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The Latest In Pro Forma Reporting
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Posted by: Jack Ciesielski 10/26/2005 7:51 AM
When it became clear that reporting stock option compensation was inevitable, you knew this was going to happen: compensation charges tied to stock options would simply become a backed-out item in the neatly-spun pro forma earnings. What you would hope though, was that such inane "add-backs" of compensation expense wouldn't be expanded to include restricted stock charges. Managers know a good thing when they see it: the early indications are that they're going to add back all stock-based compensation charges.

EBITDA reporting, long a staple of pro forma reporting, is being expanded to exclude stock-based compensation by some firms. One example is microelectronics supplier Entegris, noting in their earnings release that EBITDA excludes stock-based compensation containing primarily restricted stock charges. One wonders: will the term EBITDASC (Earnings Before Interest, Taxes, Depreciation, Amortization, and Stock-based Comp) become part of the financial vernacular? That's doubtful: aside from sounding awful, it just draws attention to the fact that the figures exclude something to which management would rather just not draw attention. Namely, their pay.

Last week, the Wall Street Journal's Justin Lahart reported that Linear Technology was excluding all stock-based compensation from their pro forma earnings - including restricted stock charges. Their earnings release is probably a model of what to expect from companies: they don't overtly state they're pulling out restricted stock from GAAP earnings to get to pro forma earnings. Instead, they note that stock-based compensation under Statement 123(R) includes all forms of stock-based compensation including restricted stock, and then proceed to excise total stock-based compensation charges from earnings.

There are plenty of companies excluding stock-based compensation charges from their earnings in the current reporting season, which is the first one that will include earnings with Statement 123(R) compensation charges. (That's for companies with June 30 year ends.) Beware the generic "Statement 123(R) stock-based compensation" add-back because companies aren't being extremely descriptive about what's in it. You might assume that it's just options expense, but it might contain a healthy dollop of restricted stock comp, too - and for years, that never really bothered anybody. It's hard to recall instances of constantly-reported restricted stock add-backs. (If you can think of any examples, please drop me a line.)

So what? It's easy to dismiss such charges as a simple non-cash charge, but it's getting to the point where we're almost talking about earnings before costs. During the stock option accounting wars, restricted stock accounting was never contentious, even though it hit earnings. Now that both kinds of stock compensation currency are being recorded, they're all getting thrown out of earnings under the rubric of being "non-cash" - as if they were non-compensation, too.

They're not non-compensation - they're a factor of production in an economy driven by the brains and services of employees. You want cash flow, go to the cash flow statement. You want valuation on a cash flow basis, go to the cash flow statement for a start, and project cash flows yourself and discount them to a present value. You want to know what happened in a company, in totality of transactions for a given period of time, you look at earnings as a measure of performance.

Increasingly that performance includes restricted stock as a factor of production. For the S&P 500, restricted share grants increased 13% in 2004 - after increasing 74% in 2003 and 37% in 2002. That's not a trend likely to recede. It would be incredibly naive of investors to forgve companies for incurring compensation expense just because it's denominated in shares of stock, especially as it becomes a more material part of the corporate fabric.
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