Stock Options: Be Prepared for a Sea Change
21 November 2000
In our view, the collapse of the NASDAQ over the past few months has
initiated the second leg down of a fully-fledged high tech stock bear market.
But for the odd exception, the list of corporate casualties reporting
disappointing earnings goes on and on. This has now evolved into a season
of earnings warnings. Rebounds in the interim may have more to do with
shorts covering positions than wounded investors coming back for more
punishment, except for the few eternal optimists that believe everything they
hear and see on television.
In this skittish investment environment we revisit employee stock option
plans, which up until recently have thrived in a market that has made options
exercises much more lucrative for employees than trying to earn a living the
old fashioned way. Over the last ten years in particular, stock options have
become an increasingly large component of employees’ compensation
schemes, particularly in the high-tech sector. A stock option gives the
employee a right to buy a share of a company’s stock at a specified price
over a period of time over the term of the contract. The option’s exercise
price is usually the most recent prevailing market price at date of grant. If the
company’s stock price falls, the option simply remains unexercised, although
in practice this is not always the case. On Wednesday October 18, 2000, for
example, the Financial Times reported that Sprint became the first
telecommunications carrier to announce a re-pricing of some employee
stock options in an effort to ward off a brain drain among its key employees.
However, if the company’s stock price rises, employees can exercise their
options; that is, they can buy company shares at a price below the prevailing
market price and then sell them at the higher market price for a profit.
Employees do not need to put capital at risk; yet, if the company’s share
price appreciates, they can earn substantial capital gains.
With the seemingly endless bull market of the 1990’s, management,
especially in the tech sector, embraced stock options as an effective way to
reduce wage costs. Employees perceived corporate stock options as a
perpetual road to riches because the stocks themselves seemed inevitably to
appreciate in value. This phenomenon has until recent times encouraged
corporate employees to accept more of their compensation in the form of
stock options. Prior to the onset of these spectacular capital gains in high
tech shares, employees generally insisted on straight cash compensation, as
opposed to possibly greater compensation through the form of capital gains
derived from the exercise of stock options in the future. The apparently
non-stop rise in share prices of the past two decades, however, has
engendered a marked shift of overall compensation package preferences on
the part of employees now weighted heavily in favor of options, thereby
enabling management to pay below-market wages in exchange for generous
stock option packages.
There is considerable dispute over the importance of employee stock option
compensation. There are also major disagreements about the way in which
the cost of stock options should be accounted for in financial statements.
Recall that after a protracted political process, in 1995, FASB changed the
accounting rules with regard to employee stock options. FASB initially
recommended that the cost of options be reported in earnings, but eventually
backed down under Congressional pressure (who in turn were pressured by
lobbyists from Wall Street and Silicon Valley) and accepted footnote
disclosures instead. In our view, criticisms which detail the extent to which
current accounting rules overstate corporate profitability have excellent
merit as it is clear to us that cash is required to immunize against stock
option dilution. We will not enter into a debate as to whether this should take
the form of full cost accounting or footnote disclosures. In either case, there
is a germane impact on earnings.
There is another component to the conundrum. The practice of selling of put
warrants/options on a company’s stock can be viewed as the stepchild of
employee stock option grants. The objective was that put premiums would
generate cash to help fund stock repurchases. Stock repurchases were
needed to minimize the effect of shareholders’ dilution, brought about by
employees exercising their stock options.
Because high tech stocks have been especially volatile in recent years,
options on their shares have high-implied volatilities - that is, the sale of put
options by high tech companies on their stock has generated exceptionally
high premium income. This premium income from put option sales, if
properly executed within the constraints of accounting rules, does not flow
through the income statement. Instead, put premium proceeds are credited
to shareholders’ equity. The financing section of the cash flow statement
reports the proceeds as an inflow of cash. So far so good.
What is less appreciated is the extent to which the practice of selling put
options discriminates against current shareholders when the market turns
south. It ultimately results in an unexpected dilution of shareholders’
interests. Not many investors appreciate the ramifications of a put warrant
scheme gone sour. We use the term options and warrants interchangeably.
