Looting 101

Common across American business, but particularly cherished by the tech sector, is stock grants to senior management.

It turns out that the primary reason for this is that it allows companies to ignore the cost of stratospheric pay levels and creating misleading metrics to justify bonuses:

Investors liked what they saw in PayPal’s second-quarter financial results, reported by the digital and mobile payments giant on July 26. Revenues grew to $3.14 billion in the quarter that ended in June, an increase of 18 percent over the same period last year. Total payment volume of $106 billion was up 23 percent, year over year.

Even better, PayPal’s favored earnings-per-share measure — which it does not calculate in accordance with generally accepted accounting principles, or GAAP — came in at 46 cents per share, 3 cents more than Wall Street analysts had expected. The company has trained investors to focus on this number, rather than on the less pretty GAAP-compliant numbers most companies are judged by. And focus they did.

Exceeding analysts’ estimates — “beating the number,” in Wall Street parlance — is crucial for any corporate leader interested in keeping his or her stock price aloft. Even the smallest earnings miss can send shares tumbling.

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Naturally, many factors contributed to PayPal’s second-quarter earnings. But one element stands out: the amount the company dispensed to employees in the form of stock-based compensation.

How could stock-based compensation — which is a company expense, after all — have helped PayPal’s performance in the quarter? Simple. The company does not consider stock awards a cost when calculating its favored earnings measure. So when PayPal doles out more stock compensation than it has done historically, all else being equal, its chosen non-GAAP income growth looks better.

Accounting rules have required companies to include stock-based compensation as a cost of doing business for years. That’s as it should be: Stock awards have value, after all, or employees wouldn’t accept them as pay. And that value should be run through a company’s financial statements as an expense.

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Back in the 1990s, technology companies argued strenuously against having to run stock compensation costs through their profit-and-loss statements. Who can blame them for wanting to make an expense disappear?

They lost that battle with the accounting rule makers. But then they took a new tack: Technology companies began providing alternative earnings calculations without such costs alongside results that were accounted for under GAAP, essentially offering two sets of numbers every quarter. The non-GAAP statements — called pro forma numbers or adjusted results — often exclude expenses like stock awards and acquisition costs. And the equity analysts who hold such sway on Wall Street seem to be fine with them.

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PayPal is by no means the only company that adds back the costs of stock-based compensation to its unconventional earnings calculations. Many technology companies do, contending, as PayPal does, that their own arithmetic “provides investors a consistent basis for assessing the company’s performance and helps to facilitate comparisons across different periods.”

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PayPal takes the opposite approach. [From companies like Google and Facebook] And look at what it does to its results.

Under generally accepted accounting principles, PayPal reported operating income of $430 million in the second quarter of 2017. That was up almost 16 percent from the $371 million it produced in the same period last year.

But under PayPal’s alternative accounting, its non-GAAP operating income was $659 million in the June quarter, an increase of almost 25 percent from 2016.

So what’s to account for the added $230 million in operating income under PayPal’s preferred calculation? Most of it — $192 million — was stock-based compensation PayPal dispensed to employees in the June quarter and added back to its results as calculated under GAAP.

That was a big jump — 57 percent — from the $122 million PayPal handed out during the second quarter of 2016. And back in 2015, PayPal reported just $89 million in stock awards.

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Craig Maurer is a partner at Autonomous, an independent investment research firm in New York. He follows payments companies and rates PayPal’s stock an underperformer.

In a telephone interview, Mr. Maurer was critical of how the company accounts for stock-based pay. He said that as a percentage of PayPal’s non-GAAP operating income, stock-based compensation has risen to 29 percent this year from 17 percent in 2015.

“They are literally taking a cost out of their income statement, moving it to a different line and backing it out of results,” Mr. Maurer said in an interview. “And you can see that it’s adding significantly to their ability to meet earnings expectations. If you backed out the difference between what we were expecting on stock-based comp in the quarter versus what they reported, it was 2 cents of earnings.”

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PayPal’s stock-based compensation practices have another noteworthy effect: They drive executive pay higher at the company. Here’s how.

The company says it has three main metrics for calculating its managers’ performance pay each year. One of those measures, its proxy shows, is non-GAAP net income. So, as PayPal awards more and more stock to its executives and employees, non-GAAP net income shows better growth. And the greater that growth, the more incentive pay the company awards to its top executives.

For PayPal insiders, at least, that’s one virtuous circle.

While I have commented on a number of problems in the American economy, particularly excessive rent seeking through IP, it's important to note that business practices that have the effect of allowing managers to loot their companies, and defraud investors are a problem as well.