Scamify

Investment Analysis Clubs Saul’s Investing Discussions
1

There’s a completely legal Ponzi scheme underway. A thing of beauty to watch unfold.

Here’s how it works…

You start a business selling a service for less than it costs. Customers are naturally
thrilled to get something below cost, so your sales skyrocket. You give out stock to employees
who are naturally thrilled to accept stock in lieu of cash because as sales skyrocket the stock
price skyrockets.

Meanwhile, you convince investors to look at your “adjusted costs” – your costs minus the stock
compensation. As you give out ever increasing stock compensation, your “adjusted costs” begin to
decrease in relation to sales. Eventually you appear profitable! Your stock skyrockets even more!

You just keep repeating that loop.

Here’s how the numbers actually look:


                              2012     2013     2014     2015     2016     TTM
                             -----    -----    -----    -----    -----    -----

Revenues                     $1.00    $1.00    $1.00    $1.00    $1.00    $1.00

GAAP Costs                   $1.06    $1.08    $1.21    $1.09    $1.10    $1.09

Adjusted Costs               $1.05    $1.05    $1.16    $1.03    $1.03    $1.02

SBC as Pct of Revenues        1.7%     3.5%     4.2%     5.4%     6.4%     7.1%

For every dollar of revenue you bring in, you have about $1.10 in costs. But, as you give out more
and more stock each year, you’re adjusted costs go down! Of course that’s not sustainable, but who
cares!? You’ve got a great backstory about the founder, some current buzzwords, and a nine year
bull market where most everyone has been lulled into forgetting that the value of an investment
comes from its cash flows. You’ve created an almost mystical experience for investors.

Really, a thing of beauty.

Who benefits? You – the founder – and your friends, and sell-side analysts and underwriters, and
newsletter and advisory services that bang the drum, and speculators who get in early and pump the
stock on message boards. Lets hope they’re not all in cahoots!

All of the above tongue-in-cheek, of course…or is it?

Ears

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2

Excellent post, ears! It may just be that non-GAAP reporting hit some sort of inflection point. In recent weeks, Google, Facebook and others have announced a shift away from non-GAAP reporting. Here’s a Business Insider article worth a look:

http://www.businessinsider.com/facebook-embraces-the-gaap-20…

Facebook admitted all the stock it gives employees is a real business cost, and it could make some other companies look bad

Facebook is no longer reporting non-GAAP expenses, income, tax rate, and earnings per share (EPS), it says. It will still use non-GAAP numbers in limited ways, such as to share with investors the impact of foreign exchange rates on its revenue, and to give insight into free cash flow.

But it is getting rid of non-GAAP numbers for the meat-and-potatoes portion of its results.

Facebook, like Google, has the luxury of a healthy bottom line, which makes it easier to enact the change. For tech companies with less reliable profits, or worse, companies that are losing money, including stock compensation expenses would make financial results look pretty ugly in the eyes of investors.

As this bull market continues on, growing ever more richly priced, I see more and more similarities to the late stages of the great Dotcom Bull Market. Financial/performance metrics changed in the way they were valued/perceived both then and now. Old-fashioned value investors generally look at numbers for sales, profit margins, cash flows, retained earnings, earnings per share, etc… As the Dotcom Bull approached its peak, one heard mostly about “eyeballs”,“clicks” and potential market size/customers. Traditional financial metrics took a back seat to various and sundry enthusiasms. I’ve been experiencing deja vu lately.

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Great post!

I actually generally do not read this board, but I do read your posts, so this latest post created an ethical dilemma for me. As usual, I resolved that dilemma in favor of expediency. Hey, everybody does it; I just admit it.

Anyway, after reading your post, I did a TON of research, which involved things such as division, and it seems pretty clear to me that you did not just make Scamify up; it is actually a real company! Yes, in fact, it is . . .

Amazon!!

Ha, ha just kidding; it is Shopify, of course. I did check the numbers, though, just to be sure, although the name sort of made it clear.

But there are probably a lot of other companies it could be. Maybe even AMZN? I do not own much AMZN at all, so I probably will not bother checking. But I do own SHOP.

