Interesting article on the effects of stock options on cash flow. Well worth reading.
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By Michael Rapoport
A Dow Jones Newswires Column
(This story was originally published late Wednesday)
NEW YORK (Dow Jones)--Turns out there may be a little justice in the world
after all.
As the stock-option revolution has collided with reality in recent months,
technology-company employees are the ones who've suffered from the carnage that
resulted. They're the ones who took a hit to their pocketbooks when stock
prices plunged and their options went underwater - while their employers, the
ones who were so profligate in issuing the options to begin with, have reaped
plenty of benefits in the form of seeming improvements to their financial
results.
But that unjust situation is liable to change soon, a new study indicates. And
it's about time.
The study, issued Tuesday by Merrill Lynch & Co., focuses on the quality of
tech companies' earnings, which can best be described as questionable. Among
other findings, the report documents that stock options have been helping prop
up the companies' cash flow to a stunning extent. On average, the report says,
nearly half of operating cash flow at 37 major tech companies came from the tax
benefits that flow from stock options.
And those benefits are now drying up, the report contends, thanks to the
market slide that has made so many options worthless. As a result, cash flow at
these companies - perhaps the best gauge of a firm's financial health - is
liable to take a major hit.
"Going forward, we think cash flow is going to be substantially less," said
Steve Milunovich, Merrill's technology strategist.
According to the Merrill report, an average of 48% of fiscal 2000 operating
cash flow at the major tech companies surveyed came from tax deductions that
companies take when their employees exercise stock options. That's up from 22%
in 1999 and 9% in 1998.
Companies can take a tax deduction when options are exercised based on the
difference between the exercise price of the options and the market price at
the time. The deduction doesn't show up on a company's income statement, but it
does appear on its cash-flow statement, and it's added to the balance sheet as
part of paid-in capital.
Sounds like the companies are getting the best of both worlds, doesn't it?
They reap the benefits of the tax deductions while at the same time excluding
the expense of issuing the options from their much-ballyhooed "pro forma"
earnings, thereby inflating the earnings figure they like to focus on.
(Whenever you see a company refer to pro forma earnings that exclude
"stock-based compensation," this is what it's talking about.)
At some companies, the tax benefits have been large enough to swing what would
otherwise be significant negative cash flow into the positive column. Nortel
Networks Corp. (NT), for instance, had $447 million worth of options-related
tax deductions in 2000 - a whopping 1,118% of its $40 million net cash from
operations for the year. That 1,118% is excluded from Merrill's 48% average, by
the way, or else that average would be even higher.
Another company on Merrill's list, Brocade Communications Systems Inc. (BRCD),
had $148.4 million in tax benefits in 2000, or 213% of its operating cash flow
of $69.7 million.
Those benefits contrast dramatically with what many tech-company employees
have gone through. Many employees received options as a big part of their pay
package, only to see those options sink far underwater as the market plunged.
According to the Merrill study, 41% of the options outstanding at the 37
companies as of the end of 2000 were underwater as of late March (that is, the
stock's market price was below the options' exercise price), although Merrill
expects that many of those options will ultimately be repriced.
What's worse, many employees who exercised options ended up facing major
income-tax bills, even though the paper gains they made later disappeared as
the market plunged. The difference between the exercise price and the market
price at the time the options are exercised - yes, the same difference for
which companies can take a deduction - is taxable for employees even if they
never sell their shares. So some employees ended up with the worst of both
worlds: shares that have lost most of their value, and a lot of money owed to
the Internal Revenue Service.
But take heart: The companies are about to get hit hard too, Merrill says.
That stands to reason - with so many options underwater, and with options no
longer nearly as popular as they were barely a year ago, there are likely to be
far fewer options exercises, and consequently fewer tax deductions to be had.
Companies' options-related tax benefits will "fall dramatically," Merrill says,
and will significantly dampen cash flow in the process.
At some companies, it's already happening. At Yahoo! Inc. (YHOO), for example,
options-related tax deductions made up 34% of cash flow during 2000. In the
first quarter of 2001, it was only 3%.
Nortel, for its part, had only $33 million in tax benefits from options during
the first quarter of 2001 - part of the reason, though certainly not all of it,
that it had negative operating cash flow of $863 million for the quarter.
Spokespeople for Nortel and Yahoo! couldn't be reached for comment. Brocade
said in a statement that "we follow generally accepted accounting principles
with the accounting of our stock-option programs, and disclose the impact of
those programs in our public filings."
Robert Willens, an accounting expert at Lehman Brothers, agrees with the
Merrill report's contentions. "There's no question about it," he said. "There's
been huge tax benefits in the past, and they're going away."
Of course, they might not be going away just yet. Some companies have
continued to show strong contributions to cash flow coming from options-related
tax deductions. At Brocade, for instance, where tax benefits were more than
twice operating cash flow in fiscal 2000, they're still 130% of cash flow in
the first six months of fiscal 2001.
Still, it's something to think about, particularly if the market doesn't
recover soon. Relying on the whims of the market to get "cash" from
options-related tax deductions is just no substitute for a healthy, growing
business that throws off cash. Judging from the Merrill report, that's
something that some technology companies have yet to figure out.
-By Michael Rapoport, Dow Jones Newswires; 201-938-5976;
michael.rapoport@dowjones.com
JAPG |
