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August 24, 2023

Share-based remuneration – what is there to be scared of? Part 2

Following our first blog on share-based remuneration (SBR) (Share-based remuneration – what is there to be scared of? Part 1), we are at a point where we see SBR as a cost that must be considered in some way, and where we understand that, as with many other accounting items, we are dealing with estimates with inherent and unavoidable errors.

We can now examine whether SBR is actually worth worrying about!

We look at both the US and UK stock markets, because even if the scale of SBR in the UK may not be great, the scale and nature of SBR in the US could have significant implications for both sentiment and analysis in the UK.

We examine the SBR costs of companies set against their market capitalisation, EBITDA costs, and positive EBIT.  This should provide some insight into the scale of the issue, how it affects companies on an operational basis and how their performance and prospects are analysed, and the implications for comparative valuations between companies and markets.

Evidently this approach is not going to be appropriate for some business types, for example banks and property companies, and we have removed these from our population (see footnotes). To keep the population manageable and to exclude what we fear might lurk in the small and micro caps (both UK and US), we include only those companies with market capitalisations above $500m.  Using Refinitiv as our source in July 2023, this gives a population of 1,815 US-listed companies and 198 UK-listed companies.

Black cloud hanging over us? SBR vs Market Cap

As can be seen from the charts below plotting SBR/M.Cap vs. M.Cap, the results are at first sight difficult to interpret, even when we restrict the chart to companies with market caps <$50bn and SBR as % of market cap <10%.  They don’t really tell us much, other than to remind us just how out there the US tech mega-caps are. What these 2D charts are missing is that the vast majority of both US and UK companies are below 1%, with both the blue and orange dots lying many layers deep.

Share based remuneration vs market capShare based remuneration vs market cap range

Within our population there are 105 US companies with SBR > 5% of market cap, 30 above 10% and a handful of anomalous ones above 20%.

As shown in the table below, the $3.5bn market cap US-listed company with SBR of 45% of market cap is Ginkgo Bioworks, which has the following in its FY22 20K filing: ‘R&D and G&A expenses included a significant charge for stock-based compensation expense as a result of the modification of the vesting terms of RSUs and all related earnout shares.’ In other words, this figure includes years’ worth of incentivisation, and it is something that anyone analysing the company would probably not factor in as an ongoing charge.

Working our way down the table, TuSimple, the self-driving articulated truck venture, has had a delisting notice from Nasdaq.  System1, an ‘acquisition marketing platform’, had a significant corporate transaction, and Pagaya, an AI powered personal credit analysis network, having listed in April 2021 saw its share price collapse in August and September 2022.  You probably get the idea…

Share based remuneration vs market cap table

Average for headlines, aggregate for analysis

The average figure for SBR as % M.Cap from this population for the US listings is 1.9% (std. dev. 3.0%), while the aggregate figure is a less concerning 0.65%.  For the UK listings, the figures are 0.7% (std. dev. 1.5%) and 0.5%, respectively, suggesting that, while we cannot just dismiss the issue out of hand, there is no cause for immediate panic.

It is sometimes difficult to put variables like this in context.  How right or wrong is it that there is an ‘annual charge’ of 0.5% of market cap due to SBR?  Right or wrong, this is not a figure that has much significance in relation to analysis of the equity market as a whole, especially if it does not change markedly from year to year. We would certainly like to hear a UK active fund manager argue that the drain of 0.5% of assets every year is something to be up in arms about.

There are only two UK-listed companies in the population with SBR / market cap > 5%: Tremor International and Boohoo.

Tremor International is a media technology business with a video first platform for the management and placing of marketing content within digital media. Its leading shareholders include a Saudi family office with 24% and News International with 6%.  It has undergone several major technology and strategic realignments since floating on AIM in 2014.  It is profitable.  It is jointly listed on AIM and Nasdaq, and incorporated in Israel. Its SBR in FY22 represented 9.1% of its $555m (£423m) market cap.  It may be ‘fully exploiting’ SBR but it has also been buying back shares at a far greater rate than it has been issuing them directly or indirectly (via SBR). Most investors would identify SBR as an issue, but we are not sure that many would start their analysis with SBR or expect to allocate much time to its detailed implications.

Boohoo’s issues are perhaps best described as well documented, and while SBR is clearly an issue, at 6.8% of its $589m (£448m) market cap, it is evidently linked to other matters and challenges across the business that are almost certain to be the first call on the investors’ research time.

Impact on analysis of performance and prospects: SBR vs EBITDA Costs

Cash-generation issues aside (a big aside), one of the keys to equity analysis is profit performance and where margins can go to, so we should consider SBR in terms of the actual operations of the businesses, as a % of costs.  We are looking here at EBITDA costs, taking revenue less adjusted EBITDA and adding SBR to get to our fuller costs figure.

As above, we have plotted charts for both the wider population of stocks and for a market-cap range that is more in line with the UK market.

SBR vs EBITDA vs market capSBR vs EBITDA vs market cap range

Within our population there are 358 US stocks and 17 UK stocks with SBR >10% of EBITDA level costs.  When we raise the hurdle to >20% of costs, the numbers fall to 88 US stocks and 5 UK stocks (a broadly similar % reduction).