Microsoft has been a big seller of put warrants. The company’s put-warrant
contracts allow it to choose a net-share settlement. Consequently, no
put-warrant liability results. All proceeds are credited to shareholders’
capital, as outlined in EITF Issue No. 96-13: Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in, a Company’s
Stock. When contracts provide Microsoft, or any other for that matter that
sells puts, with a choice of net cash settlement or net share settlement, the
presumption is that the company will settle in shares, to avoid any impact on
earnings, other than the effect of additional shares being issued. For
example, when a put warrant drops below its strike price and warrant
holders exercise, the transaction will have no effect on the net income of the
company that sold the put, if the counter party’s claim is settled by stock
issued out of treasury. On the other hand, the losses on contracts that require
settlement in cash are accounted for as a charge in the income statement.
The rule being that transactions in an enterprise’s own capital stock shall,
under all circumstances, be excluded from earnings. As noted, shareholder
dilution results when the puts are exercised and shares are issued to settle
the claims.
We quote from Microsoft’s 2000 10K: "Prior to the termination of the stock
buyback program, Microsoft enhanced the program by selling put warrants to
independent third parties. These put warrants entitle the holders to sell
shares of Microsoft common stock to the Company on certain dates at
specified prices. On June 30, 2000, warrants to put 157 million shares were
outstanding with strike prices ranging from $70 to $78 per share. The put
warrants expire between September 2000 and December 2002. The
outstanding put warrants permit a net-share settlement at the Company’s
option and do not result in a put warrant liability on the balance sheet."
Microsoft's Cash Flow Statement reports the following inflows on account of
put-warrant sales:
$ millions
1996
1997
1998
1999
2000
Total
Put Warrant
Proceeds:
124
95
538
766
472
1,995
The 157 million warrants outstanding at June 30, 2000, represented a
potential put warrant liability of $11.6 billion, at an average strike price of
approximately $74. At a stock price of $59 (where Microsoft traded for the
month of October 2000) the warrants are $2.3 billion in-the-money, assuming
no expirations and exercises. That’s more than the total put proceeds
received since 1996. Thanks to a nice bump due to only average earnings
announced recently, Microsoft’s stock price now stands at $69, so the
problem is not quite as acute today. But at its lowest price in October 2000,
the company stood to pay out, through the issue of common stock, $3.7
billion for the privilege of having collected $2 billion in put premiums since
1996, which entails extraordinary dilution for existing shareholders, not to
say an unwise business strategy. The $3.7 billion number is the maximum
exposure under current assumptions. As noted, expirations and exercises
may have the effect of reducing the amount and investors should scour the
company’s filings for updated information.
Of course, the sale of puts to third parties would not have been a problem if
the stock had stayed above $74 until 2002, but stock markets, sadly, don’t
always prove to be so accommodating, as current volatile conditions
illustrate. To settle the above-mentioned contracts at approximately $2.3 to
$3.4 billion, Microsoft may have to issue more than 50 million shares in a
net-share settlement transaction. This would represent 1% of Microsoft’s total
common stock outstanding. This loss would not be reflected in earnings
(since it is not settled in cash), yet it would be foolish to minimize the
importance of this exposure just because treasury stock is used to settle the
claims. With a declining stock price, put warrant sales become too risky an
activity for a software business to be involved with and this practice of selling
put warrants to raise cash for stock repurchases will come to an end. We do
not anticipate seeing millions of dollars in put warrant proceeds in the cash
flow statements of tech companies, for years to come. Another "pillar" that
propped up the stock option scheme has collapsed.
We find a similar problem at Dell. As of July 28, 2000, the company had 107
million warrants outstanding, with an average strike price of $46. At a price
of $27 (average price for October 2000), the warrants are $2.1 billion in the
money. To settle the options at current prevailing prices, Dell would have to
issue approximately 75 million to 100 million shares in a net share settlement
transaction, representing approximately 3% of the total shares outstanding.
What makes it worse is that Dell had only received $100 million in put
premium proceeds during the past four years. Dell’s CFO has a tough
assignment ahead as he explains the put warrant derailment.