So here are some thoughts:

First, I agree with your implicit suggestion that SBC is an expense, pure and simple, just as much as if it were given to the employees in cash. I know people on this board disagree; that fact does not trouble me in the least, because I am right (and modest, to boot).

Second, though, is there an argument (for SHOP, or for other companies) that spending up front to build a business and grab market share is OK? (Here we are just looking at GAAP costs and ignoring the accounting tricks played with SBC.)

For example, there are some software products (e.g., enterprise accounting software, supply chain management software, HCM software, etc.) where switching costs are considerable, revenues are recurring, and the resulting stickiness of a customer relationship makes it sensible, arguably, to spend now to gain a long term revenue stream. I think even AMZN can make an argument that it builds sticky relationships via network effects.

If one buys this argument, though, there should come a time when the excess spending stops and profits begin to be realized. It is certainly fair to ask if this day will ever come with SHOP, AMZN, etc. (Although I am not even sure that SHOP can make a real solid “stickiness” argument . . . do you think they can? I just do not know the details of their business well enough.)

Here is a second argument: Possibly the time comes when the business has grown, the revenue stream is substantial, and the meteoric-growth start-up phase is over. Maybe at that time SBC can be reduced to sensible bonus levels, as has happened over time with AAPL, MSFT, etc. Stated another way, and slightly revised, at some point the meteoric acceleration of the stock price slows down, and this would reduce the SBC number by keeping multi-year award values closer to the value at the award date. (Possibly part of the increase in SBC figures results from huge surges in the value of later years of multi-year vesting awards.)

I would be interested in your thoughts, if you are interested in sharing them.

Rich

BITB

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I’ve been experiencing deja vu lately.

I’ve been experiencing deja vu too but have been considering that we may once again be in the early stages of a future bubble. People have been so scared of the stock market for the last 17 years. I think that may be coming to an end and we may be now entering the early part of the next technology bubble. Watch for people becoming less and less scared of the market as it rises. Remember 2 years ago when every little thing cause the market to drop…Greek crisis, debt ceiling, FED raising rates, FED not raising rates, China slowing, etc, etc. Market drops to news seem to have ceased. I don’t think it’s a bubble yet but maybe something like it was in 1996. Perhaps the market will have amazing returns for the next 4 years. It certainly is an interesting time.

Chris

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I’ve been experiencing deja vu too but have been considering that we may once again be in the early stages of a future bubble. - Chris

You may very well be right. I find it disquieting that the VIX remains so low (a sign of complacency) as the markets bounce around at all-time highs. I’m fairly certain there will be a Market correction sometime this year. Should the Market behave as it has recently (i.e., “V-bottom” responses), then I’d say the Bull might keep running. My portfolio grows more conservative as the enthusiasm for momo stocks grows.

6

To me it feels a lot more like 2017 than 1990, 1997, 2001, 2007, 2009 or 2015. I remain fully invested and have no plans to do otherwise.

Scaremongering is something financial advisers do to scare up business. No thanks.

Denny Schlesinger

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7

Fills like 1983 to me.

I was conviced that the 50 peecent run up was too much and could not be sustained.

The Dow was at 1200, the crash in 1987 took it back some, but no where near 1200.

Cheers
Qazulight

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8

I think even AMZN can make an argument that it builds sticky relationships
If you as I do and look on Amazon first that’s sticky enough for retail, even e-retail. If Amazon has it and it doesn’t seem too expensive I don’t bother looking elsewhere. I probably buy 85% Amazon. 10% eBay, 5% Wal Mart e-store.
Will Amazon be as big as WMT eventually? They have a shot at it.

9

Rich,

Let’s compare Amazon in its early years to Shopify today.

Amazon invested heavily in marketing and infrastructure in its first five years, but these
were mostly fixed costs – costs they could leverage in subsequent years. In other words,
in those subsequent years once they generated enough revenue to cover those fixed costs, every
additional increase in revenue meant a corresponding increase in operating profit and a corresponding
decrease in operating costs as a percent of revenue. They did this without resorting to stock
compensation – their stock compensation was minimal in those early years (less than 1% of revenues).

