Pay attention class, there will be a test!!!
Stock options are not a free lunch
By Gretchen Morgenson
IT'S ANNUAL REPORT TIME AGAIN, and this year's reports reveal the
astounding bonanza executives are reaping from the exercise of stock
options (see story, p. 220). Cheryl Breetwor, chief executive of
ShareData, a Santa Clara, Calif.-based supplier of employee stock plan
software and services, calls the spread of employee options the "Silicon
Valley model."
"The Silicon Valley model is working," Breetwor says. "Making chief
executives and employees stakeholders is good for America, it's good for
our competitiveness."
Warren Buffett, however, disagrees. In his recent letter to
shareholders, he wrote that after Berkshire Hathaway acquires a company,
it will often report higher employee compensation costs. Buffett: "Their
reported costs will rise after they are bought by Berkshire if the
acquiree has been granting options as part of its compensation packages.
In these cases, 'earnings' of the acquiree have been overstated because
they have followed the standard—but, in our view, dead wrong—accounting
practice of ignoring the cost to a business of issuing options."
Buffett continued: "When Berkshire acquires an option-issuing company,
we promptly substitute a cash compensation plan having an economic value
equivalent to that of the previous option plan. The acquiree's true
compensation cost is thereby brought out of the closet and charged, as
it should be, against earnings."
Buffett isn't the only spoilsport. "The last word is not yet in on how
expensive options truly are," Scott Spector, partner in compensation law
at Fenwick &West in Palo Alto, Calif., says. Though he adds: "People
just will not work for a company that won't offer stock incentives."
Edward Lazear is a professor at Stanford Graduate School of Business and
a senior fellow at the Hoover Institution, specializing in labor
economics. "It's difficult to show that options provide any real
incentives," he says. In fact, he argues that options, because there is
risk attached to them, cost companies more in employee compensation than
straight salary would.
The trap here is that the cost of the options is hidden from
shareholders. Why hidden? Because of the way stock options are accounted
for in financial statements. They are not listed as a cost and therefore
result in an understating of true employee costs and a corresponding
overstatement of net profits. Options also reduce costs another way: by
cutting a company's tax bill. When an employee exercises an option
grant, the tax liability on the transaction is transferred from the
company to him.
"When something looks too good to be true—like options do—it usually
is," says Steven Hall, managing director at compensation consultant
Pearl Meyer &Partners.
The apparent free lunch is a by-product of the great bull market. David
Leach, managing director at Compensation Resource Group in Pasadena,
Calif., recalls that in the 1970s, when stocks were in the tank, cash
compensation was king. As the market began crawling out of its hole in
the early 1980s, the trend went to bigger salaries and more generous
bonuses. Only when it was clear that a bull market was under way did
stock options become prevalent. First they were limited to corporate
chiefs; in the late 1980s and early 1990s companies as varied as
PepsiCo, Cirrus Logic, Merck and Wendy's International began including
all employees in their stock option programs.
According to a survey by ShareData, 45% of companies with option plans
and 5,000 or more employees now grant options to all their workers.
Three years ago only 10% did. And companies dispensing option largesse
to all employees are not limited to Silicon Valley startups. This year
37 companies do, including Amoco, Chase Manhattan, Compaq Computer,
DuPont, Eli Lilly, Kimberly-Clark and Warner-Lambert.
At smaller companies, of course, the devotion to stock options is even
greater:74% of companies with less than $50 million in sales offered
stock option plans to 100% of their workers. Shipping and mining concern
Oglebay Norton Co. has abandoned salary altogether for its chief
executive. It bases John Lauer's entire pay on stock incentives.
"Compensation packages are totally market-driven," says Leach. "Stock,
stock and more stock." Newish twists include premium options—where a
company's executive gets to exercise his grant only if the stock reaches
a preset premium to the current market price.
What companies do not like to do is remind shareholders though it is
obvious to people like Buffett—that options are highly dilutive.
According to Pearl Meyer &Partners, shares allocated for management and
employee equity incentive plans at the 200 largest companies last year
rose to 13.2% of shares outstanding, up from 6.9% in 1989 (see chart, p.
215). "We used to advise companies that an allocation of 10% was too
much dilution," says Steven Hall of Pearl Meyer, "but we blew through
that level years ago."
Options dilute per-share earnings because they increase the divisor
applied to net profits to figure per-share earnings. If exercise of
options increases the number of shares outstanding by 10%, that results
in 10% dilution. Thus a 20% increase in net earnings produces an
increase of only 9% in earnings per share.
Mortgaging the future
These companies have option allocations greater than 25% of their shares
outstanding.
