<THE EVENING NEWS>
Friday, May 7, 1999
MARKET CLOSE
DJIA          11031.59  +84.77   (+0.77%)
S&P 500        1345.00  +12.95   (+0.97%)
Nasdaq         2503.62  +31.34   (+1.27%)
Russell 2000    436.11   +2.73   (+0.63%)
30-Year Bond   92 2/32   -8/32   5.81 Yield

HEROES

Naval shipbuilder Newport News Shipbuilding (NYSE: NNS) steamed ahead $5 3/4 to $32 3/4 after fellow shipbuilder and defense contractor Litton Industries (NYSE: LIT) offered to acquire the company and Newport News merger partner Avondale Industries (Nasdaq: AVDL) in separate transactions with an aggregate value of $2.4 billion in cash, stock, and assumed debt. Avondale rose $4 5/16 to $36 1/16 on the news while Litton shed $1 5/8 to $63 1/8. Defense industry analysts of all shapes and sizes, from the Wise on Wall Street to the not-so-wise on Capitol Hill, generally predicted that the merger will get the nod from the Defense Department, which torpedoed General Dynamics' (NYSE: GD) offer for Newport News last month. The Litton deal would ensure competition in the nuclear boat market, with Newport News being the Navy's sole nuclear aircraft carrier maker and a competitor of General Dynamics in nuclear submarines.

Offshore drilling platforms builder J. Ray McDermott (NYSE: JRM) jumped $4 3/4 to $35 1/4 after majority owner McDermott International (NYSE: MDR) offered to acquire the remaining stake in the company it does not already own for $513 million, or $35.62 per share in cash. The deal represents a 32% premium to the $27-per-share, all-stock offer left on the table when the two companies called off an initial round of merger talks last month due to an inability to reach "an acceptable financial agreement." In light of today's news, it appears that statement was a nice way of saying that J. Ray McDermott's independent shareholders (including holdovers from the 1995 McDermott/Offshore Pipelines merger that gave birth to J. Ray McDermott) wanted cold, hard cash for their shares -- not stock in a slow-growing energy services company whose shares are trading at roughly the same level they were when the Offshore Pipelines merger went through.


QUICK TAKES: Natural foods supermarket operator Whole Foods Market (Nasdaq: WFMI) gained $4 to $42 5/8 after posting fiscal Q2 EPS of $0.43 compared to $0.40 last year, beating the Zacks mean estimate by a penny... Interactive bingo game developer Multimedia Games (Nasdaq: MGAM) cashed in a $2 1/4 gain to $9 after Business Week's "Inside Wall Street" column speculated that the company could be a takeover target... PC input/output interface connections technologies company QLogic Corp. (Nasdaq: QLGC) picked up $14 3/16 to $90 1/16 after reporting fiscal Q4 EPS of $0.45, up from $0.23 a year ago and ahead of the First Call mean estimate of $0.40... Integrated oil and gas firm Texaco (NYSE: TX) gushed $5 1/16 higher to $67 1/4 on rumors that rival Chevron (NYSE: CHV) may be interested in acquiring the company. Chevron lost $2 15/16 to $94 7/8 today.

E-commerce software developer Sterling Commerce (NYSE: SE) moved up $5 3/4 to $38 3/4 after reporting fiscal Q2 EPS of $0.36, up from $0.29 a year ago and in line with the Zacks mean estimate. Warburg Dillon Read started coverage of the company this morning with a "buy" rating... Sunglasses retailer Sunglass Hut International (Nasdaq: RAYS) brightened $1 to $14 15/16 after Morgan Stanley Dean Witter reportedly raised the company's fiscal 1999 earnings estimate to $0.55 per share from $0.50 and its price target for the stock to $20 per share from $14 per share. Yesterday, the company reported that its April same-store sales rose 5.1% from a year ago... Bank holding company Republic New York Corp. (NYSE: RNB) added $8 7/16 to $70 on speculation that it may be a takeover target.

