TOWARD AN UNDERSTANDING OF STOCK BUYBACKS.
In Post # 3319, Michael Greene made a very interesting observation. He pointed out that a stock buyback at the option price transforms the cost of employee stock options effectively to an interest-free loan in the amount of the cost of the repurchased stock. This suggests that the stock buyback could limit the theoretical cost of an employee option to the after tax cost of interest on the loan. Since this cost is independent of stock volatility (assuming the holder of the option waits until expiration to exercise the option), a policy of stock buybacks appears to eliminate the need for option pricing to satisfy FAS 123.
Nothing is straightforward when dealing with options, and this is no exception. Under the assumptions of Black-Scholes, Michael is wrong. He neglected to account "theoretically" for the likelihood that the stock fails to outperform the cash equivalents over the option holding period, causing the stockholder to suffer a loss on the stock repurchased by the company, in addition to having to endure interest costs (or lost opportunity of funds). The Black-Scholes formula takes this into account, because it is neutral about the future direction of the underlying stock price.
With Black-Scholes assumptions, stock repurchases are unrelated to anticipated costs of options. Think of stock buybacks under Black-Scholes as a completely separate transaction presumably motivated by an irrelevant belief by management that the stock is undervalued.
Now, again let's get real. I might argue that some companies are efficiently priced, but not WIND. And with all the sales information available in a database to WIND managers concerning thousands of design wins and other developing deals, I certainly would expect key executives to know with near certainty whether the company will continue performing at above-average levels over the next two to three years. This means that Black-Scholes assumptions conflict with estimates key executives are capable of making today - much like a peek is better than a finesse in the game of bridge.
WIND management might realize that the chances of the stock appreciating less than the company's cost of money over a prolonged period of time is negligible. As a consequence, a stock buyback coincident with the granting of options will achieve the exact results described by Michael. Thus, in the real world, Michael's observation is entirely correct, and provides a foundation for understanding the implications of WIND's buyback program. If you look at WIND's track record for granting options, subtract cancellations, and consider the shortened length of time some employees hold the options, the after tax interest costs to underwrite the options through buybacks are, as Michael shows, tolerable.
With a program of stock buybacks, employees can still hit it big when the stock price jumps, but with a reduced burden on stockholders. Since there are no free lunches, you might wonder at whose expense do the employees benefit? The answer is past investors who failed to appreciate the value of the company, and sold shares cheaply back to WIND.
But if WIND management can see better than ordinary investors that the stock is likely to outperform cash equivalents, should stock repurchases be expanded for purely economic reasons? It depends, but unfortunately the answer is mostly no. It saddens and irritates me to say that, but its true. Let's look at the major reasons why.
Small companies never should allocate cash for stock if there is the slightest chance that a shortfall of cash may necessitate additional financing. This is one reason why it was strategically important that WIND followed through with a secondary offering two years ago, and completed the convertible bond offering last summer. First you fill up your coffers, then you decide how to allocate cash. WIND currently is positioned to use cash to transfer the cost of options away from stockholders and/or to purchase back stock at fire sale prices, as well as invest in technology.
But there are other considerations that tempers WIND's enthusiasm for repurchasing stock. For example, there might be conditions associated with the bond offering which restrict the use of funds. But the most noteworthy consideration is a requirement that a company may not aggressively purchase stock in the two years prior to a merger and be guaranteed of meeting criteria for the pooling-of-interests method. To be specific, the accounting standard APB Opinion 16, which governs criteria that dictate a pooling-of-interests merger, contains the following criteria, among others:
d. Each of the combining enterprises reacquires shares of voting common stock only for purposes other than business combinations, and no enterprise reacquires more than a normal number of shares between the dates the plan of combination is initiated and consummated.
(1) Treasury stock acquired for purposes other than business combinations includes shares for stock option and compensations plans and other recurring distributions provided as systematic pattern of reacquisitions is established at least two years before the plan of combination is initiated. A systemmatic pattern or reacquisitions may be established for less than two years if it coincides with the adoption of a new stock option or compensation plan. The normal number of shares of voting common stock reacquired is determined by the pattern of reacquisitions of stock before the plan of combination is initiated.
(2) ------
This means that any company that buys stock back erratically faces a burden of proof exercise to meet conditions for a pooling-of-interests business combination. Were WIND to engage in erratic buybacks, the company would become a less attractive acquisition candidate. It also would find potential acquisitions more difficult to justify on the basis of future earnings - because of the expectation that the acquisition may have to consummate using the purchase method. (Pooling-of-interests allows the "acquirer" to avoid making a charge to goodwill equal to the excess over book value of the price of the acquisition. Amortization of goodwill often sufficiently burdens future earnings that a failure to qualify for pooling-of-interests will kill the deal.)
Maintaining eligibility for this preferred form of acquisition overrides most other economic considerations, and effectively eliminates aggressive stock buybacks. Otherwise, if cash is freely available, then stock buybacks are justified whenever the market significantly under-values the stock. It makes no economic difference if stock is repurchased to offset dilution from employee stock options or just because the stock is believed to be cheap. The justification for repurchasing the stock in either case is exactly the same.
WIND management has never concerned itself with hiding dilutive effects of stock options. Share count grew predictably and steadily during the first couple of years after going public. Share count subsided for the fiscal year just ended due to repurchases of stock. But ask yourself, did WIND repurchase stock to diminish dilution, or did the company repurchase stock because they know it is cheap, and APB Opinion 16 requires that they use stock options as the excuse? HINT: Ron Abelmann reportedly said the stock is undervalued at the annual meeting. Ron is a realist, and he never made a statement like that before the company began buying back stock.
Allen |
