Google Stock-Sharing Plan May Bite Investors
By GREGORY ZUCKERMAN
Staff Reporter of THE WALL STREET JOURNAL
January 19, 2006; Page C1
Google Inc.'s profits are climbing, its stock price has been soaring and analysts are upbeat on the Internet-search company's future.
But few investors are focusing on the growing number of restricted shares and options that Google is handing out to employees, which will emerge as a sizable expense in the next few years. That expense added up to a hefty $600 million or so as of Sept. 30 of last year, all of which will be charged against future earnings.
As Google's business grows and it courts employees in a competitive marketplace, it is picking up the pace of its issuance of "performance-based stock units," according to securities filings, a form of compensation that many investors overlook. Between March 31 and Sept. 30 of last year, Google gave out 498,000 units, a close cousin of stock options, which likely will convert into Google shares over a four-year period.
[Going Gaga]
The units are valued at the price of Google shares at the time they are granted. Since the average stock price was about $300, the units represent an expense of about $150 million. Because the units vest over four years, accounting rules require the company to count one-quarter of their cost as an expense each year. So, Google took just $8.9 million of expense for the units during the second and third quarters. The remaining cost will hit earnings over the next few years.
Google handed out virtually no stock units in the first quarter of 2005. But it gave out 154,000 stock units in the second quarter and 344,000 in the third period. The total outstanding grants, including those given out in the fourth quarter, will be disclosed when Google files its annual report in March. Google is on pace to give out more than one million of these share units a year. With the stock around $450, that means Google will be on the hook for an expense of about $450 million at this rate, most of it to be booked in future years.
It all comes on top of other looming employment-related expenses. Google handed out new stock options -- a form of compensation that has received much greater attention over the past year or so -- with a cost of approximately $300 million in the first nine months of 2005. And it reported $143 million in deferred stock-based compensation as of Sept. 30, stemming from options, restricted shares and other units issued to employees.
All in all, Google faced almost $600 million of the stock- and option-related employment expenses as of the end of the third quarter of last year.
"These are expenses yet to be recognized, and unless the employees who are incentivized generate more than enough revenue to cover the cost, there could be some earnings shortfall down the road," says Robert Willens, Lehman Brothers's tax and accounting analyst. "It's not an unusual method of compensation, but it's something investors need to be cognizant of."
To be sure, the cost will be spread out over a period in which Google's earnings likely will surge, though it likely still will represent a significant cost. Analysts estimate that Google earned about $1.5 billion in 2005, and will earn about $2.6 billion in 2006, according to Reuters Research.
"As we hire rapidly to scale up the company, it is natural to issue a larger number of stock awards than we would otherwise," says Steve Langdon, a Google spokesman. "The cost to the company of these stock awards occurs only over the periods the awards vest, which is when the employees earn the related benefit."
Google also notes that it incurred an expense of $143 million through the first nine months of 2005 from old options and restricted shares, so the mounting expense from the units and options won't be the first time it has faced charges due to prior awards.
Bill Miller, who runs the Legg Mason Value Trust mutual fund, a big holder of Google shares, argues that the expense of the units is rightly spread out over time because the benefit from the workers also will be received over time, much like the cost of a tractor is allocated over the period the tractor is used.
Bulls also point out that the new shares and options amount to just 1% to 2% of shares outstanding. And many investors tend to ignore what they consider to be non-cash charges, like expenses for shares and stock options.
Still, with Google ramping up its issuance of the stock units, the future expense is clearly rising. And with Google shares trading at a steep 51 times its expected 2006 per-share earnings -- three times the price-to-earnings ratio of the broader market -- anything that may drag down these earnings makes the stock that much more expensive.
The performance-based stock units are included in Google's quarterly securities filings, but they aren't in its balance sheet, in keeping with accounting rules; nor is the price at issuance stated. That makes it harder for investors to tally up their cost.
Employment-related costs are an issue for many technology companies, which have begun to count options and other share awards as an expense under accounting rules enacted last year. Microsoft Corp., which switched to granting stock awards rather than options over a year ago, granted almost 45 million of these awards in its fiscal year ended June 30. Since the awards were granted at an average price of about $24, Microsoft incurred an expense of just over $1 billion. The majority of the shares will vest over five years, reducing earnings in that period.
But Microsoft is expected to earn more than $16 billion in fiscal year 2006, much more than Google. As such, Google is facing a relatively higher future expense. Of course, Google is increasing its earnings and employee base at a faster clip than Microsoft.
Some investors ignore the options issuance because it can be challenging to place an exact value on them. Options are only worth something if the stock moves higher, and they can expire worthless. But, Google's rising share units are harder to dismiss. They have value no matter what the shares do. And as long as employees stick around long enough for the units to vest, the units can be converted into shares. With Google on a roll, few employees holding the units are likely to quit.
"Our objective is to get to substantial scale as quickly as possible," Google's chief financial officer, George Reyes, said at an investor conference in late November, explaining the rising employee ranks.
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com
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