Materiality for Muppets. Salesforce Muppets.

By mark cabaniss - August 21, 2012 | Tickers: MSFT, ORCL, CRM | 0 Comments

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Are you a muppet?  One way to tell is whether you know Rule 10(b)-5 of the Securities Exchange Act of 1934.  Another way to tell is whether you are an investor or a stockbroker.  "Muppet" is today's Wall Street slang for gullible clients, who still have some money, the kind you can offload piles of toxic securities onto, just before those securities blow up.  Things like the infamous Timberwolf.  If you are a Muppet, do not be ashamed, for in today's era of completely worthless regulators, we are all muppets.

Today we're going to examine the concept of Materiality as it relates to the purchase of securities, and what the lawyers at the SEC might be looking for if they weren't too busy doing important law enforcement stuff like  watching porno.  Under rule 10(b)-5 it is illegal "[t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading."   There is nothing magical or conceptually difficult about whether or not something is a "material" fact.  "Material" means simply whether it is something the average investor would want to know before purchasing the security in question.  To illustrate materiality, we're going to use a recent earnings press release of a major company, and explain how various statements in it might be material misstatements or various statements not in it might be material omissions.  It is hoped that after today's reading you will better understand how companies (mis) shape investors perceptions by the information they put in and leave out of statements they release to investors, and how the SEC could, in theory, make company insiders communicate more transparently with the investors who buy their stock, if the SEC cared about such things, instead of porno, porno, porno, porno, porno.

Now -- we're going to need a recent earnings press release, to go through as an example.  Oh look!  Here's one!  It's for Salesforce.com (NYSE: CRM) 

One of the big questions I have regarding Salesforce is the way they pay their top executives so much in stock options, and yet back out those options from their earnings statements, as though the amount of compensation given (that word is conciously chosen), to their top executives is somehow not relevant to their ongoing lack of profitability.  The following excerpt pretends to be an attempt to explain just why all this stock-based compensation should be backed out of the GAAP earnings statement and not considered by investors in the new, improved, non-GAAP earnings statement.  Although the following excerpt makes reference to other expenses also backed out of the earnings statement, we're going to focus on the stock option expense, as it is far and away the biggest expense that Salesforce backs out of their GAAP numbers to create (that word is chosen) their non-GAAP numbers.  When evaluating the following statements, keep in mind that in Fiscal 2012 Salesforce awarded $229 million in stock-based compensation to their employees, which works out to $1.61 per share.  In 2012 they lost $.09 per share.  Had they not given away the $229 million, they would have made $1.61 per share.  (The $.09 per share differential is due to the two different share counts used to generate the GAAP and the non-GAAP numbers.) 

And now we will go through the excerpt and evaluate each sentence for possible omissions and misstatements of material facts according to the materiality standard.  But before we disect it line by line, first read the whole thing:

Ok -- first line:  "The primary purpose of these non-GAAP measures is to provide supplemental information that may prove useful to investors who wish to consider the impact of certain non-cash items on the company’s operating performance."  Seems straightforward enough, until you read it in conjunction with the very last line, which says that the amount of stock-based compensation isn't related to operating performance:  "stock-based compensation expense varies for reasons that are generally unrelated to operational decisions and performance in any particular period."  I'm confused already.  If the amount of stock-based compensation isn't related to operating performance, then why would you provide it as supplemental information to investors who want to consider it's impact on operating performance?  Wouldn't that be misleading?  To provide information that you yourself deem irrelevant to a particular calculation to someone you know is wanting to perform that calculation?  And if "the primary purpose" of the non-GAAP numbers is to provide information, what is the secondary purpose?  Muppetry?  Could that be it?  Oh well; why nitpick?  Even though porno beckons, let's just assume that the purpose of these numbers is to "provide information" rather than to cheerlead and move on.

Second line:  "Non-cash stock-based compensation, amortization of acquisition-related intangible assets, and the net amortization of debt discount on the company’s convertible senior notes are being excluded from the company’s FY12 financial results because the decisions which gave rise to these expenses were not made to increase revenue in a particular period, but were made for the company’s long-term benefit over multiple periods."  This seems to say that these expenses are not relevant because they can't be tied to a particular time period.  Not one quarter; not one year.  But since companies only report on quarterly and annual bases, these expenses will, apparently, never be relevant to the company's financial results.  Never?   Even if the company never makes a profit?  Muppet investors here might be wondering how much non-cash stock-based compensation Salesforce gave away last year, and the year before that, and the year before that, because if they are giving away the same or nearly the same amount of money to their executives every year, year after year, then that would certainly make it look as though this years optionpalooza actually is tied to a particular period, i.e., this year.  And if the options giveaways were not made to increase revenues in this particular period, (certainly an odd choice of words:  how would options giveaways ever "increase revenues," in this or any other period?) doesn't that raise the unanswered question of which period(s) the options giveaways were designed to "increase revenues" in?  And if the options giveaways were not done to "increase revenues," in this or any other period or periods, why were they done?  If they don't increase revenues, how are they of "long-term benefit" to the company?  For that matter, how is "increasing revenues" rather than increasing profits of "long term-benefit" to the company?  That almost seems like a Freudian slip.  Increasing revenues might be good for the options-cashing-out executives of a company that trumpets revenues instead of profits, but increasing revenues at the expense of profits is emphatically not in the long-term interest of the company.  It is the opposite. Potential muppet investors won't find the answers to any of these questions; they have been omitted. 

