Market Rap: Options Bleating From Cypress
By Bill Fleckenstein
03/05/2002 18:09
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The Rat In Rationalization : Yesterday's fireworks were unable to carry the night (their day) as we ping-pong'd around the globe. Japan finally came off the boil and was down a bit, although Hong Kong was firm. Europe was not doing all that much this morning, and our futures were down a tad. Then, as we prepared for casino time, an Intel INTC tout ricocheted off Wall and Broad, compliments of one of the biggest and deadest of the dead-fish community, who is himself attached to a rather large dead-fish house. (This particular Piscean should be remembered for his eloquent rationalization of Rambus RMBS the whole way up and down as that stock spiked from 20 to 120 back in the mania days. My personal view is that anyone who could be a big believer in that particular situation is completely unable to do analysis.) It seems that our friend, the big dead fish, thinks that Intel will guide revenue estimates higher at their midquarter update. (More about that below.)
Intel Joins Old Biddies' Club : In any case, that put a bid in Intel, and it appeared to put a bid in the tech tape, as well. From the get-go, there ensued an opening blast stoked further by the ISM (formerly NAPM) when it reported a 20%-better-than-expected number in its nonfactory survey. I don't know how many different ways we are going to slice and dice these different purchasing manager surveys, but in any case, that really threw gasoline on a lit fire. An hour into the trading session, the S&P was up about 0.5%, the Nasdaq was up 1% and change, the Dow was kind of dogging it, and the mighty, mighty SOX was roaring, up another 2.5% as everything chip-related was on fire. But the white-hot enthusiasm was not sustainable and we promptly had a setback that returned us closer to the opening levels. That said, even as the major averages backed off, the SOX held its ground.
Bubbleonia Bank For Settlement : Over the course of the day, we basically just saw a lot of flopping and chopping in a very wide range, with a couple of surges up to the highs and a couple of slides back to the lows. The big averages pretty much settled near their lows, whereas the Nasdaq kind of settled in the middle of its range. The all-powerful SOX settled pretty near to its high, as people continue to chase motion. There was a lot of noise around about data from the Semiconductor Industry Association, which I think some people tried to spin into something positive, though basically it was a nonevent/negative if one examined the innards. But I believe that the casino attendees were in a mood to ignore anything bad as they just focused on trying to hop a moving train. Beyond that, I didn't see anything too earth-shaking, other than the fact that retailers were weak on the back of lowered expectations out of Costco COST .
Golden Fruition of the Mission : Away from stocks, gold and silver lost about 1% apiece after the completion of the Bank of England's gold sales. The metals tried to rally but flipped over and sank, as apparently too many people were positioned for a rally. Fixed income was getting smacked again initially, with the 10-year down three-eighths of a buck, but it roared back to close almost flat on the day. The net changes in the currencies were so small as to not be worth mentioning.
Shall Every Silicon Valley Be Exalted? : Turning to the news, may I now direct your attention to an opinion piece in yesterday's Wall Street Journal entitled "Options Aren't Optional in Silicon Valley," by T.J. Rogers, the CEO of Cypress Semiconductor CY In my opinion, here is a case of corporate America at its self-serving worst. Specifically, Mr. Rogers was up in arms about the proposed legislation to change the treatment for stock options. With a heavy heart, he frets that the bill "threatens to kill our employee options system by forcing companies to write off as losses the stock-option gains of their employees. . . " Now, that's somewhat disingenuous. The legislation would not force companies to write them off as losses. It would mandate that they state them as the expense that they are. Before we go any further, I would grant Mr. Rogers the point that the total value of stock-option grants is probably higher than what people would be compensated in the form of W-2 income. No employer in his right mind would pay somebody the egregious amounts that these options have turned into, but to say that the law would compel companies to write off stock-option gains is a complete mischaracterization.
Gravity In Cypress Space : He then goes on to say, "Never mind that we have seen quite clearly that Enron's problems are hardly about stock options." Huh? Why else do you think executives promote stocks and risk everything -- to get stock prices to the moon. You think if Enron's head guys were just getting a salary, their greed would have pushed them to do what they did? In any case, this piece of fiction is followed by another completely erroneous point: that Silicon Valley "has demonstrated that stock options promote long-term thinking." I guess he just decided to make that up, because I don't think that anyone can say stock options promote long-term thinking, and Silicon Valley's existence certainly does not justify that claim.
