and the fact that Wall Street analysts go along with this concept, in my view, is scandalous. is not alone in taking this approach but it is one of the most visible. In its most recent quarter, stock-based compensation of $115 million represented a whopping 12.9% of $893 million in sales.

However, after examining this a little more in depth, I believe I can come up with a valid theory to support CRM's view and this is how it works. When a profitable company gives out free shares to its employees, current shareholders are diluted and EPS declines. So there is clearly a negative effect on the income statement. However, what if a company's business plan is to aggressively grow revenues but never earn a profit. Well that assumption changes the picture entirely with regard to stock-based compensation. Suddenly, handing out all these shares just is not so bad anymore. If a company anticipates losses indefinitely, every share of stock that a company gives out now actually increases EPS by spreading these losses over a wider shareholder base. The EPS loss contracts and EPS rises! Could this be CRM's justification?

Those of you, and there are many, who have been critical of CRM's treatment of stock-based compensation and other aggressive accounting treatments, like adding back the amortization of goodwill, may just want to take another look at this issue.

Disclosure: I am short CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: These are the personal views of Wall Street Titan and should not be used for your investment decisions. All investors should always do their own due diligence.