Money Manager Whitney Tilson, wrote a 3 part stock option article last summer, Let's see what he's got to say about
ESOP's(Employee Stock Option Plan). His focus is Dell for his insightful article.
I've been meaning to post this since I cited it last summer.
I'm bad -g- Dell's spokesman TR Reid, responded last year that "stock options are the norm in his industry".
We've seen that their was an explosive growth in ESOP's in the 1990's and it helped to create the accounting techniques that are now coming under greater scrutiny.
This situation of greater scrutiny and Congressional hearings and legislative proposals to modify the tax, accounting and financial practices has occurred with great cyclical repetition over the years, after periods of great investor speculation in financial markets.
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The New Fundamentals
The High Cost of Dell's Stock Option Program
By Whitney Tilson
Special to TheStreet.com
6/26/01 1:44 PM ET
URL: thestreet.com
After owning Dell (DELL:Nasdaq) stock for many years, I sold the last of it in January because I am not sure how much -- if any -- free cash flow Dell is really generating for shareholders. Those last two words are critical, because even with the slowdown in PC sales, Dell is undoubtedly generating robust free cash flow. But a great deal of it appears to be going to management and employees, in the form of stock options, rather than to common shareholders.
Dell spokesman T.R. Reid responded to my questions by noting the company is in an industry in which stock options are the norm. "It is highly unlikely the company could have achieved such high rates of growth over time, and resulting shareholder value, without stock-based compensation as a tool for recruiting, providing incentive to and retaining literally tens of thousands of employees," he said. Stock options, he added, have allowed Dell to take a relatively conservative approach to other compensation.
I agree that Dell's stock option program is necessary, but investors should carefully consider its true costs, which don't appear on the income statement.
This issue is not unique to Dell. As a recent article in Fortune notes, many companies, especially those in the technology sector, issue large numbers of stock options to employees. Similar arguments could be made for other companies that issue large numbers of stock options to employees -- that includes most companies in the technology sector, and many companies beyond it as well.
The Data
This chart shows Dell's free cash flow and amount spent on share repurchases on the left axis, and the year-over-year change in diluted shares outstanding on the right axis:
(they intersected)
Dell's Balancing Act
Is Dell's stock buyback program shareholder-friendly or not?
(Note: All numbers are in millions of dollars. Free cash flow is cash flow from operations, minus depreciation and amortization, which I use as a proxy for maintenance capital expenditures. I did not subtract cap ex, because this would penalize Dell unfairly for its investments in growth. Normally, I also subtract "tax benefits of employee stock plans," which in my opinion have nothing to do with operating activities, but I have not done so here because free cash flow is being compared with amounts spent repurchasing shares resulting from those same employee stock plans.)
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Dell generated healthy free cash flow, totaling $10.8 billion, in the 13 quarters covering fiscal years 1999, 2000 and 2001, plus the recently reported first quarter of fiscal year 2002. (This figure significantly exceeded net income of $6 billion during this period, demonstrating how the company's direct model combined with effective working capital management -- not to mention $2.6 billion of tax benefits of employee stock plans -- enhances its cash flow.) Dell used 56% of its free cash flow over these 13 quarters to buy back its own shares, which can be a shareholder-friendly action.
This sounds great, but there are two problems with what is happening. First, it is unclear whether Dell's share repurchase program in the past few years has been creating or destroying shareholder value. The stated purpose of the program is to offset the dilution due to Dell's stock option program, but that's not necessarily a good thing. As Warren Buffett wrote in his 1999 annual letter to Berkshire Hathaway shareholders, "There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds ... and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated."
Dell has had plenty of cash in recent years, but was the stock really trading below conservatively calculated intrinsic value above $40 and even $50 within the past year? If not, then Dell was destroying shareholder value when, for example, it spent $2.7 billion in FY 2001 buying back 65 million shares at an average price of $41.54. Dell continues to spend nearly all of its free cash flow to buy back shares in the belief that, according to Reid, "We don't think we're a $24 to $26 stock long term." Current and prospective Dell investors will have to decide for themselves whether they think this is a good use of Dell's cash.
The second problem is that Dell is getting less and less bang for its share repurchase buck. Let's look at the data for each year:
In fiscal year 1999, Dell spent $1.5 billion on share repurchases, equal to 65% of free cash flow. Consequently, diluted shares outstanding fell by 2.6% during the year, which is exactly what a shareholder would like to see (not to mention that the stock nearly quadrupled).
In fiscal year 2000, Dell scaled back its share repurchases to only $1.1 billion, or 28% of free cash flow. Wise move, given the stock's lofty valuation -- it traded at a price-to-earnings ratio above 70 for much of the year -- but consequently, the share count only fell 0.7%.