Mister Rogers Nays : He does go on to make a good point about the argument that "This is the business expense that Senator Levin is unreasonably painting as unscrupulous tax avoidance." That happens to be true. The taxes are paid by the employees, and the corporations therefore should not have to pay the tax. But what Mr. Rogers wants is to have his cake and eat it, too. He wants the tax deduction but he doesn't want to take the expense hit of the stock options. He goes on to wail about how unfair it would be to have to suffer the dilution created by the extra shares and count it as expense as well. But he doesn't seem to mind all the good things that options have brought to him and to people who have them.
Crocodile Tears in Cypress Swamp : Next he claims, "The Levin-McCain paper loss generated by those options could easily reduce earnings by $50 million a year, devastating our profitability." What Mr. Rogers means is not "substantive economic earnings" but reported earnings. This just goes to show you what a benefit it has been to not have to record employee expenses and how that has inflated the apparent profitability of companies that rely heavily on them. There's the real rub. It's not that the taxes aren't paid. They are. It's that the earnings and cash flow are systematically exaggerated. Obviously, the point I already made, that the total option cost is probably higher than the direct compensation expense would be, needs some resolution, but these executives cannot continue to have it both ways. They cannot pretend that a legitimate expense isn't an expense and take the tax deduction as well. They should be forced to decide which one they prefer.
Buffett School Of CEObedience Training : But it is this kind of analysis that has killed previous attempts at reform. A similar sort of analysis and hand-wringing by technology chieftains brought us the Private Securities Litigation Reform Act of 1995, which opened the door to unchecked CEO touting, which has gotten us to the sorry state embodied by Enron. I am making this point again for new readers, as regular readers know it's been a hobbyhorse of mine for quite some time. Actually, other people far smarter than I have weighed in on this before. In the Berkshire Hathaway BRK.A annual report of 1998, Warren Buffet said (if not necessarily in this order), "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? If expenses shouldn't go into calculations of earnings, where in the world should they go?"
But Grandma, What a Big Bottom-Line You Have! : Segueing from Warren Buffett to his brilliant sidekick, Charlie Munger, I'd like to discuss a fable penned by him, which he disseminated at the annual meeting of Wesco Financial (WSC:Amex) in May 2001. Munger tells the story of a mythical company that had a wonderful business. Its expenses were mainly employee expenses. Then the founder died, and new executives came in to run the business. Obviously, this story predates Enron and a lot of the attendant flap, but you will not fail to be struck by its prescience, beginning with Charlie's description of the company's appetite for stock options: "This amazingly peculiar accounting convention had been selected by the accounting profession, over the objection of some of its wisest and most ethical members, because corporate managers by and large prefer that their gains from exercising options covering their employees' stock not be counted as expense in determining their employees' earnings."
New Forwarding Address: P.O. Box Purgatory : He goes on to say, "Fortunately, the income tax authorities did not have the same amazingly peculiar accounting idea as the accounting profession. Elementary common sense prevailed, and the bargain element in stock-option exercises was treated as an obvious compensation expense, deductible in determining income for tax purposes. Quant Tech's that's the name of his hypothetical company new officers, financially shrewd as they were, could see at a glance that given the amazingly peculiar accounting convention and the sound income tax rules in place, Quant Tech had a breathtakingly large opportunity to increase its reported profits by taking very simple action. The fact that so large a share of Quant Tech's annual expenses was incentive bonus expense provided 'a modern financial engineering opportunity' second to none." Finally, this wonderful little yarn concludes with a satisfying ending, in which the greedy company's spectacular success ends in implosion.
Munger's Fable Puts It On Buffett Table : With Warren Buffett and Charlie Munger as helpers in this, I would just like to sum up my objection to T.J. Rogers' article by saying that he basically protests too much. Options have meant a great deal to many people, but they also have distorted lots of financial statements. And, together with the Private Securities Litigation Reform Act, they have certainly created a lot of abuse. These things will have to change going forward if financial statements are going to mean something.
