Must read article on stock options courtesy of street.com;
Silicon Valley: Peeking Behind Oracle's Numbers
By Medora Lee
Staff Reporter
10/6/98 3:46 PM ET
SAN FRANCISCO -- What goes around, comes around.
There was a time when employee stock options were a relatively cheap way for technology companies to reward staff without hurting the bottom line. Now as stock prices decline and companies squeeze every revenue stream for profitability, these plans become more troublesome.
Oracle (ORCL:Nasdaq) looks like one of the biggest culprits in the stock options scheme. Just last month, the database giant beat analysts' expectations for the fiscal first quarter ended Aug. 31. It reported 20 cents earnings per share, or EPS, four cents better than First Call's consensus estimate.
That sounds good, but no cigar. Take a step back and look at Oracle's annual report filed in July. It reported fiscal 1998 diluted EPS at 81 cents, flat from 1997 (adjusted for stock splits). But on closer inspection, if the fair value of all stock options is included, Oracle's EPS actually declined about 11% to 66 cents from 74 cents in 1997.
"The whole employee options issuing gives an illusion of profitability that's false," says Bill Fleckenstein, hedge fund manager at Fleckenstein Capital in Seattle, who says he is short most technology stocks in his $70 million fund. Rather than expensing salaries, companies issue stock options, which are later converted into stock and dilute the company's equity holdings.
Oracle is not alone. A recent TSC story highlighted the situation at Cisco (CSCO:Nasdaq). Some of Oracle's competitors are not innocent either. Microsoft's (MSFT:Nasdaq) EPS would have been 20 cents lower at $1.47 in its June fiscal 1998 year, adjusted for stock splits. PeopleSoft (PSFT:Nasdaq) would have earned 31 cents, down 13 cents from its reported 1997 EPS. J.D. Edwards (JDEC:Nasdaq) would have earned 35 cents instead of the reported 39 cents in its October fiscal 1997 year.
Under pressure from the Securities and Exchange and Commission last year, companies are now required to state in annual reports what earnings would be if all outstanding stock options are accounted for, but the disclosure is often buried in the notes of financial statements.
Oracle stands out because over the past few years the company has seen a greater percentage of its earnings tied up in stock options compared with rivals.
Based on employee stock options, Oracle's fiscal 1998 earnings would have decreased 18.5% from what the company actually reported. This is a sharp increase from the decline of 5.6% that such a dilution would have caused in 1997. An Oracle spokeswoman says the company has a policy of not talking about employee stock options.
Some analysts watch these figures for possible dilution effects or potentially huge expenses that a company will have trying to cover the options.
Tom Hensel, an analyst at Everen Securities, defends Oracle by pointing out that Oracle took a one-time, $167 million charge for an acquisition in 1998 that depressed earnings. To make a fair comparison, he says, that charge must be added back in, which would give Oracle pro forma diluted earnings of 82 cents.
But Hensel, whose firm has not underwritten for Oracle, also notes that in March Oracle adjusted a fifth of its options down to market value after December's profit warning knocked the company's shares from $32 to $22, citing the need to hang on to employees in a competitive market.
"I consider that a no-no," he says. "But at least they didn't do it with the executives and only with some in the rank and file. So, the dilution effect wasn't huge. But I still think it seems unfair to the shareholders who might have bought the stock at $35."
Last month Ciena (CIEN:Nasdaq) was forced to reprice employee stock options, as its stock tumbled.
More problems could arise if employees, fearful of a long bear cycle, start to demand real compensation, Fleckenstein says. "The problem with [paying employees with stock options] is that when the stock goes down, employees have nothing. It will become a huge problem for companies if employees start to demand cash, not paper."
But Hensel is also concerned when stocks are climbing. "Microsoft had a big problem when its stock kept rising because it cost more to buy the stock needed to cover the options," he says. "That was why it had to keep selling puts and warrants to hedge."
German software company SAP (SAP:NYSE ADR), which also faces general European aversion to stock options programs, avoided the debate all together by opting instead for a worldwide "stock appreciation right" program earlier this year that regularly pays a bonus based on the amount SAP shares appreciate from a specified base.
"It's a cash-based program so it affects our profit and loss and is immediately reflected in earnings per share," says Bill Schwartz, vice president of human resources at SAP. "Because it's also not an equity grant and there are no shares reserved for employees, there's no dilution of shares."
Damned if you do, damned if you don't.
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