Company/
businessTotal
allocation* 1996-97
grant rate*Delta Air Lines/
airline55.47%1.24%Merrill Lynch/
brokerage53.956.44Morgan Stanley Dean Witter/
brokerage51.223.87Microsoft/
software44.834.45Bankers Trust/
banking43.098.79Lehman Brothers Holdings/
investment banking42.5810.08Dell Computer/
computers38.685.73Travelers Group/
financial services37.065.88ITT Industries/
defense36.961.76JP Morgan/
banking31.893.91Warner-Lambert/
pharmaceuticals29.141.50Transamerica/
financial services27.932.45Time Warner/
entertainment26.012.19BankAmerica/
banking25.572.70*Percent of weighted average shares outstanding on a
fully diluted basis.
Source: Pearl Meyer & Partners, Inc.
What this means is very clear: Though the options don't count as cost,
they are a mortgage on future earnings. We are not talking about a
handful of companies putting future earnings per share at serious risk.
Scott Spector, the lawyer in Palo Alto, says options grants at the
Silicon Valley companies he advises are up to 24% of total shares
outstanding, versus 15% three years ago. Last year 72 of the top 200
U.S. companies went to shareholders for approval of new or amended stock
option plans. For the past several years only 50 companies had been
asking for such approval. Among the 200 largest companies in America, 14
of them now have options allocations greater than 25% of their shares
outstanding . These include Delta Air Lines, Merrill Lynch, J.P. Morgan
and Transamerica Corp.
A gold mine for the top brass
The value of all in-the-money options, unexercised, by top executives at
Forbes 800 companies approaches $11 billion.
Source: Forbes
To the degree that options are used as incentives to attract and keep
talented workers, they are, properly speaking, a labor cost. But
accounting standards do not require a company to run the costs of
issuing these options through its income statement as an expense. Thus,
companies that count on options to recruit and keep employees are
understating labor costs and overstating earnings.
An in-depth study of the impact of employee stock options on the 100
largest U.S. companies was recently released by economic advisory firm
Smithers &Co. in London. It was prepared by Smithers' Daniel Murray and
Andrew Smithers, and John Emerson, accountant with the firm Robson
Rhodes. The study took six months of sleuthing. "The data were very
difficult to get," says Smithers. "It's only in the footnotes to the
financials in a company's 10-K. But we found the amount of hidden costs
at these companies is significant."
Here's their astonishing conclusion: If the 100 companies had charged
the costs of option programs to their income statements, their profits
in 1995 would have been on average 30% lower than those actually
reported. In 1996 full-cost accounting for options would have resulted
in earnings 36% lower than stated.
Put another way, profits in 1996 would have been up only 11% over the
previous year, rather than the 23% these 100 companies claimed.
Presumably, the overstating would have been even worse in 1997.
Would the market have risen 20.3% in 1996 if the 100 biggest companies
had reported earnings gains of only 11%? Doubtful. Based on his group's
findings, Smithers figures that the current P/E multiple on the S&P 500
is 35, not the 28 usually shown.
But the real drama emerges when Smithers examines individual companies
to see how their earnings would fall if options were expensed as an
employee cost rather than capitalized, as they essentially are now.
Eleven companies of the 100 would have shown a loss in 1996 had they run
the cost of options through the income statement (see table, The high
cost of employee stock options).
The dilution effect
Shares allocated for management and employee stock incentive plans at
the 200 largest U.S. companies has almost doubled in the past eight
years.
*calculations are bsed on weighted average shares outstanding on fully
dilluted basis.
Source: Pearl Meyer & Partners, Inc.
These are big-name companies: Bristol-Myers, Dell, Hewlett-Packard,
Monsanto, Time Warner and others. And according to Smithers, another 13
companies—including Coca-Cola, Gillette, Merrill Lynch, Sun Microsystems
and Waste Management—would have seen their 1996 profits cut more than
half had they treated options as a compensation expense. Smithers &Co.
hastens to make clear that it cannot guarantee the precision of its
numbers, because the nature and availability of the data required it to
make a number of assumptions. But if it erred at all, they believe they
erred on the conservative side.
Smithers comes up with its figures by adding together the estimated
value of options that were exercised during the year and the estimated
cost of immunizing the company against future increases in its stock
price, which would have the effect of upping its total option costs. The
estimated immunization cost covers two factors: the difference between
the share price and exercise price on existing options and costs
associated with net new option grants.
One way to cover the cost of delivering options to workers, says Daniel
Murray, is to buy the equivalent amount of listed options in the open
market at the time of the option grant. This would immunize the company
against price increases in the stock, and prevent earnings dilution.
