An interesting article on the potential impact of stock option accounting...
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From todays Daily Reckoning...
[Sorry for the length...In the interests of full disclosure I have no position in any stocks mentioned either short or long]
THE STOCK SCANDAL YOU HAVEN'T HEARD ABOUT YET
By Porter Stansberry
Yesterday Coca-Cola, one of the most respected companies in the world, announced that it would begin expensing options. Any company that wants to keep its good name will soon follow.
In the long run, that's a good thing for investors.
But, in the short run - as companies are forced to come clean with options expenses - investors will be shocked to realize that most of the fastest growing companies in the market were actually not growing at all.
What today are the most expensive stocks in the market, will suffer enormous devaluations as investors come to understand the shell game that was being played with options and share buybacks.
If you haven't already, check your portfolio for "options printing" companies and make sure that the companies you own have really been making money. You can begin with what I suspect will easily become the "poster child" of such shareholder abuses.
Once the most highly respected - and the most profitable - company in Silicon Valley, this company will soon find itself in the middle of the next national scandal...and the focus of media, investor and political scorn.
Its CEO, once regarded as the best CEO in America, will see his reputation...well, return to the mean. And investors in a company that once posted a 9,000% return to shareholders will see their investment wiped out.
But first, if you'd like to understand the next big scandal to sweep Wall Street - a scandal that will make the others pale by comparison - you have to understand in some detail how the cost of granting stock options is represented to shareholders.
Options accounting is considered arcane and a minor financial detail today. In fact, the SEC only requires companies to report their options expenses as a footnote. But you'll soon see a lot more focus on these numbers...
A stock option granted by an employer is the right for an employee to buy a share of the company's stock at today's price. Normally this right extends out into the future - ten years, for example. In theory, options align the employees' interests with the shareholders. But experience is proving quite the opposite. Employees, including CEOs and other executives, don't have any downside. If the stock crashes, he doesn't lose a penny. If the stock soars, he's a millionaire.
The prevalence of these kinds of plans, not to mention the size of the grants given to senior managers, explain why companies during the bubble were being run in such a risky fashion - the managers had nothing to lose. But here's the real scandal. And what management likes about this kind of compensation...it's free. The cost of granting options doesn't appear on the income statement.
Trouble is, as Warren Buffett said recently, if options aren't compensation, what are they? And if compensation isn't put on the income statement, where do you put it?
Consider: if options grants don't show up as compensation expense, they never appear on the income statement. And if a company uses free cash flow to buy back all of the shares granted via options, there's never any record of the extra costs.
Options allow executives to hide the effect of their enormous compensation packages from the bottomline. For example, the CEO of the company I'm going to warn you about today - where options have gotten out of control - realized over $57 million in compensation from exercising options in 2001. That was more than 25% of his company's net profits for the year.
Meanwhile, on the income statement, only his $300,000 salary counts against earnings. On average, over the last six years, this CEO made $32 million per year. Almost none of that expense showed up on the income statement. Companies would never dream of paying executives so much money, except for the fact that investors don't see the effects of this compensation on earnings.
According to current GAAP accounting standards, this company produced outstanding EPS growth - 168% over five years. Even in 2000, when the market tanked, this company still grew earnings by 21%.
Because of this growth and its status as a leading big cap stock, you can understand perhaps why the stock still trades at outlandish prices: 78 times earnings and over 10 times sales.
But, if you deduct the expense of options grants using the Black-Scholes method to determine the value at the time of issue, you see an entirely different picture.
After you expense the value of the options granted, instead of 168% growth over five years, earnings only grew 39% over five years. Hardly remarkable, especially for a high tech company with great position in the market. After all, there was a high tech boom, remember?
Accurate accounting also shows that, like most companies in the sector, this firm had a sizeable decrease in earnings in 2001. As should be reported to shareholders, earnings after stock compensation fell by 29% in 2001.
You have to wonder how the market would price this "growth stock" if shareholders knew that really, counting all costs to shareholders, the earnings per share didn't grow by 21%, they fell by 29%! My guess is that, if the market realized that this company's earnings were actually decreasing, the shares might not trade at 78 times earnings. Maybe 7 times. Or maybe 8 times. But not 78 times.
