There is an interesting article in Forbes this month making the case once again why one needs to be very careful and skeptical with regard to reported cash flow from operations numbers. Often times much of this cash flow subsequently disappears to buy back stock options to offset dilution. For the same reasons, we should be leery of the free cash flow from operations numbers that Mike Buckley regularly presents on the moderated G&K thread. His adjustment of subtracting tax benefit from exercise of stock options fails to address problems with that number as well. The Forbes article appears below:
forbes.com
<<An Expensive Option
Elizabeth Macdonald, 08.16.04
As Silicon Valley tries to sidetrack a reform ending its free lunch of stock options, we found how much they cost investors in an often-ignored way: buybacks to mop up dilution.
The stock option war is heating up, and Silicon Valley thus far is winning the day. Under pressure from high-tech executives the U.S. House of Representatives in late July voted to defang a proposed accounting rule that would compel companies to count the value of employee stock options as compensation cost. The tech crowd, in particular, is addicted to paying workers with options because options get a free ride on the profit-and-loss statement. They aren't counted as a cost, either when they are awarded or when they are cashed in.
Too bad for the rule-making Financial Accounting Standards Board, which has been struggling for a decade to end this charade. The FASB wants option issuers to estimate the theoretical value of an option when it's granted and count that as a cost. Under present rules companies have to disclose these costs only in footnotes. The House vote was on a bill to limit options-expensing to a company's leading five executives. In the calculation of the expense figure, moreover, the company issuing the option could assume zero price volatility, which is absurd. If the House bill passes the Senate, the FASB would have to retreat.
A surface logic attaches to the argument of the anti-FASB lobbyists: A company doesn't lay out a single penny when granting options, and besides no accurate way exists to value them. So, in the words of Intel Chief Executive Craig Barrett, these are "imaginary expenses." Jeffrey Peck, spokesman for the International Employee Stock Options Coalition, which represents high-tech and biotech firms, sneers that "what the FASB is proposing is a really novel idea."
But the anti-FASB rationale falls apart if and when the options-granting does indeed trigger a cash outlay--to mop up the dilution from the employees' new shares. Companies pay huge sums to buy back stock and reverse the watering-down of earnings per share caused by employee options exercises.
Suppose that, when the stock is at $30, the worker gets an option granting him the right to buy a share at $30 anytime in the next decade. The immediate cash value of this piece of paper is indeed zero. But it might be worth, say, $8, that sum reflecting the probability that the stock will get to $40 or $50 before the option expires. One way to come up with the $8 figure is from the Black-Scholes options valuation model. The formula is controversial, but it does a pretty good job of predicting the prices of exchange-traded options.
Because this debate is too often treated as a philosophical abstraction, we are, with help from professor Charles Mulford, director of the Georgia Institute of Technology's Financial Analysis Lab, making it real with some concrete numbers. Eight of the heaviest options users on the Nasdaq spent $50 billion, or 24% of their cumulative $210 billion in cash flow from operations from fiscal 1999 through fiscal 2003, mopping up dilution from employee options, according to Mulford's analysis. (The mop-up cost he's counting is not the money spent on the shares but the excess of the amount spent over what the employees paid when they exercised the options.)
We examined five years instead of one to even out the irregularities in the timing of grants and buybacks--a company might issue options in 1998, see them exercised in 2000 and get around to the buyback in 2001. Mulford counted only shares bought back to undo the effects of options exercises, as opposed to, say, the effects of convertible bonds.
Imaginary expenses? No, that $50 billion was in hard cash. When the tech execs argue options don't cost a thing, says Lynn Turner, former chief accountant at the Securities & Exchange Commission, "they're out in la-la land."
Intel spent 18%, or $9.7 billion, of its operating cash flow over the five years to take care of dilution from its stock options. Biotech firm Amgen spent 38% of its $10 billion in operating cash, Dell, 39% of its $19 billion. And although Microsoft dumped its option program in favor of stock awards in September 2003, it still needed to spend 29% of its $71 billion in cash from operations to take care of stock options over the five-year period. All but one company, Cisco Systems, are chronic repurchasers. Cisco started only two years ago.
Now these buyback outlays are not hidden from shareholders. They show up on the "flow of funds" page that follows the P&L. At the top of the page is the cash flow from operations, consisting for the most part of profits with noncash depreciation charges added back. Next comes cash flow from financings, which includes money raised or spent in the issuance or repurchase of shares. The footnotes show how much employees spent exercising options ($30, in our example) along with corporate money spent buying the shares back (at $40 or $50 or whatever).
The Internal Revenue Service has to contend with the same accounting issues on corporate tax returns. Rather than haggle with corporations over the theoretical economic value of an option when it's granted, it allows a compensation deduction if and when the option is exercised. The deduction is the spread between the exercise price and the market value at the time of exercise. These tax deductions are worth lots of cash to the employers. Last year they cut Microsoft's tax bill by $1.4 billion. Joseph St. Denis, senior director at Fitch Ratings, a Wall Street credit ratings firm, says that since the tax benefit goes into the cash-from-ops figure, that's all the more reason for the option buyback cost to go there, too.
The table (below) lists eight options addicts. Alongside the cash mop-up costs we indicate the effect FASB-style expensing would have had on earnings over the five years. These figures come courtesy of Jack T. Ciesielski, publisher of the Analyst's Accounting Observer, a newsletter. He gleaned them from the disclosures companies make in footnotes mandated by the FASB.
While tech companies quibble about the validity of Black-Scholes pricing, most agree with the Mulford math on the impact on operating cash but decline further comment. While Dell doesn't dispute the analysis either, it notes there's a payoff in strengthening and stabilizing its staff. The computer maker has been doing options-related buybacks since 1996.
Intel spokesman William Calder says Intel's stock repurchases over the last ten years outstripped its exercised options, with 1.7 billion shares bought back, while employees exercised only 857 million options. Mulford points out that Intel will still have to keep the buybacks going, given its love of options. Peck, of the high-tech coalition, admits that there really is a big cash expense from buybacks related to option exercises. Still, he adds, "We believe the cost is properly reflected in dilution." You'll eventually feel the pain of employee costs when your profits get diluted away, so why remind yourself of the damage now?
Costly Cleanup
Stock buybacks to take care of dilution from exercised options can be a pretty expensive enterprise. Here is the cumulative cost of such buybacks covering fiscal 1999 to fiscal 2003; 2004 disclosures did not have enough information on options exercises.
Company Buyback Hit to Options cost
cost* cash from as share of
($mil) operations earnings**
Adobe Systems $579 30% 57%
Amgen 3,823 38 18
Cisco Systems*** 744 6 67
Dell 7,421 39 29
Intel 9,665 18 16
Microsoft 20,317 29 22
Oracle^ 5,368 37 13
Sun Microsystems 2,242 22 NA
*Five-year total: cash paid to buy back stock to cover exercised options, minus employees' payments to purchase the stock. **Sum of five years' cost of options, divided by the sum of five years' earnings. ***Cisco has bought back stock for only two out of the five years. ^Through May 2004, when its fiscal 2003 year ended. NA: Not applicable; Sun Microsystems had no net profits for this period. Sources: Georgia Institute of Technology's Financial Analysis Lab; Analyst's Accounting Observer. >>
Thanks to Mick Mormony for posting this article. |
