Twitter (NYSE:TWTR) investors often care about several key numbers: its monthly active user (MAU) growth, its average revenue per user (ARPU), and its continued lack of profitability. However, there's one figure Twitter glosses over that shouldn't be ignored: the amount it spends on stock-based compensation.
Last quarter, Twitter reported a net loss of $125 million, which was mostly attributed to $177 million in stock-based compensation expenses. Like many companies, Twitter excludes stock-based compensation from its "adjusted" earnings, but investors should nonetheless consider it a major weight on its bottom line.
Why stock-based compensation matters
Over the past 12 months, Twitter had a negative free cash flow of $120 million. Companies with cash flow problems often use stock-based compensation to attract new employees. This practice surged in the 1990s because of the combination of promising tech start-ups entering the market, new limits on executive compensation, and murky accounting practices.
Stock options granted to employees were subsequently treated as free currency, which weren't initially reported as "real" expenses. But when the options were exercised later, companies incurred large expenses that were then excluded from non-GAAP earnings. In 2006, companies were finally required to value options as an expense when granted. This caused many companies to replace options with restricted stock, which couldn't be sold for several years, since options no longer provided an earnings benefit.
Enriching employees at the expense of investors
In the third quarter of 2014, Twitter paid out 47% of its revenue as stock-based compensation -- more than any company in the S&P 1500 Composite Index. Last quarter, Twitter paid out 37% of its revenue as stock-based compensation. Only one S&P 1500 company -- United Therapeutics -- paid out a higher percentage.
Twitter hasn't ever posted positive earnings per share without excluding stock-based compensation. In other words, Twitter pays its employees handsomely while failing to deliver any real profits to investors. Looking ahead, Twitter plans to pay out $700 million to $750 million in stock-based compensation in fiscal 2015, which would be equivalent to around 30% of its expected annual revenue.
In 2014, Twitter paid out 57% of its stock-based compensation to R&D employees, or software engineers. According to Glassdoor, Twitter paid its software engineers an average base salary of $128,000 per year, which is 42% above the national average, plus an average of $66,000 in annual stock bonuses.
As Twitter issues more shares to pay its employees, it also dilutes the shares of existing shareholders. Over the past year, Twitter's share count soared 74%, according to FactSet. By comparison, Facebook's (NASDAQ:FB) share count only rose 10% during that period.
Investors aren't getting their money's worth
I wouldn't mind Twitter paying its employees so well if the company was making clear progress. Unfortunately, Twitter is suffering from stagnant MAU growth and is diluting its brand by expanding into too many businesses.
In the first three quarters of 2014, MAUs respectively rose 25%, 24%, and 23%. In the fourth quarter, that growth slowed to just 20%, with 288 million MAUs. Back in 2013, CEO Dick Costolo claimed that Twitter would have 400 million MAUs by the end of the year.
Faced with slowing MAU growth, Twitter is trying to maximize ARPU by adding new services like video ads, video editing tools, online payments, e-commerce partnerships, and group chats. But by doing so, Twitter could become a clumsier version of Facebook and clutter up its News Feed with too many ads and promotions.
Meanwhile, news agencies, high frequency trading firms, and even Google (NASDAQ:GOOG) (NASDAQ:GOOGL) now subscribe to Twitter's "firehose" feed of tweets. Firehose subscriptions accounted for nearly 10% of Twitter's top line last quarter, but they arguably encourage the company to turn a blind eye to the spread of spam accounts across the network, since they expedite the spread of individual tweets. Twitter acknowledged that 8.5% of its MAUs included these fake accounts, bots, and "third-party applications" last quarter, but it has done little to curb that growth.
Why Twitter needs to reduce stock-based compensation
Diluting existing shares to compensate employees with options or restricted stock might seem lucrative when a company's stock is stable or rising, but Twitter stock has slumped 13% over the past year.
To be fair, Facebook, Google, Amazon, Salesforce, and LinkedIn all exclude stock-based compensation from their non-GAAP adjusted earnings. But unless Twitter solves its core problem -- its lack of free cash flow growth -- it will keep using stock-based compensation to pad its software engineers' extravagant salaries. That practice will keep its bottom line in the red for the foreseeable future.