Materials and structural testing systems and products maker Instron Corp. (AMEX: ISN) rose $4 1/4 to $20 3/8 after agreeing to be acquired by private investment group Kirtland Capital Partners for $22 per share in cash, a 36% premium to the company's closing price of $16 1/8 per share yesterday... Telecommunications firm Bell Atlantic (NYSE: BEL) climbed $2 5/16 to $58 3/16 after the Justice Department cleared its merger with GTE (NYSE: GTE) on the condition that the companies shed their overlapping wireless properties... Contract irradiation and sterilization services provider SteriGenics International (Nasdaq: STER) picked up $2 3/4 to $14 1/2 after posting Q4 EPS of $0.24, beating analysts' estimates by a penny... Drug developer Sepracor (Nasdaq: SEPR) advanced $11 1/2 to $96 after Warburg Dillon Read started coverage of the firm with a "buy" rating and a 12-month price target of $143 per share.

IPO Friday: Website development software provider NetObjects Inc. (Nasdaq: NETO) jumped $1 to $13 after selling 6 million shares at a price of $12 per share... Online advertising management services firm AdForce Inc. (Nasdaq: ADFC) moved up $14 15/16 to $29 15/16 after selling 4.5 million shares at a price of $15 per share... Voice and data conferencing technologies company Latitude Communications (Nasdaq: LATD) marched up $1 13/16 to $13 1/16 after selling 3 million shares at a price of $12 per share... Online audience measurement products provider Media Metrix (Nasdaq: MMXI) soared $28 9/16 to $45 9/16 after selling 3 million shares at a price of $17 per share.

GOATS

Inline skate, bike, and skiwear maker K2 Inc. (NYSE: KTO) schussed down $11/16 to $10 1/8 as the company's board elected to discontinue the company's quarterly cash dividend. "In recent months K2 has been presented with a number of potentially attractive acquisition opportunities," said President and CEO Richard Rodstein, so the board decided "it was prudent under the circumstances to redirect cash resources in order to maximize K2's flexibility to respond." While the prospect of new business opportunities may be encouraging to K2 management, most shareholders would probably prefer that the company show an ability to generate cash; over the past couple of years, cash from operations has been negative. Today's news signals that a return to better days is some time off. Revenue growth has slowed in recent years at K2 as changing recreational and style trends have strained many a company. The Fool's Warren Gump discussed sporty stocks in a recent column.

Shares of gold producers fell broadly today after the Bank of England surprised many with plans to slowly sell nearly 60% of its gold reserves in a move to rebalance its portfolio and increase its foreign currency holdings. About one-fifth of the bank's gold will be auctioned off by next March. Other central banks and the International Monetary Fund have made similar announcements this year, pressuring gold prices. Today, June gold futures fell $7.00 to $283.70. A host of stocks paid dearly. Ashanti Goldfields (NYSE: ASL) dulled $1 1/2 to $8 3/16, Anglogold Ltd. (NYSE: AU) gave up $1 3/16 to $22 15/16, Barrick Gold Corp. (NYSE: ABX) shed $2 3/4 to $20 1/2, Homestake Mining Co. (NYSE: HM) put down $1 3/16 to $9 7/16, Freeport McMoRan Copper & Gold (NYSE: FCX) dumped $1 15/16 to $15 3/4, and Placer Dome (NYSE: PDG) lost $2 7/16 to $13 3/16.

QUICK CUTS: Internet bank Net.B@nk (Nasdaq: NTBK), which filed to sell 3 million shares of common stock (adjusted for a 3-for-1 split planned for May 15) and $100 million worth of convertible subordinated notes, retreated $5 1/2 to $165... Cosmetics, skin care, hair care, and fragrances company Estee Lauder (NYSE: EL) was smudged $4 3/16 to $95 5/16 following news of a public offering of up to $362 million in company stock by members of the Lauder family. Chairman Leonard Lauder received an open letter from the Fool's Dale Wettlaufer last night... EarthWeb (Nasdaq: EWBX), which provides online information and services to computer programmers, developers, and technicians, lost $2 7/16 to $37 1/16 after the company announced plans to sell 1.3 million shares of company stock at $37 each, a 6.3% discount to the company's closing price yesterday.

