The ‘Tech Stock’ Con Returns

As a follow-on to my denunciation Thursday of the practice at too many companies of excluding stock-based comp in the calculation of “adjusted” earnings, here’s a paraphrase of what the CFO of an online lender (that shall remain nameless) had to say on his company’s recent earnings call:

We’ve decided to change how we define adjusted EBITDA in order to be consistent with other technology-driven companies. Henceforth we will exclude stock-based compensation by adding it back to net income when we calculate adjusted EBITDA. [Emph. added]

So this lender isn’t actually a lender at all, according to our man. It’s really a technology company. If you were working on Wall Street in the 1990s when the technology stocks were zooming, this may ring a bell. Back then, recall, any company with even the most tenuous connection to computers would insist that it was actually an Internet company, and tell investors it deserved and Internet-company-like valuation, which at the time was an order of magnitude or two higher than regular companies. The companies’ bankers were more than happy to help in perpetuating this con, as were the analysts in the bankers’ firms’ research departments. Ah, the good old days.

The catch, of course, was that if a given company was going to maintain this charade properly, it had to maintain Internet-company-like growth. Most could not, of course, so that sooner or later the rapid growth stopped, the stock collapsed, and the entire enterprise usually ended in tears.

It was an unfortunate enough process when it happened to non-financial services firms. But when financial firms like lenders try put themselves in a position where they’re having to push for growth, the result can be disaster. “Pushing for growth,” by definition, means agreeing to the next, slightly-less-marginally-profitable transaction that you likely wouldn’t have agreed to otherwise. In the case of the lender above, it likely means lending money to people you’d normally turn down.  If your company happens to be levered 3-to-1 and is funded by something other than bank deposits, it doesn’t take a lot of those extra loans to go bad before you’re out of business entirely.

I mention this because lately a number of recently IPO’d financial services companies, in newish subsectors like peer-to-peer lending, say that the technology they’ve developed is so cutting-edge that they shouldn’t be thought of (or valued) as financial firms at all but rather—you guessed it—as technology companies. What’s more, in many cases the market seems to be buying that line. We’ve looked at several of these companies in some detail. Regardless of what they say, they’re not primarily tech companies. They’re in the lending business. It’s hard not to conclude that this isn’t going to end well.

What do you think? Let me know!