TO P/E OR NOT TO P/E?
Mauldin
Porter Stansberry in the Daily Reckoning brings us yet another
egregious example of a major company where management is using the
company to line its own pockets at the expense of shareholders (I
have taken the liberty of editing Porter). Please note that this
company has a market cap of $13 billion, so it is in a lot of
technology portfolios:
"Options allow executives to hide the effect of their enormous
compensation packages from the bottomline. For example, the CEO of
the Maxim Integrated Products (MXIM) 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, MXIM 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
perhaps understand 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, Maxim 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%!
Here's what else the market apparently doesn't recognize about
Maxim: 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.
"...Maxim 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.
"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, Maxim 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." (End quote.)
Both Dell and Maxim are profitable companies who are leaders in
their market sectors. They produce high quality products at
competitive prices. They will be in business, and probably will grow
their business, over the next decade.
Yet, are these good stocks to own? Maxim will have to spend, by my
calculation, over $3 billion (at today's prices) in stock buybacks
over the next ten years just to keep from diluting current
shareholders. They will have to substantially grow net income in
order to do that.
Understand, these are companies which are highly regarded. When you
search for reports on Maxim and Dell, you get glowing praise. But
when investors start to realize these companies make little or no
money after options are accounted for, how long do you think their
stocks will trade at outrageous multiples. Maxim is at a P/E of 82,
and today, as the market melted 400 points and the NASDAQ fell 3.5%,
Maxim actually rose in price. Investors clearly think this is one of
the best run companies with bright prospects.
The question that will be on the investor's mind in the future, as
we progress into a secular bear market and accurate accounting
standards, will be just who is the benefit of such bright prospects?
If Dell and Maxim are the best, what do the average and poor
companies look like?
If Intel used proper accounting, its profits would drop 80%.
Microsoft's would drop 40%. Cisco would have no profits. All Cisco's
35,900 employees get stock options. Cisco spokesman Steve Langdon
said, "Expensing options is not a good idea and would prevent
companies from offering stock options to their rank-and-file
workers."
It is hard for me to believe that all 35,900 workers are so critical
that salaries alone are not enough to keep them. If options are
truly such an important component of their pay that employees would
not work there without them, then Cisco is selling products for less
than it costs to make them. It seems to me that options at Cisco are
preventing the workers from offering profits to their shareholders. |