Here's what else the market apparently doesn't recognize about this company: options expenses are rising. Employees' options that will vest in the next ten years now equal more than 25% of the entire capital stock of the company. If employees choose to exercise their options, there will be a 25% tax on earnings growth as the number of shares grows.
To keep this outlandish executive compensation off the minds of investors, the company has to prevent dilution - new shares - at all costs.
Who controls dilution? Why...the same executives who make millions on options. In fact, executives now use even more cash than provided by operations to buy back shares of stock - no matter how expensive the stock is! - just to prevent the real cost of options compensation from ever being reported to shareholders.
For example, this company made $223.8 million from operations in the last six months of 2001, according to its most recent filing with the SEC. But, during the same period, it repurchased $354.4 million of its own stock...which was trading at prices that today look, well, slightly expensive: 20+ times book value, 100+ times sales and 140+ times earnings.
Did management truly perceive that its shares were undervalued and the best place to spend $350 million? Or...were the executives engaged in a conspiracy to prevent shareholders from seeing an accurate accounting of its expenses - particularly executive compensation? The answer, at least to me, is obvious. But there's more.
If management thought its shares were attractive enough for the company's money...why are the same shares not attractive enough for management to even hold?
In the last six months, management has sold nearly 1 million shares of stock. And, despite 20 years of large- scale option grants, insiders own less than 1% of the total shares outstanding. Incredibly, the founder and CEO of the company in question currently don't own a single share of stock. Nor, according to SEC filings, do five of the company's Vice Presidents.
If stock options were truly meant to align the interests of management and shareholders, the management would at least hold some of the shares they're granted. But, these managers don't. Instead they cash out of every single share.
What's more, the company I've been describing to you is in the highly competitive analog semiconductor field. It's been the dominant company in this sector for a long time. Rapidly changing technology requires huge capital investment for research and investment. Yet, while the company spent $350 million on its own stock in the last six months of 2001, it only parted with $250 million on research and development - for all of 2001.
If you were looking for stocks to sell short in this market, you'd start by looking for large growth companies - heavily bought by index funds - that aren't growing anymore and are still hugely overvalued.
It's always hard for big companies to maintain large percentage growth gains to profits, simply because their markets become saturated and the numbers get so big. That's why companies over $10 billion typically trade at lower valuations than stocks below $1 billion. Not always though... In the U.S. public equity markets there are only eight companies over $10 billion in market capitalization whose shares still trade in the stratosphere of valuation. By any measure these stocks are incredibly expensive - more than 10 times sales, 50 times earnings and five times book value. The eight stocks are: Ebay, Taiwan Semiconductor (TSM), Serono SA, Paychex, Microsoft, Maxim Integrated Products and Immunex.
Out of these, four have net profit margins less than 20%: TSM, Immunex, Ebay and Maxim. And, out of all of these dominant growth companies only two have negative short-term growth expectations: Immunex and Maxim.
But only one - Maxim Integrated Products - is not yet already a part of my victim's portfolio of recommended short sales. In a happy coincidence, the company I've been describing to you today, the poster child for excessive options compensation, is Maxim Integrated Products.
The stock, in time, will become the prime example of the excesses of the 1990s in Silicon Valley. The executives got rich and today's shareholders are holding the bag. They just don't know it yet.
Good Investing,
Porter Stansberry for The Daily Reckoning
P.S. When the truth about options compensation and share buyback programs finally comes to light, the resulting carnage on Wall Street will be bigger than anything we've seen to date. Bigger than WorldCom, bigger than Tyco and bigger than Enron.
It will hit the most expensive stocks in the market - the firms thought to be robust growth companies. There will be total carnage. Maxim spent $503 million buying back its own stock in the last five years. If it still had that money today, it would have 50% more cash on hand than it does right now. And it might really need that money... sales over the last three quarters are down 41% and net profits are down 46%.
P.P.S. What's more, if you're looking for evidence of corporate arrogance, you'll find no better example than Maxim. CEO John Gifford's employment contract stipulates that he gets to name his own cash bonus each year. He also nominated Eric Karros - a professional baseball player - to the board of directors in 2000 at the peak of the bubble.
Naming your own bonus...nominating professional sports heroes to your board...these are the kind of things that show how much hubris this company's senior management has become imbued with. And it's the kind of thing that the newspapers will eat up once the story breaks.
But what's bad news for other investors can be great news for you. Sell Maxim short. |
