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Contributors: Douglas McIntyre Jon C. Ogg

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Monday, September 18, 2006


From The Average Joe Investor

So I'm looking at Adobe Systems (Nasdaq:ADBE) who reported their third quarter earnings last night after the close. By all accounts it looks like Adobe did well - investors certainly are happy about the results, as I write this the stock is up 11% and that's down from the 13% gain that they were sporting earlier in the day.

When I looked throught their press release, though, I keyed in on the following:

Non-GAAP diluted earnings per share, which excludes amortization of purchased intangibles, amortization of Macromedia deferred compensation, restructuring charges related to the Macromedia acquisition, a charge for incomplete technology related to a small acquisition, SFAS 123R stock-based compensation, tax differences due to the timing and deductibility of the Macromedia acquisition-related charges and SFAS 123R stock-based compensation, and investment losses, were $0.29. Adobe's third quarter non-GAAP EPS target range was $0.25 to $0.27.

Holy gibberish Batman! What the heck is going on here... Well basically the majority of the paragraph is talking about various charges related to the acquisition of Macromedia. The theory behind backing these out of the net income number is to show Adobe results on an "normalized" basis with out the extra expenses related to the acquisition.

I can also see why investment losses would be excluded since they are not really part of the business operations of Adobe. Their investment activities consist primarily of equity investments and their interest in Adobe Ventures (a VC partnership with Granite Ventures). What I will say about the investments, though, is that they're not immaterial, and investors should certainly keep an eye on whether Adobe is actually creating value through these investments or whether they should be just giving that extra cash back to shareholders.

What really interests me, though, is the adjustments for SFAS 123R. If you're not familiar with SFAS 123R, it is a FASB (Financial Accounting Standards Board) rule put in place to make sure that equity instruments (particularly stock options) are accounted for in financial statements. Why is it important that options and other equity instruments be accounted for? Because they are typically used as compensation and have a definite impact on shareholder value. Options are not free money, when a company exec exercises their options it dilutes the shareholder pool for existing shareholders.

I think about it this way: if I'm investing in a company I want to be in the know about what it costs to run the business. Whether you're paying employees in cash, stock, stock options, or gift certificates you've gotta pay them, and I want to know how much it's costing me as a shareholder. Personally, I prefer that employees (CEO and other execs included!) just get paid cash, I don't know that I've seen any statistical studies that have shown any extra performance from companies that grant options versus those that don't, and cash is nice and easy to account for. Besides, I want the executives of the companies I invest in to be focused on building a great business, not trying to push for short term stock price movements to make sure that their options are in the money.

What only makes the matter worse is that Wall Street analysts endorse these non-GAAP numbers that generally exclude stock option expenses. It sure is nice for companies to be able to exclude part of their compensation expenses, but if we continue to overlook option costs, we might as well just go ahead and go the whole nine:

Non-GAAP diluted earnings per share, which excludes SFAS 123R stock-based compensation, general and administrative costs, manufacturing expenses, and completed and yet-to-be-completed R&D were $8.97. MaxEPS Corp is happy to announce that on a non-GAAP basis they have achieved 100% operating margins for the eight straight quarter.

To Adobe's credit, they report GAAP earnings up front and then go into the exercise of calculating non-GAAP, but the same can't be said for everyone else out there. The use of options as part of a compensation package isn't necessarily a bad thing, but I think we still have some work to do on how to best reflect this issuance expense in financial reporting.

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