Snap: Stock-Based Compensation – A Real Expense

Often I end up in discussions on this platform about whether stock-based compensation is a real expense or not. Often the argument prevails that it is a non-cash expense, therefore, it does not show up in the cash flow statement and can be ignored for earnings purposes as well.

I strongly disagree with these observations and hope to shed some light on the issue with a real example.

Why Stock-Based Compensation?

The reason for share participation among workers are plentiful and certainly in a competitive labor market, as it allows companies to make workers co-owners creating alignment in incentives. More so, stock-based compensation is key at the start of a company, when typically companies are not listed entities yet, as they are cash starved as this form of compensation provides another way of incentive.

So, incentives and longer tenure are key advantages from a corporate site, while employees can participate in the success of their work as well, albeit that they could do this in a publicly listed environment by simply buying shares in the company they work for. While that is true, it ignores tax implications of such programs, something I would like to stay away from just now.

On paper, it makes great sense, and I am a big believer in such programs, provided that the company designs these plans in the right way, but also accounts for them in the good way.

An Example – Snap

After Snap Inc. (NYSE:SNAP) just posted its second quarter results, shares came onto my radar. Snap is one of these businesses which uses stock-based compensation aggressively, while it is poorly accounted for in my view. While the example focuses on Snap, the reality is that I could have taken a dozen other names here.

For the year 2021, Snap posted very strong results with revenues up 64% to $4.12 billion, yet my interest goes to the bottom line. The company posted a GAAP operating loss of $702 million and a GAAP net loss of $488 million. So far, the GAAP numbers as adjusted EBITDA was posted at a positive number of $616 million, while free cash flow came in at a positive number of $223 million, as adjusted earnings were reported at $775 million.

Between the adjusted and GAAP profitability numbers is a gap of $1.26 billion, comprised out of $1.09 billion in stock-based compensation expenses, $107 million in payroll tax expenses related to such compensation, and $63 million of amortization charges.

So Snap was incurring $1.2 billion in GAAP costs last year related to stock-based compensation, of which $1.09 billion was in the form of dilution and the remainder in payroll expenses. However, let´s treat them as one for now.

How Big Is This?

Let’s put this $1.2 billion expense in relation to the size of the businesses to realize how large this is. Not only is the expense equal to 30% of sales, it is granted to just 5,661 workers, implying that compensation runs at over $200k per employee on average, as the distribution is probably quite skewed. While the company does not split out the normal salaries, it seems fair to say that these stock-based compensation expenses are huge in relation to total compensation, and are more than a little extra provided on top of the common salaries.

The real interesting question is what happens if this practice continues (like it has done over the past years already). Management and analysts, and some investors, have been lured into the non-GAAP earnings numbers, as indeed cash flows are positive here. Hence, the business is throwing off cash, but dilution is fierce. The share count rose from 1.48 billion shares between the fourth quarter of 2020 to 1.67 billion shares by the end of 2021, although the increase in that number cannot entirely be attributed to stock-based compensation, as share counts can deviate as a result of convertibles and options as well, certainly if shares are on the rise.

The issue is that this expense is very real over time. Let´s assume that Snap continues to post sales at $4.1 billion, adjusted earnings at $775 million, and net losses of $488 million. Of course, we have to make an assumption for the share price, as it has come down under a lot of pressure, but let us generously (for the sake of the dilution argument) take a price of $50.

The current net cash balance is about $1.5 billion as the company was valued at $83.5 billion in terms of equity value at $50, for an $82 billion enterprise valuation. I know that at the time of writing shares have fallen below $12, yet using that number, while maintaining the dollar expense on stock-based compensation, would really result in huge dilution and it would not depict a fair picture either.

Some Math

Let´s assume the business operates like this for the next 10 years and shares trade at $50. In this case, the company will issue 24 million shares a year to see the share count rise from 1.67 billion to 1.91 billion in ten years’ time, as $12 billion in compensation will be paid for with dilution.

Adjusted earnings came in at $775 million, or $7.75 billion over the 10-year window, resulting in a $9.25 billion net cash position. The 1.91 billion shares value equity of the firm at $95.5 billion at such a period in time in the year 2032. After subtracting a net cash balance of $9.25 billion, this works down to an $86.25 billion enterprise valuation.

Hence, the valuation has risen by $4.25 billion, being the sum of adjusted earnings for the period of 10 year, exactly highlighting the dilution. So, while the company posts earnings, the reality is that a current shareholder holds less of the business in ten years’ time. Given that the performance is flat, one would have to see the value of its holdings come down, assuming a similar earnings multiple.

Of course, the alternative works as well. Assuming that the company would pay out the $1.2 billion in compensation in cash, it would have incurred a $425 million cash outflow per year, resulting in a net debt load of $2.75 billion in ten years’ time, of course not accounting for interest costs in such a scenario. The share count would be stable at 1.67 billion. This results in an equity valuation of $83.5 billion, a valuation which rises to $86.25 billion if we factor in net debt.

So in the end it really does not matter, assuming no interest costs, no timing elements, etc., as the positive thing about stock-based compensation is that companies appear cash flows profitable, while they really are not from a shareholder point of view if we account for dilution, yet it typically provides cash flows to be used for instance for opportunistically timed buyback programs.

The issue in both cases is that a current $82 billion enterprise valuation ends up at $86.25 billion in ten years’ time, indicating about a 5% increase in the value while the business has not changed. The difference is simply the accumulation of GAAP losses incurred along the way, indicating the degree to which this is a real expense. Moreover, in this example at $50 here, a 24 million shares issued per year marks just 1.5% dilution per annum, but we have seen many more severe cases, which hence much larger outcomes down the road, for that one only has to do the exercise at a much lower share price levels.

Concluding Thought

Of course, the discussion on stock-based compensation has many more elements to it with regard to cash statements, vesting periods (which can be beneficial to the company), and a timing element as well. Silicon Valley is seeing some disgruntled employees now after many of these workers have seen their holdings come under a lot of pressure, as exactly now might be the time that you need them motivated and willing to stay. There are two major implications for me:

1) One should not exclude stock-based compensation if we are trying to look at the P&L, as the 10-year example has shown that if the business is uneconomical on GAAP accounting, ignoring the stock-based compensation simply ignores the dilution.

2) Related to this is really a day of potential reckoning. While some dilution in a year is not that bad, the biggest concern in the example above is that investors might one day realize that the business is not economical, and hence valuation multiples might dip meaningfully (which has already happened to a large extent in today´s technology world).

After all, in some cases stock-based compensation is more than a nice extra or incentive factor, as in the case of Snap compensation runs at $200k on average in 2021. Assuming some work there for three years, they have been granted/paid such stock-based compensation, presumably taking lower salary cost than otherwise the case. In the meantime, they sit on meaningful losses, creating a real stress situation now as well, and likely unrest in organizations now as well.

In the end, GAAP does not lie! While I really like the stock-based compensation plans, some moderation and proper accounting seems best advised.