The average for the US listings is 4.8% (std.dev. 6.9%) and for the UK ones 1.6% (std. dev. 2.8%), suggesting a somewhat more significant issue in the US than in the UK; and, we suspect, a greater issue for the US than many UK readers might have been expecting.

Perhaps the most striking thing about the charts is the significance of SBR to the mega-caps.  To an extent, these figures are driven by their strong share price performances in recent years – leading one to ponder quite what accounting profitability would be left were the mark to market and full possible cost accounting lobby to get their way on SBR accounting. (In case of panic, please read first blog on SBR…)

Share based remuneration vs EBITDA mega caps table

The scenery is less dramatic if we look at aggregate figures. In aggregate in the US, SBR is 1.9% of the cash costs figure, while in the UK it is 0.7%.  When we consider what staffing costs are in terms of overall cash costs in the ‘no such thing as a typical business’, these figures no longer appear quite so alarming.

The UK stocks where SBR is > 10% are Big Technologies (M. Cap. $0.9bn) 20.7%, Tremor Intl (M. Cap. $0.6bn) 17.8%, Oxford Nanopore (M. Cap. $2.4bn) 16.6%, and DarkTrace (M. Cap. $2.7bn) 11.0%.

Big Technologies provides software and hardware for the remote monitoring of offenders (and others).  It promotes itself as SaaS-like, which is itself a warning sign to some, but it has made real progress with its solutions globally in an industry that could see significant take-up and change in coming years.  We have commented on Tremor Intl above. Oxford Nanopore should perhaps be looked at in the context of US-listed comparators (see below, although we are mindful of falling into the diagnostics vs treatment trap), and in a similar vein DarkTrace’s 11.0% looks unambitious compared to large established US software companies (e.g. Adobe 12.1%, Salesforce 11.3% and Microsoft 7%) and fellow cyber software play Crowdstrike (18.4%).

IPOs mean heightened danger and distortions

Tremor Intl aside, these stocks, Big Technologies in particular, highlight the issue of SBR for recently floated companies.  The IPO is typically seen as an opportunity to reward and incentivise employees.  As a result, major grants are usually made at or around the IPO.  The resulting figure may therefore not reflect what is actually years’ worth of remuneration and incentivisation, even if much of it may not have been in contractual form for that long. The calculation of the value of the SBR is of course based on assumptions about the behaviour of the shares.  Completely unknown at the time of float, companies typically rely on guidance from their investment banks and other advisers to ascertain how volatile their shares are going to be!

Further to this, it is pretty rare for companies to join the market on the first day of their financial year, so the SBR in the first year of listing is only a fraction of the full-year charge, and SBR strategies may not be fully enacted at the float.  Big Technologies floated in the summer of 2021 with a year-end of 31 December; FY2021 SBR was £1.4m and in FY2022 it was £6.1m, although this was partially offset by the deferred tax impact of £1.6m. The one-off nature of IPOs (and other major corporate events) can provide plenty of excuses to ignore SBR, although, in fact, these very excuses are reasons for extra vigilance.

Biotechs (and Tech) – SBR is just sharing the KoolAid?

Within the healthcare stocks, SBR accounts for an eye-watering proportion of costs for some companies, as can be seen in the table below.  However, while the considerable SBR is clearly something that has to be factored into analysis and valuation, this is a relatively trivial task alongside the challenge of assessing (guessing) if the product is actually going to work, be granted regulatory approval and find a viable route to market. While the table below does not comprise all US-listed biotechs, it does suggest that Oxford Nanopore’s 15.7% is not out of line with those of its comparators, even though it might feel somewhat extreme by UK standards.

Share based remuneration vs EBITDA table

If we remove the healthcare stocks from our population, waving goodbye to a swathe of biotech bets, there are 230 stocks remaining with >10% SBR/EBITDA Costs and 28 with > 20%.

These 28 with >20% SBR/EBITDA Costs could best be described as a mixed bag of technology businesses, with few other than Snowflake and Atlassian standing out as companies where the prima facie long-term prospects appear strong from this side of the pond.

If we remove the tech stocks from the population, we are down to ‘only’ 56 companies with SBR >10% of EBITDA Costs, of which the vast majority are tech enabled or high finance, including Blackstone, Moelis and Evercore.

It is difficult to avoid the conclusion that we are looking at a relatively tight set of sectors and drivers – perhaps not that surprising given that the US market strength in recent year has not been that widely spread.

SBR impact back in the real world?

So what is happening in the more traditional sectors?  In retail or among the industrials?

Are these sectors living off the fumes of SBR, paying their staff on the equity never-never? And are UK-listed companies forced to pay staff only in cash, putting them at an international competitive disadvantage and making international comparisons near impossible?

Everybody’s doing it, but some more than others

Looking across the electronics, aerospace and high-end engineering industries suggests that for the most part there is not that much to choose between the US and UK among more mainstream companies that we might see as sensible or acceptable comparators, as shown in the table below.

