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July 10, 2003
Do You Want Some Expensed Stock Options With That Merger Monday?

Microsoft announced that it is going to stop issuing stock options and start expensing previously issued options. Furthermore, the company also stated that stock shares will be issued in place of stock options, and that older under water options will (reportedly) be sold to JP Morgan so that employees will receive some return. 
http://www.microsoft.com/presspass/press/2003/Jul03/07-08CompPR.asp

The Microsoft news is noteworthy not only because it will likely compel more tech companies to voluntarily begin expensing options, but also because it suggests Microsoft is aware that investors are intelligent enough to figure out what the company is worth without having to riffle through footnotes to find compensation estimates.  Incidentally, other company’s do not currently treat, or plan to treat their shareholders with the same respect. For example, YHOO reported earnings yesterday, and beyond a single line in its statement of cash flows (tax benefits from stock options) the company made no other direct mention of stock options.  Moreover, the news agencies that picked up the YHOO earnings release ignored options/diluted matters completely. While investors await YHOO’s more in-depth 10-Q filing, is the current data a rounded interpretation of financial facts?


Market Reaction To MSFT
Despite widespread fears that expensing stock options could wreck tech share prices, MSFT shares traded lower yesterday by only 23 cents (-0.83%). This decline is hardly what you would expect given that the company just volunteered to potentially trim earnings by 30%.   

(In Millions)

2002

2001

2000

1999

1998

1997

Net Income

7,829

7,346

9,421

7,757

4,462

3,439

Pro Forma

5,355

5,084

8,172

7,046

3,912

3,038

% Diff if Expensed

-31.60%

-30.79%

-13.26%

-9.17%

-12.33%

-11.66%


However, for a company like Microsoft – which has a cash war chest, and possesses one of the highest margin businesses in existence - a higher P/E multiple resulting from expensing stock options is unlikely to dent investor enthusiasm. Also, don’t forget that while stock compensation will soon begin to hit MSFT’s net income, the company’s buy back program may still ensure that EPS remain robust (by making reduced earnings divisible by fewer outstanding shares).

The Ballooning Buy-Backs That No One Seems to Care About

Put in the envious position of producing consistently strong cash flows, many prominent tech companies were essentially faced with two choices during the 1990s concerning their use of excess cash: use this cash to declare dividends or buy back stock.  Knowing that only one of these choices could boost earnings per share (and that investors really didn’t care about dividends), most company’s elected to buy back stock.  Accordingly, in less than a decade stock repurchase programs exploded for companies like MSFT, DELL, IBM, etc.  During the 1990s stock option issuance also grew: about 2% of the workforce of publicly traded companies held stock options in 1992 versus 15% in 2001 (National Center for Employee Ownership).

There are three related reasons why a company buys back stock:

1) To signal to investors that management believes the company’s share price is undervalued and/or that this is the best use for excess cash.
2) To distribute cash to investors more tax-effectively than issuing dividends. 
3) Managements desire to combat stock options dilution and/or improve earnings per share.

Number 3 is bolded because the conspiratorial eye cannot help buy connect the dots: unexpensed stock option issuance increases during the 1990s and buy back programs coincidentally also began to increases? 

The Buy Back Scam

The reason why buy backs can be referred to as a ‘scam’ is because many companies increasingly turned to buy backs to manage the dilutive impact of stock options during the 1990s.  This would not be such a problem if companies had expensed either the stock options or the buy backs. However, in most cases neither was.

Although not the biggest abuser on the block, MSFT partook in the buy back/option issuance craze. Furthermore, and unlike many others, the company admitted early on its intentions:

“The Company repurchases its common stock in the open market to provide shares for issuing to employees under stock option and stock purchase plans.”
MSFT’s 1996 10-K

If you want to know exactly what has been irritating FASB since the early 1990s, it is statements like this one. Without doubt, the first battle FASB and corporate America to expense was triggered by FASB asking the following question: “How can we allow companies to pay employees with stock options and then entirely negate this expense (as if it never existed) by repurchasing shares?”

In the case of Microsoft, its buy back program continually enlarged during the 1990s, from $250 million in 1992 to more than $6 billion in 2000 and 2001. The program also became larger as a percentage of available cash, which obviously had something to do with the fact that dividends were passé.
 

Shorts Squeezed?

In order to ensure that Wall Street’s monopoly on information is not put at risk, the NYSE procures short selling stats on only a monthly basis.  These dated and usually useless stats were worth remembering this past Monday, or when stock prices rocketed higher for questionable reasons.

Quite frankly, the ‘short sellers are being squeezed’ mantra can not be overstated.  Rather, the U.S. stock markets are amidst their most powerful and convincing bear market rally since March 2000, and during this rally short selling interest has increased!  Suffice it to say, should stock prices continue to rise – and dependent upon the July short selling stats – there could still be a plethora of short sellers waiting to be squeezed. 


Beyond short covering, another explanation for the markets’ rally earlier this week was that asset allocation models were taking money out of bonds and putting it to work in stocks. The question that deserves to be asked each time this simplistic theory is repeated on CNBC is: ‘how many safety minded bond investors have suddenly snapped and dumped their U.S. Treasury’s in order to purchase Ebay for $115 a share?’ 

Tech Mania Finds Fuel

Commenting on this week’s tech rally, the Dallas Morning News reports:

“It sure feels like a (tech) revival…Chief information officers surveyed in June said they expected spending to increase 5.6 percent in the next 12 months -- the biggest growth expectation in the last 15 of CIO magazine's monthly polls. And Goldman Sachs reported that technology expenditures could rise next year.”

I am not entirely sure how is the investor is supposed to respond to factoids. Does a 5.6% increase in spending somehow make the 15.5% 5-year future growth rate estimates for Intel more appealing?  Did Goldman Sachs accurately predict anything tech related during the last 3-years?

Other motivational events for tech this week have been increased speculation that Microsoft will declare more dividends, and a misinterpreted statement from Cisco’s CEO about a possible turnaround in IT spending. Again, I don’t know how the investor is supposed to respond to this ‘news’.

Carnival Back In Town

Like most investors unwilling to take part in the orgy of speculation in tech, I marvel every time shares rally for no other reason than because Wall Street has found some more money to throw around.  As for the toned down lies and ‘interest rates are low!’ mantras Wall Street analysts continue to promote, based upon continued equity inflows it is becoming increasingly clear that individual investors are buying into rising prices either for fear of missing out on gains, or because they actually believe what Wall St. is shoveling them.

This week, every time a merger announcement crossed the wires the markets crept higher.  One can not help but recall when Wall Streeter’s previously touted term ‘Merger Monday’ as a reason to be in the markets; the carnival offered a seemingly endlessly amount of excitement, and the cost of admission was a mere 75-80% of your ‘diversified’ capital…

Non expensing Ebay is at $115 a share because Wall Street will never change, and there are still plenty of suckers left to be fleeced.  And while expensing options may not necessarily collapse stock prices – nothing can collapse a ponzi-pyramid except mathematics - thanks to Microsoft and the more than 200 other companies that have voluntarily decided to expense, FASB should be able to finally win the war in 2004. 

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