TO ALL: Thoughts on employee stock options.
There has been no response to my inquiry to the company on employee stock options. However, I have been thinking about this and doing "what if" calculations. As a result I have resolved this issue to my own satisfaction. The following comments and conclusions involve some assumptions and value judgments and therefore you may not end up where I am. For what it is worth here are my thoughts.
The FAS 123 restatement of earnings in the 10K serves a useful purpose in reminding us that there is an employee compensation cost which is not recognized in reported earnings. The imputed compensation cost, however, is just the current value of the options at the time of grant and is therefore not an accurate measure of the actual financial impact that occurs upon exercise (or cancellation for that matter).
In order to assess this impact let's assume that an employee received an option four years ago with an exercise price of $10 and that today's market price is $40. He is now exercising this option. The $30 difference between the market price and the price which he pays for the share represents taxable compensation to him and a tax deductible expense to the company. What is the impact upon the company and current shareholders when this option is exercised? Let's look at two scenarios. The company has the option of issuing a new share or one which has been repurchased.
If a new share is issued the company receives the $10 exercise price plus a tax saving. The $30 which is deductible by the company will, at a 40% corporate tax rate, result in a $12 tax saving. Thus the company ends up with an additional $22 in the till and there is one additional share outstanding. (Point of reference -- current book value is about $4/share.) Question - if the share price had soared to a much higher level would current shareholders suffer a loss from exercise of this option? No, there is still a one share dilution but the cash inflow is now increased from the larger tax benefit.
Alternatively, the company could buy the share on the open market rather than issue a new share. Let's ignore issues about the timing of the repurchase and assume that the share is bought at the time of exercise at $40. The company now spends 40 for the share and receives 10 from the exercise. It still has the tax saving of 12 so the out-of-pocket cash drain is 18 and the share count is unchanged. What would be the effect in this case if the share price had soared to a much higher level prior to exercise? There would be an increased cash outflow, after the tax benefit, equal to 60% of the price increment.
Should WIND issue new shares or repurchase shares to meet option exercises? Alan Benn and others on the thread have put forth the opinion that it is desirable for a company to buy back shares when they are significantly undervalued but not when the purpose is just to inflate EPS. I share this viewpoint. More importantly, at this early stage in the development of the embedded market, gaining market share is crucial and WIND should be spending whatever is necessary to maximize its market share and not using cash for share repurchases unless the price is compelling. There is also a practical restraint. WIND's free cash flow (operating cash flow minus necessary capital expenditures but excluding the one time land purchase) in FY98 was roughly $30 million. As of January 31, 1998 there were 1,735,000 options vested and exercisable at an average exercise price of 5.56/share. At our arbitrary market price of 40/share the cash outlay after tax benefit to purchase these shares would be $35 million. There were an additional 2,693,000 options granted in past years but not yet vested with an average exercise price of 26.75/share. An additional cash outlay of $21 million would be required in the future to purchase shares to cover the exercise of these options at a market price of 40/share but the cost could be much more if the share price rises. Then there is the issue of on-going option grants (almost two million last year) for an expanding number of employees. The bottom line is that, in addition to being undesirable, it is not practical at the current rate of option grants for WIND to fund option exercises through stock repurchases from free cash flow. The large majority of option exercises has been and will continue to be funded with newly issued shares. WIND's stated policy is to spend a modest $2.5 million per quarter on stock repurchases.
ANALYSIS
What are the long term implications of this on-going dilution to current shareholders? I have run calculations using a number of different sets of assumptions. To my surprise even pessimistic assumptions about the rate of dilution did not lead to uncomfortable investment returns. The overriding concerns for shareholders remain the rates of growth in revenue and earnings and what value investors will be willing to pay for this growth.
Just for illustrative purposes let's take one middle of the road set of assumptions to see what happens. Assume 40% growth in both revenue and net income and a constant P/E of 40. We are not privy to the company's plans for future option grants and in past years they have varied widely, however they have averaged about 7% of the previous years shares outstanding so let use this. Assume that 20% of these grants will be canceled due to employee turnover and the remainder will be exercised uniformly over their remaining life after vesting. Note that the years of delay between grant and exercise reduce the ultimate rate of dilution because of the increased share base in the interim. Let's further consider the convertible notes to be a "done deal" (i.e. they are converted into shares at $48.50/share) and roll the 2.89 million shares into our current share count. This will avoid confounding this source of dilution with the option dilution effect which we are trying to understand. Given this particular set of assumptions, over the long haul, the share dilution from options would, on average, reduce reported EPS by 3.7% year to year. This effect would be cumulative. For example, if EPS grew at 40% with no dilution the increase over 5 years (1.4^5-1) would be 438%, e.g. 1.00/share would grow to 5.38/share. With dilution the EPS increase over 5 years (1.4^5 x 0.963^5-1) would be 345%, e.g. 1.00/share would grow to 4.45/share, a 35% CAGR. For any given year though, depending on the amount of vested options exercised, the dilution impact on EPS could be less or considerably greater than 3.7%. Under these assumptions the balance sheet remains very strong over the long haul with a substantial growth in the cash account. This, of course, is only one of an infinite set of assumptions. If we reran the calculations with a grant rate of 10%, rather than 7%, of the previous years outstanding shares the resulting CAGR for EPS would only drop from 35% to 33.8%.
How about the quality of the reported EPS? Quality is compromised because of the overstatment of earnings resulting from the delayed payment of compensation. These compensation costs, paid via shareholder dilution, do not show up in earnings reports until perhaps six or seven years after being incurred. Does this make any difference? It seems to me that this question cannot be easily answered but could have a significant effect upon share price. Quality of earnings is not a hot button for investors today but it has been in the past and could become so again resulting in a reduction in the multiple that they will pay for reported earnings.
CONCLUSIONS
I performed this rather rough and simplistic analysis in order to determine whether or not I, as a shareholder, should be greatly, moderately or not at all concerned about the impact of employee option grants on shareholder value. My bottom line is that I am only mildly concerned by what I see. The company's performance has been outstanding. They have consistently been out in front of the new developments in the embedded world not playing catch up. The financial execution has been consistent and strong. Although the number of option grants appears to be on the rich side, if the company continues to execute as it has, there will be very attractive returns for shareholders as well as employees. The only change that I am making as a result of my analysis is to reduce my opinion of fair value by 10 to 15 percent and thus what I would be willing to pay for additional shares.
I do not expect everyone to agree with the above but it has satisfied my needs. I would be interested in seeing other analyses and conclusions.
Regards, Michael
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