Internet investment firm CMGI (Nasdaq: CMGI) moved back $5 7/8 to $221 1/4 today. The company restated results for the last four quarters because of research and development charges pertaining to Lycos (Nasdaq: LCOS), which it partially owns... Shares of Nucor Corp. (NYSE: NUE) rusted $1 5/16 to $59 5/16 as McDonald Investments analyst Mark Parr downgraded the steelmaker to "hold" from "buy"... Soft drink company Coca-Cola Co. (NYSE: KO) fizzed away $1 3/8 to $67 3/4 today. The company is reportedly looking to buy out its partner in its last remaining Vietnamese joint venture... Online transaction processing services provider Pegasus Systems (Nasdaq: PEGS), which said it sold 2 million shares of company stock to the public at $38.88 per share -- a slim discount to yesterday's $39 closing price -- descended $7/8 to $38 1/8.

European telecom companies operator Global TeleSystems Group (Nasdaq: GTSG) slumped $1 1/4 to $61 7/8 as the company said it owns 80.4% of French telecommunications services provider Omnicom. Global's 195-euro per share tender offer for Omnicom will end May 10... Healthcare information services company IMS Health (NYSE: RX), which pointed investors toward full-year 1999 EPS of between $0.79 and $0.81, fell $1 1/16 to $25 13/16. First Call's mean estimate for the year is $0.80... Nutritional supplements and topical products marketer Mannatech Inc. (Nasdaq: MTEX) spilled $3 7/16 to $16 15/16 after the company said Q1 EPS was $0.12, down from $0.15 last year. Operating margins fell slightly as expansion costs ticked upward.

Commodity clothing retailer Gap Inc. (NYSE: GPS), cut $5 1/8 yesterday after reporting a 1% rise in April same-store sales after a 21% gain the month before, gave up another $1 to $63 1/4 today... Energy BioSystems (Nasdaq: ENBC), which develops biotechnology-based processes for the petroleum industry, retreated $1 7/8 to $4 1/4 after grabbing $4 13/16 on a press release that said new federal standards for gasoline would benefit its business... Drug maker ICN Pharmaceuticals (NYSE: ICN), which reported Q1 EPS of $0.28 -- $0.02 below First Call's four-analyst consensus estimate -- slipped $1 7/16 to $29 13/16.

Customer management and billing software company Portal Software Inc. (Nasdaq: PRSF) gave back $6 3/8 to $31 after jumping $23 3/8 yesterday in its first day of trading. The company sold 4 million shares to the public at $14 a pop... Elsewhere in the IPO world, e-commerce software company Silknet Software Inc. (Nasdaq: SILK) frayed $4 9/16 to $24 13/16, extending its slide from its opening-day high of $35 3/4 on Wednesday... Telecommunications provider Destia Communications (Nasdaq: DEST) was divested of $1 3/8 to $8 3/4 in its sophomore session after a quiet first day of trading for its 5.2 million new publicly traded shares.

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Optionmania III: Takedown

In columns last Friday and Wednesday, I discussed how options impact income statements, the impact of options expense on several companies, and the reason companies do not currently record options expense. Investors should be aware of numerous additional anomalies associated with options. Below are several questions and my answers.

Isn't options expense incorporated in the diluted earnings per share (EPS)?

NO! The difference between basic and diluted EPS only reflects the impact of the increased number of shares issued for options on earnings. It does not incorporate the expense of the options in net income.

Using the example from last Friday, New Age posted net income of $275,000 and diluted EPS of $2.74 on 100,400 shares. While the share count incorporates the impact of options, net income does not. If we assume that Sally's options are worth $10,000 (the amount of foregone salary relative to her Old Line offer), New Age would have posted net income of $265,000 (not $275,000). The company's EPS would have then been reduced to $2.64 since 100,400 effective shares would still be outstanding. Note that New Age's EPS figure would be a penny lower than Old Line's, which is similar in every way except it uses only cash compensation. This is because the number of New Age shares outstanding has increased, causing dilution. (For simplicity's sake, taxes are ignored in this example.)

If what you're saying is true, only the income statement would be impacted. The balance sheet and cash flow statements would still be accurate, right?

Not really. All three financial statements are intertwined and inaccuracies in one carry over to the other. In the same way that net income is overstated, cash flow is effectively overstated. The actual amount of cash isn't misstated, but the company has given away a cash-substitute (the option), which is not reflected on the cash flow statement. If the company were forced to pay its employees in cash, rather than with "self-published" options, operating cash flow would be lower.