In fiscal year 2001, as the stock fell dramatically, especially in the second half of the year, Dell ramped up its share repurchases to $2.7 billion, equal to 68% of free cash flow. Yet the diluted shares outstanding rose 1.9%.
The trend continued in the first quarter of fiscal year 2002, as Dell spent 99% of its free cash flow buying back shares, yet the share count rose 0.7%.
Stock Options
Wait a second! How could the share count be rising when Dell is spending so much on share repurchases? Can you say stock options? Like many companies, especially those in the technology industry, Dell issues a large and increasing number of stock options to its management and employees.
Last year, as Dell's stock price fell, many options became worthless because they were struck at much higher prices. This is demoralizing to employees and no doubt made the company nervous about retaining its talent. So what did Dell do? It more than tripled the number of options granted in fiscal year 2001 vs. fiscal year 2000 from 50 million to 154 million. (This information is in the fiscal year 2001 10-K under Note 6 of the Notes to Consolidated Financial Statements.) It's not surprising, therefore, that Dell's share count rose despite the massive buybacks.
Reid at Dell notes the jump in stock options granted last year was due partly to many new employees and also to a special double option grant. However, unlike regular options, which begin vesting immediately, the extra options don't begin vesting for two years (all options vest over five years). Reid said the recently granted options are neither vested nor in the money, so the stock price will have to rise over time for them to be worth anything, thereby aligning Dell employees' incentives with those of shareholders.
By my calculations, had Dell wished to keep its share count steady in fiscal year 2001, it would have had to buy back 52 million more shares (on top of the 65 million shares it purchased for $2.7 billion). Using this average price of $41.54 per share, Dell would have had to spend an additional $2.2 billion, for a total of $4.9 billion. Obviously, this was not feasible given that free cash flow was only $4 billion.
Implications
Even though the cost doesn't appear on the income statement, stock options are clearly a form of compensation, and there is a real cost associated with them. Let's say a company spent 100% of its free cash flow buying back shares, yet the share count remained constant. Isn't this just a compensation expense, and therefore in this scenario the company generated no free cash flow for shareholders?
At Dell, the situation was even more extreme last fiscal year: Had it spent 100% of its free cash flow on buybacks, the share count still would have risen 0.8%. Thus, one could argue that Dell had negative free cash flow for shareholders last year.
To some extent, this analysis penalizes Dell for having a stock that's done well over time (though obviously not in the past year or so). The dilution that took place in fiscal 2001 was due mostly to stock options granted many years ago, when the stock was at a much lower price. Had the stock done badly, then many of the options would have expired worthless and the company also would have been able to buy back more of its shares for the same amount, but shareholders would, of course, be worse off today.
Is there another way to measure the cost of stock options? (Click here to read more of this article.)
PART II
6/26/01 1:42 PM ET
URL: thestreet.com
Principles for Accounting for Stock Options
So what is the best and fairest way to account for the cost of stock options? Let's start with two principles.
First, the cost of options should be treated as a compensation expense, and appear on the income statement. As Warren Buffett asked in his 1998 annual letter to Berkshire Hathaway shareholders: "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
Second, the cost of options should be calculated based on their value at the time they are issued. Let's say a company issued options and then the stock did poorly, such that the options expired worthless. Does that mean the options had no value when they were issued? Of course not. Had the company initially sold the options to investors rather than giving them to employees, it would have raised cash that could have been reinvested in the company, paid out to shareholders as dividends, etc. Similarly, if the stock did exceptionally well, such that the options became extremely valuable, is it fair to go back and deduct this high "cost" from a company's earnings? Of course not.
So why doesn't the Financial Accounting Standards Board, or FASB, require this? Primarily because options are difficult to value -- not to mention the enormous opposition from companies that use options (and benefit from the bogus accounting for them). So the FASB compromised and, beginning with options granted in 1995, required all companies once a year in their 10-Ks to estimate a value for the stock options issued (using the Black-Scholes model) and show what earnings would be had this expense appeared on the income statement.
Here are the data Dell reported in its most recent 10-K.
Dell's Calculation of Its Stock Option Costs
FY 99 FY 00 FY 01
Reported EPS $0.53 $0.61 $0.81
EPS deducting stock option expense 0.48 0.53 0.65
% decline 9% 13% 20%
Source: Dell's fiscal 2001 10-K
(go to url for charts)
The table shows that Dell's earnings last year would have been 20% lower (equal to $620 million before tax and $434 million after tax) if the cost of stock options had been expensed, and that this percentage has been rising rapidly.
