Nice article on the structural damage caused by employee stock option plans in tech companies:
interactive.wsj.com
Heard on the Street
Liberal Use of Stock Options
May Swamp Tech Investors
By ROBERT MCGOUGH
Staff Reporter of THE WALL STREET JOURNAL
What should a successful technology company do with its earnings? Many
investors would say it should reinvest in its business to promote growth.
Few would say that it should pay dividends, which are distinctly out of
style.
And then there is this business model: A booming technology company
should issue millions of shares to employees through stock options, then
spend ever-higher levels of its earnings buying back stock, so it can go out
and issue even more millions of shares to employees.
Perhaps this business plan sounds more like a gerbil running on an exercise
wheel than a recipe for business growth. Nevertheless, it is an increasingly
familiar scenario at any number of companies, according to a new study of
stock options of companies in the Standard & Poor's 500-stock index.
The study, by UBS Warburg economist Joseph Carson, found that the
volume of gains on employee stock options is indeed vast, and so
concentrated in the technology sector, that it raises questions of how these
firms will cope.
To Mr. Carson, some technology companies will face a huge drain on their
resources if they try to buy back enough stock to offset the flood of
employee stock options washing their way, as many technology companies
have done. "Clearly they're spending money on labor that could have gone
into other forms of investment that would make their companies stronger in
the long run," he says.
What if the companies don't buy back stock to offset the shares issued to
employees? Then "dilution is a problem," he says, as per-share earnings
are reduced -- not by lower income, but by the swelling number of shares
across which that income is spread.
Despite the rocky stock market of the first half of this year, Mr. Carson
found that the net gain on stock options for companies in the S&P index
has surged dramatically, to $570 billion as of June 30, from $316 billion a
year earlier, according to data from annual reports and June 30 stock
prices. Specifically, net gain is the total market value of outstanding options
($893 billion as of June 30), less the cost of exercising the options ($323
billion).
Even among S&P 500 companies, options are becoming a huge factor in
overall pay. The $570 billion net gain in options was equal to 14.6% of
wages and salaries paid by the companies in the S&P 500, up from 8.4%
a year earlier.
As big as the gains are for the S&P 500 overall, it is the gains among
technology companies that are really eye popping. Of that $570 billion
figure, $330 billion belongs to the technology sector. The gains are even
more concentrated: Six technology companies account for $180 billion.
The half dozen: Microsoft, Cisco Systems, Yahoo!, America Online, Sun
Microsystems and Broadcom.
Now, here comes an interesting comparison from Mr. Carson. The
reported earnings for these six companies in 1999 totaled $12 billion. He
notes that the net cost to buy back enough stock to offset these options is
"more than 15 times what they earned collectively in the year."
Some companies mentioned in the report point out, quite accurately, that
stock options typically vest over periods of as long as five years -- and
may be exercisable over periods as long as 10 years -- so this stock won't
cascade onto the market immediately. In the meantime, if all goes well,
earnings and cash flow, which usually exceed profit, will keep rising. For
instance, the profit Mr. Carson used for America Online was the $762
million it reported in June 1999. Recently AOL reported fiscal 2000
earnings of $1.2 billion. (Mr. Carson didn't calculate cash flow in his
report.) Still, the cascade of stock being triggered by employee stock
options looks pretty big in relation to earnings.
Of course, the biggest reason for buying back stock is to offset what is
being issued to employees and prevent dilution to existing shareholders.
Dilution, in this context, means a smaller share of the corporate pie. If you
and your sister alone own the family business, and suddenly your uncle gets
an equal share as well, the value of your holding has gone down by a third
-- particularly if the uncle adds nothing to the enterprise to get that stock.
In some instances, though not most, the potential dilution from employee
stock options can be almost as dramatic. Broadcom has issued stock
options to employees that add up to 28% of its shares outstanding, the
company says. Employees do, in fact, pay money to exercise the options
-- unlike the uncle in our example -- but they pay far less than the market
value of the stock. That discount is what makes the options so valuable.
Not all companies are committed to buying back stock. Microsoft did so
for a long time, but it isn't buying back shares currently and doesn't plan to,
according to John Connors, the software company's chief financial officer.
Microsoft put share buybacks on hold this year because it bought a
company, Visio, in a "pooling of interest" transaction, which temporarily
inhibits share buybacks. Though some interpretations of accounting rules
would allow Microsoft to start buying back shares this summer, Microsoft
says that isn't in the cards.
A spokeswoman for Microsoft adds that the software company is
managing the number of options-related shares overhanging its stock, and
that the current overhang, representing about 15% of shares outstanding as
of June 30, is lower than it was three years ago.
A Cisco spokesman says the switch maker doesn't buy back stock, and it
isn't concerned about dilution because shareholders continue to approve
the issuance of more shares and because its financial results have been, in
the spokesman's word, "amazing."
Yahoo also says it doesn't buy back stock, and notes that it has been
expanding through acquisitions. A spokesman for America Online confirms
the statistics cited by Mr. Carson, but declines to discuss the study in
detail. Sun Microsystems says it does buy stock each quarter, but that it
doesn't think stock buybacks will pose a financial burden.
Money managers who are fans of technology stocks say that, yes, dilution
from options is a concern, but the picture isn't as dire as Mr. Carson
paints. The "scariest view" of stock-option issuance is that it's "kind of a
Ponzi scheme, which I don't really believe it is," says Jay Tracey, chief
investment officer at Berger Funds. "If you're able to attract highly talented
people" via stock options, "and, by virtue of your success, enjoy
stock-price appreciation, you have the virtuous cycle working for you.
Good people stay and work harder to do better." Still, Mr. Tracey says,
"Anything that's a cycle can be virtuous or vicious. Maybe the right way to
look at it is that it leverages the game."
David Brady, manager of $1.4 billion Stein Roe Young Investor Fund,
says he does fret that if employees start to sell their massive holdings, it
wouldn't augur well for the companies' prospects, and it would put selling
pressure on the stock.
What of the argument, proffered by some fans of options, that
shareholders have approved the options plans? That isn't always the case,
says Eric Roiter, general counsel at Fidelity Investments, who worked on a
New York Stock Exchange task force that proposed changes in
regulations relating to the approval by shareholders of options plans. Under
various scenarios, it is possible to craft options plans without getting
shareholder approval. While he says Fidelity is generally supportive of
options plans, "at some point there is the risk of dilution."
Brian Clifford, a manager of the $200 million SunAmerica Growth
Opportunities Portfolio, says a big overhang of stock issued to employees
can be a worry, but that, on the whole, options have been beneficial. "It's a
vital tool for these companies to attract and retain these key personnel," he
says.
Mr. Carson doesn't necessarily disagree. But he is a stick-in-the-mud who
feels that, if options are indeed a compensation expense-one not deducted
from income under current rules-then technology companies aren't as
profitable as they would appear to be. |