Shopify has also invested heavily in marketing and infrastructure in its early years, but these
are mostly variable costs – costs that can’t be leveraged in later years. There are hardly any
fixed costs to leverage for Shopify. So every increase in revenue requires a corresponding increase in
operating cost – Shopify never breaks even, much less makes a profit. That’s where stock compensation
comes to the rescue. At least for the time being.

As Tobi says, Shopify is “people intensive”. Translation: all variable costs. If they throttle
down on revenue they have to throttle down on people. Here’s just one example of the difference
in business models: Amazon generated $524 of revenue per employee in year five, whereas Shopify
generated $205 of revenue per employee in year five.

Shopify has yet to show how it will make a profit without resorting to accounting sleight of hand.
For the slew of players making money from this scheme, that’s not an issue.

Fun to watch, though.

Thanks,
Ears

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Hi Ears,
Are you the guy that comes along with the broom and turns out the lights :slight_smile:

Andy

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For every dollar of revenue you bring in, you have about $1.10 in costs. But, as you give out more
and more stock each year, you’re adjusted costs go down! Of course that’s not sustainable, but who
cares!?..everyone has been lulled into forgetting that the value of an investment
comes from its cash flows

Hi Ears,
It seems to me that there’s a fallacy to your analysis. Part of that GAAP costs is imaginary costs from the sbc. In your example, they are never Adjusted results positive, but many of those companies are. Since the adjusted results are the actual CASH results, they may well have a GAAP loss but be significantly cash flow positive.
Saul

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12

Stock options are a cost, but also a way to print money. How do you think an Amazon or a Tesla can do things that regular businesses cannot do? Because they literally can print money for themselves. Sure, there is some devaluation, but it enables these companies a large competitive advantage.

So I do not equate stock expense with cash necessarily. Depends on the context of what the particular company is doing in regard to building long term value and crushing competition.

Tinker

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13

Watch for people becoming less and less scared of the market as it rises…Perhaps the market will have amazing returns for the next 4 years

But Chris, Our stocks are rising, but is “The Market” rising???

The Russell 2000 is up 1.9%
The IJS Value is down 1.9%
The S&P is up 6.8%

If I average them, as I’ve been doing, I get The Market up just under 2.3%.

I agree that if it’s a bubble it has to be a technology bubble. While this has been an extraordinary start of the year for my stocks, it’s nothing like the DotCom Bubble, when many of the stocks being bid up didn’t even have revenue yet, just an idea, and when very respected analysts were saying: “Yes, it’s at 200 times revenue, but comparables are at 400 times revenue, so it’s comparatively cheap.” I remember Bezos saying “I appreciate investors’ faith in our company, but we’re just a bookstore, and 200 times sales is overpriced.”

We’re nowhere near there yet! That’s not at all to say we might not see a significant correction in our tech stocks, but this is nothing like 1999 when everyone you knew was talking about the latest stock, and the proverbial cab driver was giving out stock tips.

Saul

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The Russell 2000 is up 1.9%
The IJS Value is down 1.9%
The S&P is up 6.8%

BRKA is up 0.5% YTD
NASDAQ is up 13.7% YTD

It’s a rotation into high-tech, I don’t know why.

Denny Schlesinger

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We’re nowhere near there yet! That’s not at all to say we might not see a significant correction in our tech stocks, but this is nothing like 1999 when everyone you knew was talking about the latest stock, and the proverbial cab driver was giving out stock tips. - Saul

I do not expect to relive the irrationally exuberant excesses of the Dotcom Bull. A great many people were seriously injured financially when the Market imploded. The next big blow came in 2008. As a consequence, investor participation in the Market is now at a 19-year low. If one were to Google: “Millennial participation in the stock market” one would see headlines such as these:

Why so few millennials invest in the stock market - Business Insider
Only 1 in 3 Millennials are Investing in the Stock Market - Bankrate.com
Millennials Save Plenty, But Don’t Invest - SPDR S&P 500 Trust ETF …
Just Over Half of Americans Own Stocks, Matching Record Low | Gallup
Millennials Don’t Trust the Stock Market. - TrepScore

I’m not sure what signs to examine to gauge the health of the Market. Investor participation in (and attitudes towards) the Market have fundamentally changed.

