LNKD – Fall Into the GAAP

by Dan April 5, 2016 2:08 pm • Commentary• Trade Updates

Remember back when the financial world was ending in early February and investors hastily sold shares of LinkedIn (LNKD) down 43% in a single day, more than 50% on the year, shedding more than $10 billion in market value in a matter of hours?  In hindsight that was silly right? Animal spirits had taken hold of otherwise rational investors, and LNKD was the baby with the bathwater, and the stock has since recovered a whopping 14%. Wait, what, 14%??  The S&P 500 (SPX) is up 13% and the Nasdaq Composite (CCMP) is up 15%.  What gives?

LNKD 1yr chart from Bloomberg
LNKD 1yr chart from Bloomberg

I think this is very important to consider as investors contemplate whether it is safe to get back in the pool with some over-valued, over-hyped stocks like LNKD.  LNKD is a great example of a stock where its decelerating revenue growth (expected to be 23% yoy from 35% in 2015, 45% in 2014 and 57% in 2013) is starting to cause investors to look at the gap between GAAP (generally accepted accounting principals) and adjusted earnings.  Adjusted earnings for LNKD are expected to grow 13% in 2016 to $3,22, on an a GAAP basis they are expected to decline 45% to a loss of $1.87!!! (See my discussion below of why and when this difference in earnings reporting may be important to investors in high growth stocks).

So what to do with the stock down 50% on the year??

Your guess is as good as mine, I suspect it has more to do with what sort of market we will be in for the balance of the year. When the company reports Q1 results on April 28th investors will be very keen to see whether or not the cautious guidance given in early February was overly cautious, or whether or not the issues weighing on recent results are likely to persist. Another swing and a miss and the stock breaks the Feb lows and is in the $90s.  Too quick of a reversal in trends and investors will remain skeptical as there are few one quarter hiccups with companies like this in my opinion. So the best possible scenario would be mild improvement, continued acknowledgement of headwinds and cautious optimism for the balance of the year that trends improve.

Options market makers are taking little chances of getting caught off sides, with the stock just above $114, the April 29th weekly 114 straddle (the put premium + the call premium) is offered at about $19, or about 16% of the stock price. If you bought that and thus the implied earnings move between now and April 29th’s close, then you would need a move below $95 or above $133 to make money. Since the stock’s 2011 ipo the stock has on average moved about 12.5% the day following earnings, so the implied earnings move appears fair, not particularly expensive when you consider how much time between now and the event, but not exactly cheap when you consider the very low probability of another massive move.

Short dated options prices are through the roof, with 30 day at the money implied volatility at a new highs of about 75%:

From Bloomberg
From Bloomberg

If I were long LNKD I might consider selling short dated straddles (call and put of same strike and same expiration) or strangles (call and put of different strike but same expiration) to add yield prior to earnings. For instance with the stock at $114.50 you could sell one April 22nd 114 straddle at $7 vs 100 shares of long stock. If the stock is between $114 and $121 you would have gains of the stock plus the $7 in premium received. If stock above 121 then you would have effectively sold the stock at $128, $7 in gains of the stock, $7 gains of the straddle sale.  The $7 premium serves as a buffer to the downside and the worst case scenario is that you would be put 100 more shares below $114 but effectively at $107.  The idea here is NOT to wait till April 22nd expiration, but have the stock bang around between now and then, have the options decay and close one or both strikes for a gain.

Adjusted Earnings vs GAAP

Last month the WSJ highlighted the differential in GAAP and reported earnings for the S&P 500 (S&P 500 Earnings: Far Worse Than Advertised). This after 2015 marked the slowest eps growth for the SPX (.4%) since 2009:

Look to results reported under generally accepted accounting principles and S&P earnings per share fell by 12.7%, according to S&P Dow Jones Indices. That is the sharpest decline since the financial crisis year of 2008. Plus, the reported earnings were 25% lower than the pro forma figures—the widest difference since 2008 when companies took a record amount of charges.


The difference shows up starkly when looking at price/earnings ratios. On a pro forma basis, the S&P trades at less than 17 times 2015 earnings. But that shoots up to over 21 times under GAAP.


Indeed, outside of 2008, the only other times the GAAP gap was as wide as last year was in 2001 and 2002. That was back when companies wrote off billions of dollars worth of dot-com bubble-era investments.

These sorts of concerns seem mundane during a Central Bank induced bull market in equities, but the concern has been catching some steam in the financial press since Barron’s asked the question How Much do Silicon Valley Firms Really Earn?:

The result is an inflated and distorted earnings figure — a number that doesn’t conform with generally accepted accounting principles, or GAAP, yet is widely embraced by analysts and investors in valuing tech companies. We estimate that a dozen leading companies this year will fail to expense $16 billion in stock compensation against their non-GAAP earnings.

It’s true that tech companies also report GAAP earnings, which require the expensing of stock compensation. However, many companies highlight the non-GAAP numbers that exclude stock compensation and other expenses, including the amortization of intangible assets. Stock compensation usually is the major factor that separates GAAP and non-GAAP earnings.

Ok that was a lot, but I think it is a really important topic for investors in high valuation stocks that report adjusted earnings.  It doesn’t really matter in a bull market, but it will most definitely weigh on such stocks during market corrections like the one that we just had, and it will most certainly be a massive issue if for any reason stocks go into a protracted bear market like we had from 2000 to 2002.