In a separate calculation, Smithers &Co. assumes that companies would
borrow the funds necessary to buy the options on the shares dedicated to
employee option plans; interest expense is estimated at 5% a year. A
company interested in fully accounting for the cost of its options each
year thereafter would have a recurring expense as it issued new options
and went into the open market to hedge against them. Smithers figures
that the average expense to fully hedge employee option positions at the
100 companies analyzed would have amounted to 21% of earnings in 1997.
From January 1987 to June of last year Dennis Beresford, now an
accounting professor at the University of Georgia, was the chairman of
the Financial Accounting Standards Board. During his tenure, FASB tried
to figure a better way to account for the costs of burgeoning stock
option plans on a company's financial statements. "It's hard to argue
that they're any different from cash compensation or any other employee
costs," says Beresford. "FASB felt it was a cost."
The board tried to come up with a standard that would require companies
to run option costs through their P&L. But the effort became political
roadkill after the BigSix accounting firms and much of corporate America
lobbied heavily against it. "The argument was: reduced earnings would
translate to reduced stock prices," recalls Beresford of the brutal
battle that finally buried the idea in 1995. "People said to me, 'If we
have to record a reduction in income by 40%, our stock will go down by
40%, our options will be worthless, we won't be able to keep employees.
It would destroy all American business and Western civilization,' " he
says. The bull market was more important than accurate financial
reporting.
What the accounting board did come up with was a way to signal to
shareholders the diminishing effect of stock options on earnings. But
investors have to comb through the footnotes to a company's financial
statements to find the data. There, companies now report how their
earnings might be affected by options held by employees.
But FASB 123, as it's called, leaves lots of room for interpretation. As
a result, investors can't be certain that all companies are valuing
their options the same way. For instance, two semiconductor companies
with the same option plans and number of options outstanding, can come
up with wildly different results. Complains Cheryl Breetwor of
ShareData: "There are significant flaws in the standard. This muddies
the waters."
Indeed, Dell Computer, in its most recent annual report, says its pro
forma option costs in fiscal 1997 amounted to only $22 million pretax.
This, even though it issued almost 43 million shares at a weighted
average fair value of $3.73 each.
So the options frenzy mounts as more and more businesses count on a
rising market to keep employee costs down and reported earnings rising.
Following Warren Buffett's lead, FORBES took the fair value, as reported
in company proxies, of top executives' unexercised, but in-the-money
options. To see what would happen if the costs of the packages were
included as an employee expense, we compared that value to the company's
cash flow.
The results were dramatic: The companies in the table on page 215 would
have to devote 50% or more of current year's cash flow just to pay the
fair value of the in-the-money options held by executives.
Defenders of options reply that this is all theory. In the real world,
they argue, having options encourages managers to think like owners.
Well, it does give management an incentive to talk up the stock price,
but does it make them real owners? Hardly. Option-holding employees have
a different piece of paper than ordinary shareholders have. Unlike
shares, options can be repriced downwards. At Novell, Apple Computer,
Bay Networks and Advanced Micro Devices, shareholders have recently been
asked to approve lowering prices on employees' options. But investors
who bought a stock at $30 only to see it go to $14 can't renegotiate the
price. Shareholder groups like Lens Investment Management in Washington
D.C. and Institutional Shareholder Services in Bethesda, Md. are trying
to focus shareholder attention on this issue. Patrick McGurn, vice
president at ISS says: "If a company has a history of repricing, we
recommend investors vote against its option plan."
It is not at all uncommon for management to run a company into the
ground. After the stock collapses they grant themselves options at the
lower price. When the stock recovers they make a fat profit, while
shareholders have taken a round trip to nowhere.
Shareholder interests aside, the vast spread of option programs may also
be causing us to underestimate inflation. Fed watchers know that Alan
Greenspan pays close heed to wage costs as he scours the horizon for
signs of inflation. Are these costs understated? At Smithers &Co.,
Daniel Murray believes that incomes from employment in the U.S. have
been rising around 2.5% faster than published figures state. Greenspan
is certainly aware of the danger. Minutes from the Federal Reserve
meeting of Dec. 16, 1997 say: "Employers were continuing their efforts
to attract or retain workers . . . by means of a variety of bonus
payments and other incentives that were not included in standard
measures of labor compensation."
Sounds like stock options to us.
But the game goes merrily on. "Companies realize that dilution is not
affecting their stock's price one bit," says Scott Spector. Not yet,
that is. "But the mortgage on the future is a problem that people
haven't yet addressed," he adds.
Sidebar: The great bull market in stocks and options |