The balance sheet is another issue. When stock options are exercised by employees, a company boosts its shareholder equity account by the amount of the exercise price. While this treatment accurately reflects the transaction as it occurs, it ignores the fact that the stock is actually worth more than the option price at the time of exercise. In effect, this understates the amount of equity capital invested in the business, distorting some productivity measures used by analysts (such as return on invested capital).

Are some company buyback programs related to stock option plans?

Quite often. Many companies engage in buyback programs to limit the dilution caused by stock option programs. These programs validate the theory that options costs are real.

Let's assume that a a company repurchases 1 million shares for $50 million, while employees exercise options on a similar number of shares at an average price of $30 each. From a basic shares perspective (which you should normally avoid since diluted shares is more representative, but it simplifies this example), the number of shares outstanding would remain the same -- 1 million shares were issued and 1 million shares were repurchased. The only difference is that the company has $20 million less cash because it spent $50 million repurchasing stock and only received $30 million for the stock sales. No part of this $20 million ever hits a company's income statement.

To see if a company is engaging in a stock repurchase to reduce shares outstanding or to offset option grants, look at the reported number of diluted shares. If the number of outstanding shares is not decreasing commensurately with the announced number of shares repurchased, repurchased shares are probably being used to offset option grants. In such a situation, it may be worthwhile to check out a company's annual report or 10-K to see the extent of its option grants.

Do options have any income tax impact for the company?

I'm not a tax expert and different stock option plans have different tax impacts. Some option plans do provide a company tax benefits while others do not. I do not have current information on what is deductible and what is not, but some plans do lead to significant tax benefits for companies.

Are stock options included in the government's Employment Cost Index (ECI)?

No. Many economists looking for signs of inflation have been closely tracking the ECI, which has recently indicated small wage increases for Americans. I was curious if this index incorporated any cost for employee stock options, which have become an integral portion of compensation at many companies. According to two people at the Bureau of Labor Statistics, the ECI does not incorporate options expense (although it is under consideration).

While the absolute level of stock option grants relative to total compensation is probably small, I would guess that many people are currently being granted increased options grants in lieu of raises. Determining whether options impact the ECI would be quite interesting.

What should investors do to incorporate the unrecorded cost of options?

That is up to each investor and the method used to evaluate stocks. If you believe valuation is an important factor in picking stocks, some adjustments should probably be made. Although the cost of option grants is currently ignored by most analysts and investors, I expect this will change at some point. The catalyst for this change will likely be regulatory (i.e., accounts require this expense to be recognized on the income statement) or societal (i.e., employees decide that cash is preferable to option grants). The latter scenario would force people to pay attention to the cost of options because cash compensation would jump up at many companies, decreasing earnings.

The most important adjustment to make when incorporating the impact of option grants is to net income. Unfortunately, most companies only provide information on this subject on an annual basis. (Kudos to Microsoft (Nasdaq: MSFT) for including this information quarterly on its website.) To get a thumbnail idea of the options impact on future earnings, I look at the percentage of options expense relative to the latest year's reported earnings and carry that percentage through published estimates.

For example, from their 10-Ks, I know options expense would have reduced 1998 earnings at T. Rowe Price (Nasdaq: TROW) and Starbucks (Nasdaq: SBUX) by 7% and 21%, respectively. The First Call consensus earnings estimate for these two companies are $1.63 and $0.60, respectively, in 1999. From an analytical perspective, I consider these figures to be $1.52 ($1.63*0.93) and $0.48 ($0.60*0.79). I think this "adjusted" net income should be used when calculating performance metrics like net margins and valuation measures such as the Price/Earnings (P/E) ratio. While the options expense included in the footnote of next year's annual report will probably show a different impact, I haven't found a better way to estimate the prospective cost of options.

Before closing out this series, let me point out that stock options are a very effective tool for companies to use in attracting and motivating employees. In addition, they provide a means for small, upstart companies with limited cash resources to attract superb recruits. My only beef is that they are not accounted for on the income statement, which leads to distorted financial reporting. Investors utilizing profitability and valuation measures in their decision-making process should not ignore this compensation expense.

Do you have an opinion or question on employee stock options? Can you think of a better way to incorporate this hidden expense in stock analysis? Come over to the Fool on the Hill message board to share your ideas.

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