Intel Throws Fig Leaf Over Its (Up) Date : Turning back to our friend, the dead fish on Intel, I believe that there is a 0.0% chance that the company will be able to raise revenue guidance at the midquarter update. In fact, I think there's a better chance that, however small, they will lower it. In any case, his rationale is as follows: "Based on our belief that near-term business conditions are in line to slightly better than consensus expectations, as well as our belief that the company's earnings power will significantly increase in the second half of the year, we have upgraded our rating on Intel to Strong Buy from Outperform." (The italicsare mine.)
William Tell Shoots Quiver Through Intel Price Target : He then goes on to justify why he thinks the stock could trade at 45. This is word for word, and don't worry if you can't understand what he's saying, because I can't either. "Our 12-month price target on Intel suggests that the stock should be fairly valued at a P.E.G. of 1.5 times our estimate for the company's underlying earnings power at the end of 2003. This target would also assume that Intel can trade at seven to eight times the company's fourth-quarter 2003 revenue run rate, which is comparable to levels reached in the late 1990s, before the bubble-valuation highs of 2000." Well, I got news for him. The bubble valuations weren't high for 30 days in the year 2000. It was an ongoing process that lasted several years. So rather than using a completely and totally false reference point to justify some pie-in-the-sky beliefs and hopes, let's take a look at the videotape.
P/E Apogee Orgy : At the end of 1997, Intel had revenues of roughly $25 billion and managed to earn about $0.98. Last year, at the end of 2001, they had revenue of about $27 billion and managed to earn about $0.53. Want to know what the stock traded for at the end of 1997? $17.50. So, that was the market's view of what Intel was worth before things got totally out of hand -- when they were still growing and the PC market hadn't been saturated and the whole speculative orgy of technology was still in front of us. To think that it's worth a P/E of two or three times that now is the height of folly. But this is still what passes for analysis by the dead-fish community, even post-Enron.
Intel Severs Wires To Ingram Microphone : My view has been, and I stated this about a month ago, that I did not think Intel could make the revenue estimates that have been set for this quarter, in short because I believe that the parts channel was stuffed at year-end, in addition to the fact that there had been double and triple ordering. (Q4 units sold were a record. Think about what that means!) I believe that the PC market was stuffed by Compaq CPQ and Hewlett-Packard HWP , and I pay attention when the head of Ingram Micro IM says that there's no sign of life in the PC business and Dell DELL expects PC sales to be down this quarter. Given the decline in PC sales, given the fact that we had the aforementioned demand bulge, if you will, for Intel, and given what's going on in their non-CPU-oriented businesses, I think it's very difficult for them to make their midpoint revenue estimate of approximately $6.7 billion. I think that the next quarter is going to be even more problematic.
Misfortune Intelling Having said all that, I have absolutely no idea as to what they're going to announce when they give their guidance on Thursday. It's very difficult to predict what that management will do, because any problems within a quarter that have often been obvious to me tend to not be so obvious to them -- witness their past preannouncements in Q1in three of the last four years. So, there is plenty of precedent for them to have already set the bar too high. I believe that if they affirm their guidance, they will not make those revenue numbers, and of course they will have to take down Q2 as well, in my opinion. If they choose to lower the guidance now, that will make it easier for them later, but who knows what they'll do. What I do know, however, is that paying these prices -- whether you want to call it 60 times trailing earnings or 50 times next year's hopeful earnings -- it still boils down to something on the order of 10 times revenue for a company that sells into a saturated business, has got serious competition, and hasn't been growing. Ladies and gentlemen, it seems to me to be the height of folly, even if you believe the economy is coming back. I could lay out more reasons, but I think that's probably enough for now.
Poppycock : Lastly, yesterday I talked about a wonderful little piece of software called PopUp Killer, whose site had been working on Sunday. On Monday, however, the author of this software decided to pull the product because he's having trouble with new updates. My story about this ran for a while yesterday, and then we pulled it on the news that the site was down. For those of you who are interested in tracking the software, I believe it can still be found at here . If you go into their search and ask for PopUp Killer, you can download the software from them. I only bring it up because it's just the most wonderful piece of software, and trying to travel around the Internet without it is a real nightmare. |
