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Technology Stocks : Cisco Systems, Inc. (CSCO) -- Ignore unavailable to you. Want to Upgrade?

To: rkral who wrote (59732)	6/8/2002 12:32:09 AM
From: Stock Farmer	Respond to of 77400

Ron - I too disagree with your statements 2 & 3 For #2, You claimed "As shareholders, CSCO's earnings have been over-stated because the option grant expenses were not actually claimed as expenses". I'm with mindmeld here. This is not precisely correct: Cisco's EARNINGS have not been overstated. Earnings are precisely stated. Cisco's PROFITABILITY is overstated by its earnings to the extent that cost of options to shareholders are not reported. For #3, "As general taxpayers we, in the aggregate, are paying $1.4 billion of extra taxes to cover the CSCO's tax credit .. and very few people know about that, I suspect., well here again mindmeld is right & you're wrong. IRS got their slice. Can you maybe figure out how that worked? Hint: think EMPLOYEE INCOME TAX. The company gets a tax credit, employees pay a tax. At least for NQ stock options. ISO options shift more of the tax burden off the employee and onto the company. As for #2, the grant looks like the gift of a call option from the company to the employee. I say 'looks like a gift', because many of us see no money changing hands. But the reality is that there were two property transfers, cash flows if you will permit, that produced a net cash flow of zero. The call option has a value as evidenced by options trading on the CBOE. It's called an option premium on the open market. So what actually happened is the company gifted the option premium to the employee, and the employee used the gift to buy the call option. Where did this come from? What actually happens is what actually happens. The company gave the employee a stock option. Contracts are exchanged. But NO PROPERTY CHANGES HANDS. Your equivalence statement that the company gives employees a premium and then they go buy options on the open market is inaccurate. Firstly because it assumes that the options are created in the market and forgets about where the shares come from to satisfy the option in the market. Secondly, you may think that these are equivalent acts. But the IRS and most of the knowledgeable folks on the planet do not. Smart people USE descriptions like this to wake people up to the fact that there is a cost to shareholders from stock options. Not to show how the cost occurs. A more accurate proxy is that the company conditionally promises the employee the difference between market price and strike price at some time in the future of the employee's choice as a deferred compensation, having set aside a share to issue in satisfaction of this obligation, should it ever arise. If you care to work it through, you will see that this scenario also has equivalent tax treatment to stock options. Not surprising because this is the proxy by which the IRS taxes the parties. It goes like this. Company records a deferred salary cost in the period when it is paid, but issues non-cash payment in the form of a share minus the employee's contribution of cash in the amount of the strike price. This non-cash cost is reported to the IRS as something which reduces taxable earnings and thus decreases tax liability, giving rise to a "tax credit" with loss carry forward provisions that can be used to reduce taxes in subsequent years too. This non cash cost is not reported to shareholders, because it is a non cash cost and by a quirk of GAAP such reporting is not required. Employee records the difference between stock price and strike price as income and pays tax on difference in the period of receipt. Shareholders don't see this. This would all look very clear if you saw the tax books for the company. Where you and a host of people get confused is in the fact that one can buy and sell options and so assume that the option itself is property. But the option is a contract. When you sign the contract to lease a car, the contract is not property. The car is. Same with an option. In this case, what is property is the SHARE that underlies the option. The option is merely a conditional contract allowing the holder to purchase property at a specified price. The value of the property is subject to fluctuation with a generally upwards bias, which gives the contract speculative value in addition to the value of the property under consideration at the time that the contract is entered. And it is perfectly valid to recognize the commercial activity either (a) at exchange of contract, or (b) at exchange of property. The company and the IRS and the Employee all choose to use (b). What all the noise is about is that the company reports this cost to the IRS and does not report it to shareholders except as an obscure footnote that very few people understand, even if they get to it. Period. It gets more confusing because it is preferrable to record the cost to shareholders in the year in which management makes the decision. When the actual cost is uncertain because it depends on future stock price. Then there is this: Additionally, the option grant expense has nothing to do with earnings dilution. Earnings dilution is a different cost to shareholders. The grant sets the stage for potential dilution. Actual dilution occurs when the option is exercised. In the interim, the company reports the impact of the expected dilution as "diluted EPS". We have two different events, and two different times. The first is an expense to the company, the second is a cost to the shareholder You seem to be talking as though there is a cost associated with printing up instruments of grant. Yes, but it's very small. About $0.05 apiece given modern technology. Neither company nor shareholders gain or lose when an option is granted. Where they gain or lose is when it is EXERCISED. At the moment of grant one can ESTIMATE what this future event might cost. But that's all it is. Because the value of the employee stock option to the holder is either (a) zero, or (b) whatever they get when they exercise. Nothing in between. The option can not be sold. I challenge you to figure out how an employee generates cash from an option without either (a) letting it expire or be cancelled, in which case the amount of cash is known precisely as zero; or (b) exercising at some price P different from strike price S, in which case the amount is also known precisely as P-S. Or how a shareholder incurs cost other than under (b) above. Or, with the exception of photocopying costs how the company actually incurs a REAL cost. Ron, I suggest you go talk to a competent CFO and have him or her walk you through all of this. Or give someone at the IRS a call. You seem to be confused by the issue. Which is simply this: companies report options differently to the IRS than they do to shareholders. John

To: rkral who wrote (59732)	6/8/2002 7:50:29 AM
From: RetiredNow	Read Replies (2) \| Respond to of 77400

I can break the discussion of #2 into two very different categories. 1) What you and I believe should be happening and 2) what is happening. What we both believe should happen to reflect a truer income statement is for companies to expense stock options. I agree with that. But the reality is that GAAP doesn't require it. So what is happening it that the only two places we see it is in the disclosure sections (Notes to f/s) and in the fully diluted EPS. The reality is that most analysts on Wall Street derive their fair values on stocks based on PE rules of thumb on estimated EPS. That's not how I do it, but that's how they do it. Given that, I'd argue that Wall Street is not being fooled by options not being expensed, because it shows up in diluted EPS. BTW, I'm not most people. I have a very in depth knowledge of options etc. You can go back to the prolonged discussion John Shannon and I had moons ago on options and their effect on discounted cash flows. The truth is, my main objections to not expensing options is the different treatment under the IRS rules. I hate the dual books syndrome, because it is a fraud in my opinion. My belief is that we need to scrap the IRS rules for everything and start from scratch. They aren't fair and they make no sense. They are just a bunch of convoluted rules created by special interests that bear no resemblence to reality or reason.