Adjusting earnings to reflect the cost of options would have a material impact on Dell's price-to-earnings ratio. Analysts are projecting Dell's earnings this year at 70 cents a share, giving the stock a P/E of 34.6 (based on Monday's closing price of $24.25). If we reduce earnings per share by 20%, however, the P/E jumps to 43.3.
This table shows how much earnings per share would have declined for some other representative, widely held companies last year, had the cost of stock options been expensed.
Options Haircut
How much earnings would decline if stock option costs were expensed
EPS Decline
General Electric -2%
Intel -7%
Oracle -9%
IBM -10%
Microsoft -13%
Sun Microsystems -16%
Starbucks -29%
Cisco -42%
Compaq -67%
eBay* -317%
Yahoo!* -2017%
* Had the cost of stock options been expensed, eBay's EPS in FY 00 would have been -36 cents vs. the reported 17 cents and Yahoo!'s would have been -$2.30 vs. the reported 12 cents.
Source: Companies' most recent 10-Ks
All the figures shown above are based on estimates calculated using the Black-Scholes option valuation method, as required by the FASB. This approach, in my opinion, significantly understates the true cost of options. Consider that many companies reprice options or make special, extra option grants if their share price falls (Dell and Microsoft, among others, did the latter last year), which has the effect of greatly reducing the risk that options granted to employees might expire worthless. Also, the cost of options is spread over the vesting period. In Dell's case, for example, "the Black-Scholes value at the date of grant is assumed to be amortized over the vesting period [five years], subject to revisions for later forfeitures," according to a spokesperson. This makes sense, but keep in mind that spreading out the cost has the effect of understating the true cost of Dell's massive option grants last year, which were more than triple those of the previous year.
Finally, the Black-Scholes model is dependent on the assumptions that companies make, which may not be 100% accurate. For example, Dell assumes that the "expected term" of the options it grants is five years, though they don't expire for 10 years, because, according to a spokesperson, "our experience indicates that options generally are outstanding only for five years when you factor in historical exercise and forfeiture actions." But will the future look like the past? Until recently, Dell's stock went pretty much straight up for a decade, which undoubtedly led employees to exercise their options long before expiration. But if Dell's stock were to be flat for the next five years, employees could still wait another five years for the stock to rise before they expired worthless. The difference in value between five-year vs. 10-year options is substantial. For example, according to Bloomberg, a 10-year Dell call option at today's price, using volatility of 54.85 (Dell's assumption in its most recent 10-K) is worth 35% more than an identical five-year option ($16.88 vs. $12.46).
PART III
URL: thestreet.com
The True Cost of Options
So what are stock options really worth?
A precise answer is impossible, but at last year's Berkshire Hathaway annual meeting, Warren Buffett said that for non-dividend-paying stocks, his standard rule of thumb is that an employee option is worth one-third of its exercise price (typically, this is the market price of the stock when the option is granted). Fortune also uses this "unscientific but common practice" in its must-read article on stock option accounting.
Let's use this estimate to figure out roughly how much the 154 million options Dell granted last year were worth. We don't know exactly when the options were granted during Dell's last fiscal year (Jan. 31, 2000, to Feb. 2, 2001), so we don't know their average price. But the stock's range was $16.63 to $58.13, the average price for the shares Dell repurchased was $41.54 and the average stock price during the fiscal year, according to Bloomberg, was $38.23. It's tempting to use the latter figure, but it's probably too high because many of the options were likely granted after the stock had fallen quite a bit, so let's use a number at the low end of this range -- say, $25. So, 154 million options times $25 times 1/3 is equal to $1.28 billion, which is more than double the $620 million pretax figure that Dell reported in its 10-K.
The difference is mostly because Dell spreads the cost over the vesting period, which is perfectly legitimate. In my opinion, however, the options granted last year should be expensed against last year's earnings, adjusting for anticipated forfeitures (which the one-third-of-the-exercise-price estimate already factors in). Thus, $1.28 billion minus tax is $898 million, which would reduce Dell's reported net income by 41% (rather than the 20% reduction Dell reported), making its current P/E ratio a rich 58.7.
A 41% earnings haircut doesn't surprise Scion Capital's Michael Burry, who says: "As a rule of thumb, when I look at tech stocks that rely on options compensation to a great degree, I start with a 30% downward adjustment to earnings per share. In many cases it turns out to be much more than that."
Conclusion
Many smart people have been beating their heads against a wall on this issue for years, and I still haven't seen the perfect solution. But a reasonably accurate estimate using the technique I've outlined should work just fine. As Buffett said: "It's better to be approximately right than precisely wrong."
The takeaway here is not that one should always avoid the stocks of companies that issue lots of options. Rather, the key for investors is to be aware of the impact of large stock option grants when evaluating a stock, and make appropriate adjustments. |
