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In my September 28, 2024 How Stock Based Compensation Distorts Free Cash Flow post, I state that I have been giving more thought to how stock-based compensation (SBC) distorts Free Cash Flow (FCF).
In subsequent posts that are accessible through The FFJ Archives, I look at a company's FCF using two methods. The first method is the typical method of calculating this non-GAAP metric where we deduct CAPEX from Operating Cash Flow. The second and more conservative method deducts CAPEX and SBC from Operating Cash Flow. Obviously, the FCF values are reasonably similar if a company conservatively uses SBC as part of its employee compensation programs.
I address my rationale for looking at a company's FCF using both methods in my December 9, 2024 Danaher Exposure Further Increased post.
In this post, I look at the impact SBC has on Adobe Inc.'s (ADBE) FCF.
On December 11, 2024, ADBE released its Q4 and FY2024 results and FY2025 outlook. Investor reaction to ADBE's tepid outlook has led to a plunge in the share price. My take on ADBE goes beyond its FY2025 outlook.
In this post, I touch upon why I think its conventional FCF calculation is misleading.
Conventional And Modified FCF Calculations (FY2010 - FY2024)
Technology companies are notorious for issuing SBC. They may have very low CAPEX but they spend a ton of money on research and development. They must, therefore, conserve cash for growth purposes. If they did not issue SBC, they would like need to boost wages/salaries thus impacting their cash outflows. By issuing SBC, they get to conserve cash while employees hope they reap the rewards if the company's share price increases dramatically.
Looking at ADBE over the FY20210 - FY2024 time frame, we see a company that has grown from $3.8B of annual revenue in FY2010 to $21.505B in FY2024 (impressive growth).
All the numbers look great until we compare FCF/share calculated under the conventional and modified methods. The disparity between the two results becomes pronounced in FY2021 - FY2024. In FY2024, the FCF variance has grown to $4.073/share!
Employees Hit A Gusher!
We see that ADBE has significantly ramped up its share repurchases. Great! However, I encourage you to look at the Form 10-Qs for FY2024. Search for 'Stock Repurchase Program' within these documents. Now look at what ADBE paid to repurchase its shares....much more than the current ~$460 share price!
This is extracted from ADBE's Q1 2024 Form 10-Q.
During the three months ended March 1, 2024, we repurchased a total of 3.1 million shares, including approximately 0.6 million shares at an average price of $626.68 through a structured repurchase agreement entered into during fiscal 2023, as well as 2.5 million shares from the initial delivery of the ASR entered into during the three months ended March 1, 2024.
For the three months ended March 1, 2024, the prepayments were classified as treasury stock, a component of stockholders’ equity on our condensed consolidated balance sheets, at the payment date, though only shares physically delivered to us by March 1, 2024 were excluded from the computation of net income per share. As of March 1, 2024, a portion of the $2 billion prepayment under our outstanding ASR was evaluated as an unsettled forward contract indexed to our own stock, classified within stockholders’ equity. Subsequent to March 1, 2024, the outstanding ASR was settled which resulted in total repurchases of 3.5 million shares at an average price of $578.11.
Next, search for 'Note 9. Stock-Based Compensation' in the Form 10-Qs and look at the Weighted Average Grant Date Fair Value.
On a much smaller scale, we also have shares being issued under Employee Stock Purchase Plan. This is extracted from ADBE's Q1 2024 Form 10-Q.
Employees purchased 0.3 million shares at an average price of $299.89 and 0.2 million shares at an average price of $286.05 for the three months ended March 1, 2024 and March 3, 2023, respectively. The intrinsic value of shares purchased during the three months ended March 1, 2024 and March 3, 2023 was $96 million and $12 million, respectively. The intrinsic value is calculated as the difference between the market value on the date of purchase and the purchase price of the shares.
I fully understand how the issuance of shares to employees can be a motivating tactic; they certainly were during my career.
What I don't like is when:
- companies repurchase grossly overvalued shares; and
- simultaneously issue shares to employees at significantly lower share prices.
Valuation
With shares trading at ~$460, we get a P/FCF value of ~26.3 using FY2024 FCF/share of $17.496 calculated using the conventional method. Using a $13.422 FY2024 FCF/share calculated using the modified method, we get a P/FCF value of ~34.3.
Calculating a company's value is not an exact science, and therefore, you may arrive at slightly different results. Regardless, we see that the magnitude of ADBE's SBC has a material impact on our calculations.
Final Thoughts
I have no idea if ADBE's Board is remotely considering scaling back the extent to which it rewards employees through the use of SBC. I know Salesforce (CRM), Workday (WDAY), and Zoom (ZM) are doing so.
It is alarming that some investors saw fit to acquire ADBE shares at ~$688 in November 2021. I can't imagine what would possess anyone in their right mind to do so. Fast forward to December 2024 and ADBE is an even better company than it was in late 2021 and I still think shares are overvalued at the current ~$460 closing share price on December 13, 2024.
If I consider SBC to be a 'form of financing', meaning SBC should be reflected under Cash flows from financing activities in the Condensed Consolidated Statement of Cash Flows, ADBE's recent FCF is well below what is reflected on many investor research platforms. By merely shifting SBC a few lines lower on the Condensed Consolidated Statement of Cash Flows, investors would likely come to the realization that the FCF reported by many companies (particularly in the tech sector) is not what it appears to be.
ADBE has spent ~$33.35B to repurchase shares in FY2017 - FY2024; the diluted average common shares and common equivalent shares outstanding (millions of shares) has dropped from 501.1 million to 450 million during the same period. During this same period in which ADBE has been repurchasing shares at market values, it has been issuing shares to employees at much lower values. Employees appear to be doing wonderfully at the expensive of investors!
SBC might not be a meaningful number for many companies. The differences between the FCF calculations under the conventional and modified methods, therefore, may not be significant. However, I suggest you give consideration to assessing a company's FCF by deducting SBC to determine if the FCF results reported by some companies is truly reasonable.
While ADBE might be a good company, I do not intend to come out of my comfort zone to initiate a position.
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I have no exposure to ADBE.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation. I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.