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It seems to me that there’s a fallacy to your analysis. Part of that GAAP costs is imaginary
costs from the sbc. In your example, they are never Adjusted results positive, but many of those
companies are. Since the adjusted results are the actual CASH results, they may well have a GAAP
loss but be significantly cash flow positive.

Hi Saul,

It’s only a fallacy if you ignore the wizard behind the curtain.

If they are cash flow positive because they issue IOUs, then those cash flows are not sustainable.

You’ve been going through an exercise of sorting your businesses by various criteria. Try sorting
them by quality of earnings. Give higher marks to those businesses that can increase earnings
and cash flow whether or not they use SBC. Give the lowest marks to those businesses that
can increase earnings and cash flow ONLY by using SBC.

Thanks,
Ears

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17

I agree that if it’s a bubble it has to be a technology bubble. While this has been an extraordinary start of the year for my stocks, it’s nothing like the DotCom Bubble, when many of the stocks being bid up didn’t even have revenue yet, just an idea, and when very respected analysts were saying: “Yes, it’s at 200 times revenue, but comparables are at 400 times revenue, so it’s comparatively cheap.” I remember Bezos saying “I appreciate investors’ faith in our company, but we’re just a bookstore, and 200 times sales is overpriced.”

We’re nowhere near there yet! That’s not at all to say we might not see a significant correction in our tech stocks, but this is nothing like 1999 when everyone you knew was talking about the latest stock, and the proverbial cab driver was giving out stock tips.

Correct, that we are not there. But there has been a change. The downwards swings in response to global events seems to have ceased. Could this be a first step to people “forgetting” the pain of 2001 and 2008? I don’t know. Will the times of the cab driver giving stock tips return? I don’t know. Could Greenspan have been right when he said (after the dot com bust) that there will be a second wave of technology boom? It’s difficult to notice technology acceleration when you are in the midst of it, but if you look closely you can see that technology advancement is now rapidly accelerating. The changes that we are seeing in this decade dwarf the changes in the previous decade. The impact on business efficiency may be underestimated, and if you combine this with what appears to be a current upswing in the business cycle then you could continue to see higher earnings growth than most expect. Could there be an unforeseen global shock to knock us back again? Of course that is always a possibility. Maybe I am too optimistic, but I am currently highly exposed to technology related companies in anticipation of a second technology boom.

As far as millennials fearing the stock market, that has been observed. However, I believe that as stocks rise without the constant fear mongering that has been in the news for the past several years, we will start to see a shift from a fear of losing money in the market to a fear of missing out when others are making money. I believe it’s human nature that leads to bubbles and that the will be another bubble. I’d like to be able to ride that bubble up and then get out before it pops.

Chris

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Millennials Don’t Trust the Stock Market.

Sounds like climbing a wall of worry. The best and safest kind of bull market. But who knows? Not me.
Saul

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S&P is actually up 7.58% (https://ycharts.com/indices/%5ESPXTR/ytd_return)
NASDAQ is up 13.71% (https://ycharts.com/indices/%5EIXIC/ytd_return)

An attempt at an encompassing metric is the CNN “Fear & Greed Index”: http://money.cnn.com/data/fear-and-greed/ It tracks 7 indicators:

•Stock Price Momentum: The S&P 500 (SPX) versus its 125-day moving average
•Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
•Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining.
•Put and Call Options: The put/call ratio, which compares the trading volume of bullish call options relative to the trading volume of bearish put options
•Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds
•Market Volatility: The VIX (VIX), which measures volatility
•Safe Haven Demand: The difference in returns for stocks versus Treasuries

My problem with this index is that it’s so fast-moving that it oscillates far too frequently to be used as any sort of predictor. Or maybe if it stops oscillating then it really means something?

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Hello Ears,

No question that SHOP is “people intensive”. Some of us though might have a different perspective on that. Some might call it asset-light, which provides much balance sheet leverage for growth. Some might think that the people can be leveraged mightily in a subscription model. IE, those selling don’t need to sell to the same customers, but can look for new customers to grow revenues.
Those in R & D can move from the app they have created to another one that might bring in more
business. In this fashion, once SHOP has secured the dominant position, it won’t require more
people for the business to continue growing. IMO, this is the flaw in your thesis, it may not require a growing compensation expense to maintain growth.

Best regards,

Mike

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