Third line:  "While strategic decisions, such as those to issue stock-based compensation, acquire a company, or issue convertible senior notes, are made to further the company’s long-term strategic objectives and impact the company’s income statement under GAAP measures, these items affect multiple periods and management is not able to change or affect these items in any particular period."  Management is not able to affect the amount of stock-based compensation they award themselves?  It can't be done?  Never?  If they can't do it, who can?  The muppets suckers I mean shareholders?

Fourth line:  "As such, supplementing GAAP disclosure with non-GAAP disclosure using the non-GAAP measures provides management with an additional view of operational performance by excluding expenses that are not directly related to performance in any particular period, and management uses both GAAP and non-GAAP measures when planning, monitoring, and evaluating the company’s performance."  First, presumably the antecedentless "As such" is meant as "Therefore."  Second, notice the little sleight-of-hand manuver in calling the non-GAAP (dis)information "disclosure," as if it were somehow on a par with the required, meaningful GAAP information.  Third, notice the strange claim that the non-GAAP numbers are somehow generated to help management evaluate this or that.  Of course, management can generate and use whatever numbers they want in their internal evaluations of the company's performance -- they don't have to disclose any of them.  How does disclosing as opposed to generating and using non-GAAP numbers help management "evaluate" anything?  Are the non-GAAP numbers really generated for use by management, or for consumption by muppets?

Fifth line:  "In addition, the majority of the company’s industry peers report non-GAAP operating results that exclude certain non-cash or non-recurring items."  Hmmm.  Seems like there might be an omission here of certain information that is needed to make the presented information not misleading, specifically, whether Salesforce competitors such as Microsoft (NASDAQ: MSFT) exclude hundreds of millions of dollars of stock options grants from their non-GAAP numbers.  Oops -- Microsoft doesn't.  Microsoft backed out a goodwill impairment charge and deferred revenue to get their non-GAAP number; nothing about stock options.  Another of their competitors, Oracle (NASDAQ: ORCL), does back options out of their non-GAAP numbers.  But it is worth reading the language used by Oracle in their explanation, specifically the fourth paragraph on page 11, and this sentence:  "Stock-based compensation expenses will recur in future periods."  Because the truly arresting (not a pun) thing about line five of the excerpt is the reference to non-GAAP results excluding "non-recurring items."  Just what, pray tell, might those be?  Even though line five (too) cleverly refers to what "peers" do rather than to what Salesforce itself does, and even though line two labeled the options "non-cash" rather than "non-recurring," some muppets might naively think that the hundreds of millions of stock options as compensation was a "non-recurring item."  But is it?  Since the answer to that question is omitted, we have to look elsewhere  to find that Salesforce not only grants huge options packages year after year, year in, year out, but also that the size of those grants is increasing, dramatically -- from less than $3.5 million in 2006 to $229 million in 2012.  Oh.  And guidance for 2013 is that options will be $368 million, an increase of over 60% from 2012's $229 million.  The information about options awards in prior years is certainly omitted; is it material?  Well let's see -- a recurring expense that took the company from what would have been a $1.61 profit per share to a $.09 loss per share in 2012; would you want to know more about that to put it in context? 

Sixth line:  "Management believes that the provision of supplemental non- GAAP information will enable a more complete comparison of the company’s relative performance."  Hmmm.  A moment ago it was "disclosure."  Now it is "information."  "Relative performance" can only be compared on an appes-to-apples basis; we haven't been given the information to compare Salesforce's own relative performance to the size of it's options grants in prior years.  And how are we to compare the size of it's options awards and performance to those of it's competitors, since that information has also been omitted, even in a general, what-unspecified-peers-do sense?  

Last lines:  "Specifically, management is excluding the following items from its non-GAAP EPS for Q4 and FY12 and its non-GAAP estimates for Q1 and FY13:

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