The next "pillar" under threat concerns the largesse of the IRS that granted
companies a tax deduction equal to the gains realized by employees on
exercising their stock options. This tax benefit, acting essentially as a tax
rebate, shaved off massive amounts of money from the tech company’s tax
bills. The effect was the conservation of cash that otherwise would have
gone to the national coffers. Some of this cash instead conveniently helped
to fund stock repurchases.
Again, take Microsoft as an example. During fiscal 1996 to fiscal 2000,
Microsoft spent $14.7 billion on stock repurchases. The funding provided by
the tax code was not inconsequential. Tax benefits provided by the IRS in
the form of a reduction in the tax liability, but not accounted for in income,
indirectly contributed a staggering $11.3 billion over the period. This is
because Microsoft was entitled to a $32 billion tax deduction, an amount
equal to the gain realized by employees on the exercise of their stock
options. Employees paid-in $5.8 billion as they exercised their stock options.
Proceeds from the sale of put warrants raised $2.0 billion. Cash inflows from
the above in excess of stock repurchases amounted to $4.4 billion.
As stock values decline, employees will either not be able to exercise their
stock options, or if they do, the realized gains will be much smaller by
comparison to the past. This in turn will mean a virtual evaporation of the tax
benefits and suddenly the full tax expense reported in the income statement
will become payable - except for the odd deferrals. The drain on corporate
cash flows could be severe.
During the past three years Microsoft’s tax expense, net of the tax rebate
amounted to a mere 2.4% of revenues generated during that period. Without
the tax benefit, the company’s tax bill would have been equal to 20% of
revenues. The tax haven in Redmond, WA, may be no more.
($ Millions)
1998
1999
2000
Total
Tax Expense In
Income Statement
$
2,627
4,106
4,854
11,587
Deduct: Tax Benefit
(1,553)
(3,107)
(5,535)
(10,195)
Tax Expense, Net Of
Benefit
1,074
999
(681)
1,392
As % Of Revenue
7.0%
5.1%
2.4%
In this context we mention the common practice among tech companies to
treat the tax benefits from employee stock exercises as cash flows generated
by operations, although nothing could be further from the truth. This is
practice became popular long before FASB’s Emerging Issues Task Force
Management issued EITF Issue No. 00-15 in the summer of 2000. The thinking
is perhaps that the tax benefit basically in the form of a tax rebate, was just
too good to be wasted in the financing section of the cash flow statement.
Accounting rules say that transactions in a company’s own capital stock shall
"under all circumstances be excluded from earnings." The tax benefits are
derived from stock issued to employees. These are clearly financing-related
activities – see full discussion below.
Up until fiscal 1999, Microsoft, almost alone among tech companies, dutifully
and correctly so, disclosed the tax benefit as a financing activity. To our
amazement, we discovered when reviewing the company’s latest 10K filing
for fiscal 2000, that it had changed this practice and joined its errant peers.
Microsoft now, reluctantly so we came to learn, discloses the tax benefits as
cash generated by operations. To give effect to this change it restated all
previously published cash flow statements.
Microsoft’s Cash Flow Statement
As previously reported
($ millions)
1998
1999
2000*
Operations:
Cash from operations
$6,880
10,030
8,426
Financing:
Tax benefits
1,553
3,107
5,535
* Assuming the company had not changed its reporting practice.
Microsoft’s Cash Flow Statement
As restated
1998
1999
2000
($ millions)
Operations:
Tax benefits
1,553
3,107
5,535
Cash from operations
8,433
13,137
13,961
Financing:
- no tax benefits disclosed
under this section
Without the tax benefits, Microsoft’s cash from operations would have been
$8.4 billion compared to the $10.0 billion a year earlier. This represents a
16% decline in cash from operations compared to revenues that grew at 16%
in 2000.
