The hunt for yield has driven up the valuation of large US technology companies; which increasingly are using some type of financial engineering.
As newcomers take market share in the sector, someone has to lose out – and these are often the mega cap technology companies.
These big brand names typically earned their glory in the past. Now they face slowing growth but still need to sell themselves as attractive high-tech companies to employees.
This is why they issue so many share options, despite growing no faster than the average non-tech company. This strategy has financial implications if the shares created by those options are then bought back.
Microsoft is one example (but by no means the only instance) of this. In the last fiscal year to the end of June, the technology giant bought back shares worth $6.7 billion, equivalent to over 2% of its market capitalisation. But the share count fell only 1%.
That means 1% of the company or $3.2 billion was given to employees, equal (if the same amount had been paid out in salaries) to 10% of Microsoft’s operating expenses. A 10% increase in costs would hit all kinds of things, such as perceived growth rate, margins and board remuneration.
No wonder the company crowed on its results conference call that it had kept the operating expense budget at the lower end of their guide.
Over the past five years, Microsoft has spent $29.3 billion on buying back shares but of that, $18.8 billion merely served to soak up dilution, mostly caused by share options.
The effect on profit growth is dramatic. On a five-year basis, if the option awards/buyback technique of reducing the salary bill is added back in, then Microsoft’s underlying earnings per share (EPS) growth would have been 5% instead of the 9% reported.
For IBM, it would be 8% instead of 14%, and for Qualcomm, despite having reported annualised growth of nearly 15%, the EPS would in fact have declined.
Generally accepted accounting principles (GAAP) only partly helps to detect those effects because companies are obliged to record an expense for employee stock option awards based upon the fair value of the stock option at the grant date.
The actual cashflow required to offset the dilution from those options can be much higher than that accounting charge, especially if stock prices move higher.
Improving shareholder returns
Companies who waste their cashflow on these fake buybacks could instead be giving shareholders better returns.
The cash could be used for dividends. Management could also use it to invest in mergers and acquisitions or research and development.
A lot of these companies have challenged business models, and need to invest to actively transform themselves into entities ready for the next technology trends like the cloud or the internet of things. These fake buybacks make it harder to do that by reducing cash resources and keeping them chained to their declining franchises.
There is one message investors should give such companies: stop handing out stock options if you are not an early stage, hyper growth company. There is no reason why a tech business should be different from an industrial company of the same size.