Share based remuneration vs EBITDA costs engineers

This should not come as a complete surprise.  International corporations need to pay their employees in line with the sector norms.

Looking at US- and UK-listed retailers suggests no major difference in SBR as a % of EBITDA costs too – interesting given the generally local / regional level of their operations.  Although at seniority levels where SBR is relevant, local and regional retailers are still in the market for many of the same staff as the international corporations.

Share based remuneration vs EBITDA costs retail

A general review across other sectors suggests that UK SBR is in the same ballpark as US SBR, albeit generally a bit lower with a disproportionate number of higher outliers among the US-listed companies, particularly within the financial sector.

So yes, ex tech and healthcare, the SBR as % costs is generally lower for UK companies in the population than for US ones, but it is not an order of magnitude lower and (conveniently) the scale of the difference suggests that it is not something that we have to fret over for the vast majority of traditional non-financial companies.

Distorting valuations? - SBR vs Positive EBIT

Having considered the issue of SBR within the context of comparing companies and their operational and financial performance, we can go one step further to look at SBR as % of positive EBIT to see how SBR may impact on valuation.

For the resulting US population of 1,220 EBIT positive stocks, the average SBC as a % of positive EBIT is 30%.  Thankfully, in terms of totals it is a less petrifying 10.5%; although this is hardly a comforting figure when we consider it as the amount by which we have to adjust EBIT to reach the correct figure.

For the UK population of 172 stocks, the aggregate figure is 4% of positive EBIT compared to the average of 10%.

Using EBIT as a proxy for EPS suggests – and we say this in observational terms as analysts rather than exclamatory terms as bankers or journalists – that ceteris paribus the P/E for the US stocks would be expected to be 7% higher on the basis of SBR alone. (Starting from an adjusted EPS of 100, the correct EPS with SBR taken as a cost is 89.5 in the US and 96 in the UK, and 96/89.5 = 1.07.)

If we strip out the health and technology sectors, the aggregate figure declines to 7.7% for the US and remains at 3.9% for the UK, suggesting only a 3% P/E premium.  Removing stocks above $100bn market cap moves the aggregate figures for the US and UK to 8.1% and 4.2%, respectively, reinforcing the message that, for mainstream companies valued on earnings, SBR as measured and disclosed really isn’t making that much difference at the earnings and valuation level.

SBR friend of foe? Where does this leave us?

On a general basis, our conclusion is not that SBR is something terrible that cannot be analysed or that destroys comparability between companies and markets.  It can be adjusted for, but in the UK for most companies, sectors and markets it’s not that big an issue.

Should we be concerned that declines in the share prices of major tech companies could lead to a vicious circle of disgruntled, dissatisfied techies requiring ever more shares / options be issued to maintain their remuneration levels?

If these tech sector share price declines are widespread, then share options as a currency could become irrelevant to most employers too, so prima facie we should not be worried about a war of fruitless share issuance.

But it is difficult to see how such a fall would not see negative ramifications via other economic mechanisms, not least of which is sentiment.  If a share price decline is company-specific, then it has declined because of something other than SBR.

So rather than stare into the SBR headlights. it is perhaps possible and sensible to embrace SBR and recognise it as a useful metric – a way to understand companies and identify risk.  Why does company X pay 5% more in SBR than its comparator Y? Or, should I really expect the margins of my UK-based investment to rise to 20%, in line with its US competitor, when 5% of that margin is the difference in SBR paid.

We caution against seeing high SBR as an indication of bad corporate governance or impending collapse. SBR becomes cheaper the higher the share price volatility, and is more appealing when cash resources are limited.  So, for some sectors and regions the question could be whether companies are using it enough.

SBR is perhaps more a symptom than a disease

Share-based payments cannot be ignored, but they are rarely the primary problem or issue with a company; they are more a symptom of another disorder that could be far more important to the future share price.

In the next blog we will look in further detail at the UK small and mid-caps to consider what kind of SBR issues and gremlins may lurk there.  It could prove interesting.

Ian Robertson

irobertson@progressive-research.com

Footnote:

Excluded ICB Industry sectors: Banks, Closed End Investments, Finance and Credit Services, Industrial Metals and Mining, Mortgage Real Estate Investment Trusts, Non-Life Insurance, Life Insurance, Oil, Gas and Coal; Precious Metals and Mining; Real Estate Investment and Services; Real Estate Investment Trusts; and Null responses.

This communication is provided for information purposes only, and is not a solicitation or inducement to buy, sell, subscribe, or underwrite securities or units. Investors should seek advice from an Independent Financial Adviser or regulated stockbroker before making any investment decisions. Progressive Equity Research Ltd (“PERL”) does not make investment recommendations.

Opinions contained in this communication represent those of PERL and/or our affiliates at the time of publication and PERL does not undertake to provide updates to any opinions or views expressed. PERL does not hold any positions in the securities mentioned in this communication, however, PERL’s directors, officers, employees, contractors and affiliates may hold a position,  and/or may perform services or solicit business from, any of the companies or related securities mentioned.

Any prices quoted in our research are as at the previous day’s close.