LinkedIn - Rampant Stock Based Compensation Makes It An Enticing Short

Aug. 7.14 | About: LinkedIn (LNKD)


Headlines have LNKD making a substantial profit.

Yet when all costs are included the company runs at a loss.

The organizational tendency to downplay and ignore the costs of stock based compensation has very negative consequences for the stock's future valuation.

LinkedIn (NYSE:LNKD) recently reported earnings, and to hear the company and analysts tell the story, it was a rousing success, handily beating the Street's estimates. Yet in looking at the actual numbers, I was surprised to learn that while everyone (i.e. analysts and the financial media) focused exclusively on LNKD's preferred non-GAAP metrics, under GAAP accounting the company barely eked out a profit. Moreover - in 2014 as a whole - the company may not even break even.

In the froth of today's Fed-fueled bull market, many market participants may have forgotten what GAAP means and why it exists. Generally Accepted Accounting Principles are the rules the accounting profession has determined best represent the true state of a company's finances (which investors then use to evaluate a particular company's financial health and performance). These rules are neither arbitrary nor intended to hamstring companies, rather they're arrived at after much deliberation and experience, with the explicit goal of presenting objective data.

Today however - much like in the bubble of the late 1990's and early 2000's - companies routinely flout these rules to instead emphasize much more flattering non-GAAP measures conjured up by companies to put their prospects in the best light. Analysts, who often make their living arranging financing for these companies, are frequently complicit - if not willing - participants in this charade.

Harkening back to the aforementioned 1999 bubble, rather than simply being called "non-GAAP" "earnings," the positively scrubbed financials at the time were often referred to as EBITDA or "pro forma" earnings. In response Warren Buffett commented:

Bad terminology is the enemy of good thinking. When companies or investment professionals use terms such as "EBITDA" and "pro forma," they want you to unthinkingly accept concepts that are dangerously flawed. (In golf, my score is frequently below par on a pro forma basis: I have firm plans to "restructure" my putting stroke and therefore only count the swings I take before reaching the green.)

Those of us old enough to have participated in that bubble remember how companies built on pro forma earnings ultimately fared. And the essence of the problem, i.e. inappropriate concepts leading to bad thinking, is operative once again.

Stock Compensation is a Real Expense

Of particular note at the time (and now again) was the unwillingness to count compensation by options or stock as a "real" expense. But as a consequence of the tech stock crash in 2000-2002, GAAP accounting was made much more rigid with respect to such compensation, ensuring that it was properly expensed.

Of course, as with any set of general rules, there can be legitimate debate about the particular implementation (e.g. whether to expense the difference of option strike price and the actual stock price or to use Black-Scholes to value the options), but it seems clear that stocks or options should be expensed as the accounting profession has recognized. (The argument, in short, is that stock or options awarded to employees for doing their jobs are an immediate benefit that employees receive, without which they wouldn't be working or equivalently would be demanding a pay increase to keep working). As corroboration, many employees cash in their stocks and/or options as soon as they vest, so there's absolutely no financial difference between issuing them cash or stock.

Yet today that lesson has either been forgotten, or more likely conveniently overlooked, leading to companies and analysts once again pursuing short-term profits by highlighting non-GAAP earnings which exclude such stock based compensation (SBC).

LNKD is a Case in Point.

LNKD's recent earnings brought the point home to me, because being relatively new to the stock, I was amazed to see how the headlines and analyst commentary differed so radically from the actual facts.

For example, here's how a typical financial outlet (Forbes) reported recent earnings:


LinkedIn Profit Jumps 34%, Stock Soars


On a GAAP basis - generally accepted accounting principles - LinkedIn reported a $1 million net loss, but non-GAAP net income was $63 million, up 43% and more than $14 million ahead of the Street expectation.

The GAAP loss came in at a penny per share, but non-GAAP earnings were 51 cents per share. That is a whopping 12 cents ahead of estimates and up 34% from a year earlier. All non-GAAP figures exclude tax-affected stock-based compensation expense and tax-affected amortization of acquired intangible assets.

So the "profit" referred to in the headline is obviously the non-GAAP number, but in fact there was no profit -- in the quarter the company lost $1M which was $4M worse than its result in 2013. Yet you'd never know it from the headlines or the general media and analyst coverage.

LNKD's own press release supports this line of analysis by excluding GAAP numbers from its guidance:

Full Year 2014 Guidance: Revenue is expected to range between $2.14 billion and $2.15 billion. Adjusted EBITDA is expected to range between $545 and $550 million. Non-GAAP EPS is expected to be approximately $1.80. The company expects depreciation of approximately $202 million, amortization of approximately $28 million, stock-based compensation of approximately $305 million, and 126 million fully-diluted weighted shares.

Yet - despite all the talk of "profits" in the headlines and PRs - buried in the 10Q is this:

As a result of our investment philosophy, we may not be profitable on a U.S. generally accepted accounting principles ("GAAP") basis in 2014.

A more general way to see this phenomenon is to look at Yahoo!'s presentation of LNKD's numbers.

In the key statistics we're given the GAAP numbers:

But in the Analysts' estimates we get "earnings estimates" with nary an asterisk to indicate that these are "non-GAAP" numbers which are Buffett's "enemy of good thinking":

The Problem

The basic problem with pretending that certain costs in general - and stock based compensation in particular - aren't real costs is that companies tend to overspend on them. In LNKD's case, an initial way to see this is to plot the number of shares outstanding over time.

LNKD Shares Outstanding Chart

LNKD Shares Outstanding data by YCharts

This graph shows the company's clear penchant to issue shares. But of course some of these were for acquisitions which may or may not have made financial sense. A second, more accurate metric to assess a company's willingness to issue "free" shares to employees is to plot SBC both as an absolute number and as a percentage of revenues.

LNKD Stock Based Compensation (Quarterly) Chart

LNKD Stock Based Compensation (Quarterly) data by YCharts

LNKD Stock Based Compensation (% of Annual Revenues) Chart

LNKD Stock Based Compensation (% of Annual Revenues) data by YCharts

Thus LNKD's spending is increasing both absolutely and relatively.

To put this another way, living in a fantasy land where profits exclude real costs, leads to a company culture without financial discipline. LNKD is one clear example of this, and coupled with its outrageous (GAAP) valuation metrics, I'm now short a medium-sized position.

In conclusion, however, while I think the trends of increased stock based compensation and dilution are a very bad sign for LNKD, I'm in no way implying that LNKD is the worst or most egregious example of this behavior in today's market. Instead I invite readers to leave comments pointing out the worst cases of which they're aware, as I'm always looking to add potential new names to my short portfolio.

Disclosure: The author is short LNKD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I'm short LNKD via naked calls which I expect will be converted to an outright short position. I actively trade around core positions.