What will happen next year? It can be calculated from the disclosures above
that employees realized $9 billion in options gains in 1999, on which
Microsoft received a tax benefit of $3.1 billion. In 2000, employees realized
$15.8 billion in options gains with a tax benefit of $5.5 billion. By end of June
2000, Microsoft employees owned 832 million options with a
weighted-average strike price of $41.23. Assume the average price of
Microsoft stock in fiscal 2001 is $61.23. Assume further that employees
exercise 175 million options, in line with previous years. This will give them
$3.5 billion in gains ([$61.23 - $41.23]*175 million). The tax benefit will amount
to $1.2 billion. This would be $4.3 billion less than last year. Oops! Microsoft
is facing potentially a $4 billion shortfall at the cash from operations line
awaiting shareholders at the end of fiscal 2001.
We performed the same calculations for Dell. Dell’s accountants decided
early on that tax benefits are cash flows generated by operating activities
and nobody questioned the merits of the decision - almost no one took
umbrage when we first raised the issue in Behind the Numbers (August 9,
1999).
($ millions)
1998
1999
2000
As reported:
Operations:
Tax benefits
164
444
1040
Cash from operations
1,592
2,436
3,926
Cash from operations
excluding
- tax benefits
1,428
1,992
2,886
- as % of reported number
89.7%
81.8%
73.5%
In fiscal 1999, Dell’s employees realized $1.3 billion in options gains, with a
tax benefit of $444 million accruing to Dell. In fiscal 2000, employees realized
$3.0 billion in options gains with a tax benefit of $1.0 billion. By the end of
January 29, 2000 (fiscal year-end), Dell employees owned 320 million options
with a weighted-average strike price of $11.39. Assume the average price of
Dell stock in fiscal 2001 is $31.39 Assume further that employees exercise 75
million options, in line with previous years. This will give them $1.5 billion in
gains ([$31.39 - $11.39]*75 million). The tax benefit will amount to $525
million. This would be $515 million less than last year. Although not in as bad
a shape as Microsoft, a quick calculation shows that if cash from operations
(excluding the tax benefit) in fiscal 2001 were to increase by 30% and the tax
benefit is only $525 million, a year-over-year comparison will show an
increase in cash flow of only 9%. Analysts will no doubt explain the decline
in Dell’s cash flow by asking investors to ignore the "non-recurring" nature of
tax benefits and concentrate on the "clean" number.
The value of the unexercised stock option portfolio of Microsoft’s employees
declined by nearly $6 billion in fiscal 2000 ended June 30. This decline had
been as high as $9 billion earlier in the year, whereupon management doled
out another 70 million options priced at $65. Should Microsoft’s stock rally to
$92 per share, employees would begin to accumulate stock options gains on
two sets of stock options. Why the two sets of options? New accounting rules
were introduced last year which stipulated that once companies have
re-priced share options, the cost of these options must be deducted from
profits. True to recent form, Microsoft (and Amazon.com amongst others) has
made extra, one-off grants of options to employees at lower exercise prices
this year. Since the older options were not cancelled, this does not count as
re-pricing and therefore does not affect profits. So a big recovery in the share
price could turn into a major bonanza for Microsoft’s employees and a
bittersweet pill for shareholders.
1998
1999
2000
Options Outstanding -
Millions
893
766
832
Weighted-Average
Strike Price
$11.94
$23.87
$41.23
Market Price At
Year-End
$54.19
$90.19
$80.00
Value Of Option
Portfolio
$37.2
billion
$50.8
billion
$32.3
billion*
* At $65 the portfolio is worth $19.8 billion in October 2000, assuming no
exercises.
But what if the stock price does not recover? Post year-end, employees have
seen a $12 billion decline in their options’ portfolio. Re-pricing the options
would result in expense recognition and is probably being considered.
Canceling and re-issuing the options at a lower price requires at least a
six-month’s waiting period, to avoid expense recognition. If options are
re-priced and depending on the magnitude of share price declines,
employees may have to be given proportionally more options to compensate
for their losses. This would lead to additional shareholders’ dilution.
In the 2nd quarter of calendar 2000, we postulated that the current market
turmoil would probably act as an incentive for Microsoft employees to realize
their gains and minimize the risk of further loss. We anticipated that
employees would realize at least half of their $33.1 billion exercisable gains
in fiscal 2000. We correctly forecasted that an acceleration of stock option
exercises of this magnit |
