Something I never thought I'd say, a good article from the Fools. Completed ignored Im sure.
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Stock Options Can Skew Cash Flow
Due to the way that most companies account for stock options, there is no charge to income when options are exercised. However, companies can realize significant cash flow benefits when employees exercise their options. Here, we take a look at cash flow growth of seven companies covered by Motley Fool Research -- Amgen, Cisco, Dell, Gap, Microsoft, Siebel, and Yahoo!
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By Phil Weiss (TMF Grape)
December 28, 2000
Earlier this year, I wrote the first two parts of my ongoing study of stock options . The goal of this series is to flesh out how options are accounted for, so that investors can make a more informed decision about how to view them.
As discussed in more detail in Part 1 of this series, the tax benefit related to the exercise of nonqualified stock options is typically not reflected in net income. However, it does result in a deduction on the company's tax return. Here's why: Assume that an employee who has received a non-qualified stock option (NSO) with an exercise price of $20 per share exercises that option when the stock is trading at $50 per share.
When the option is exercised, the employee is taxed on the $30 difference between the $50 exercise price and the $20 grant price. This $30 is wage income for the employee so the company has a $30 compensation deduction for tax purposes. The vast majority of companies don't include this compensation deduction when calculating income under Generally Accepted Accounting Principles (GAAP). The tax deduction is worth $10.50 to the company ($30 times the 35% corporate income tax rate). The effect of the employee stock option exercise does not affect the income statement; instead, it hits the balance sheet as a direct reduction in shareholders' equity.
Investors should also note that this adjustment to shareholders' equity might not always match the amount recorded in the cash flow statement. This mismatch happens when a company has a net operating loss for federal income tax purposes and is unable to utilize all of the tax benefit from the option exercise in the current year. This appears to be the case with Cisco Systems (Nasdaq: CSCO). In its most recent Statement of Shareholder's Equity, the tax benefit from employee stock option plans was $3,077, while the Statement of Cash Flows showed only $2,495.
The size of the tax benefit also hinges on a company's stock price. There are two reasons for this. First, an increase in the stock price over the grant price results in a greater tax benefit, and second, the price of the stock could influence the number of options being exercised. It will be interesting to observe the impact the struggling stock market has on the size of the cash flow benefit from stock option exercise that companies realize over the next year.
Below is a look at the impact of these stock option exercises on some of the companies covered by Motley Fool Research: Amgen (Nasdaq: AMGN), Cisco, Dell (Nasdaq: DELL), Gap (NYSE: GPS), Microsoft (Nasdaq: MSFT), Siebel Systems (Nasdaq: SEBL), and Yahoo! (Nasdaq: YHOO).
The first table summarizes the growth in reported cash flow from operations year-to-date and for the previous two fiscal years. The second table eliminates the benefit realized from the exercise of stock options and reveals dramatically different results. (Note: Amgen's data for 1998 and 1999 is the same. Prior to this year, Amgen recorded this tax benefit in the financing section of its cash flow statement. As a result, the amount was not part of cash flow from operations and no adjustment was required.) In the past, companies had a choice as to whether to report this item in the operating or financing section of the cash flow statement. However, this is no longer the case, as earlier this year the accounting powers that be determined that this tax benefit should be recorded as part of cash flow from operations. Microsoft also previously reported this item in the financing section. It restated its cash flow statement to reflect this change in accounting policy in its 10-K for its year ended this past June.
Reported Growth
2000 YTD 1999 1998
Amgen 27% 3% 15%
Cisco 20% 42% 51%
Dell -3% 61% 53%
Gap -91% 6% 65%
Microsoft 4% 6% 56%
Siebel 566% 37% 301%
Yahoo! 269% 163% NMF*
Adjusted Growth
2000 YTD 1999 1998
Amgen 8% 3% 15%
Cisco -49% 5% 43%
Dell 3% 45% 39%
Gap -115% -4% 60%
Microsoft 53% -16% 46%
Siebel 952% -62% 317%
Yahoo! 179% 178% NMF*
*no meaningful figure
Of all the numbers in the above table, the most distressing are Cisco's. Cisco has realized significant cash flow benefits from the exercise of stock options over the last five quarters. If Cisco's stock price continues to suffer, investors should expect the cash flow benefit from option exercise to decline, hurting Cisco's reported cash flow from operations.
I also found Microsoft's first-quarter results quite interesting, as its option-related tax benefit for the first quarter of $435 million was approximately a third of the year-ago result. Microsoft's stock price has certainly trended downward over the last year. The decline in Microsoft's cash flow benefit from this item is an example of the impact the performance of a company's stock price can have on this benefit.
The bottom line here is to be wary of the impact of stock option exercises on cash flow from operations. This benefit is not one that can be counted on with any regularity and is dangerously linked to two things that management has no control over -- stock price and the desire of employees to convert their options into cash.
In the next part of this series, I'll continue this discussion by taking a look some other issues, including the payroll taxes companies pay when options are exercised and, space permitting, the cost of the related shares to the company and its shareholders. If you have any questions, please ask them on our Motley Fool Research Discussion Board.
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