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Monday, November 23, 1998

FOOL ON THE HILL
An Investment Opinion
by Alex Schay

Check Out the Options

If you buy into the notion that net income is the amount remaining at the end of the day, after all expenses have been met or deducted, then you might be fooling yourself. What if there existed certain "shadow" expenses that didn't show up on the profit and loss statement, but actually had significant impacts on the business outlook for a firm? This might be of concern, but then again, if the people that make the rules don't deem an item an expense, then what does it matter? If it's not on the income statement, then bottom line, it doesn't exist (pun intended). That's the "reality" of accounting, right?

This auditors' eye view of the world has definitely been called into question with regard to stock options -- which have sometimes been called "the shadow currency." In the deliberations surrounding SFAS No. 123, "Accounting for Stock-based Compensation," the Financial Accounting Standards Board had a chance to require the reporting of "option-attributable compensation expense" in the body of the income statement. However, what actually emerged from the whole affair was the requirement that companies' make footnote disclosures regarding the pro forma effects of using the "preferable" stock compensation accounting. The end result is that annual report footnotes have suddenly become a part of the income statement.

Well, not really, but investors should really take a closer look at the "pro forma" numbers being reported by companies (in comparison with the reported basic EPS) -- especially those that tend to issue options like it's going out of style. This, of course, includes a sizable portion of the software and computer services firms, which rely on options compensation as a meaningful element of their overall compensation package. And this really gets to the heart of the matter; if a firm decides that in order to have competent employees it must pay those workers with options, then those awards are definitely a factor in the production process.

Dilution is not the issue here. Rather, it's the possible overstatement of earnings that results from the use of options "for free." That is, options bear no explicit cost to the firm that uses them. As one strong agitator for greater transparency on the options issue put it, "Employees pay the exercise price, pay the tax, the company gets valuable cash from both the employees and the IRS in the form of reduced taxes and does not recognize any expense on the income statement nor a liability on the balance sheet."

Oftentimes option programs are defended on precisely these grounds. It is said that they provide suitable incentives to employees without any cash outlay. In fact, shareholders can actually benefit from the exercise of options in that they bring in some hard cash, and at prices above book value. Despite the increase in shares outstanding after exercise, the added capital tacked on to stockholders equity can actually result in an increase in the ultimate net worth per share. However, this activity has one important qualification.

Say a company announces a share buyback, and most observers interpret this as a positive market signal. Hey, management is asserting its belief that the firm's stock is undervalued, right? Checking out the share dilution connected with option issuance might provide some valuable insight into what can only be construed as a cash outlay for compensation.

If a company is actually buying back higher priced shares in order to offset the share quantity dilution imposed by the issuance of options, then that should really be viewed as cash paid for employee compensation. In instances where the firm buys back shares at higher market prices, any increase in equity that might have resulted from option exercise is upset by the treasury stock cost from the buyback. While shares outstanding may have been brought back into line (to the pre-option exercise amount), stockholders equity will have been beaten down to levels below the initial option transaction. Hence, the stock buyback ends up decreasing the book value of shares and the net worth of shareholders.

The "resolution" of the options issue brought about by SFAS No. 123, and the reporting of pro forma disclosures that contain portions of grants made in 1995, 1996, and 1997, still attach no cost to grants made before 1995. If a firm makes $100 million in options grants per year with a vesting period of five years, then it is assumed that employees who qualify will have the same length of service period. This in turn means that it will take five years for the annual figures to reflect all of the compensation program -- since none of the options granted before 1995 will be factored into the pro forma numbers (with the added difficulty of a firm possibly making a $100 million grant every year, phased in over five years). What this ultimately means is that the pro forma numbers issued now are most certainly still overstating earnings -- but will grow more relevant with time.

A company that has really served as the whipping boy for the options agitators is Microsoft (Nasdaq: MSFT). In fiscal 1997 the firm showed a net increase of 21 million shares that resulted from options. Meanwhile, Microsoft had bought back $3.101 billion worth of shares, or 37 million shares. The 45 million option exercises brought in a "paltry" $597.2 million for the company, which means that it paid roughly $2.5 billion to bring its share dilution down to only 21 million shares (rather than a possible 48 million). If you buy the arguments made above, this amount should really be considered a cash outlay for paying employees.

That's not the end of the story though. Employees end up paying tax when they exercise stock options. The actual amount is the difference between the market price and the exercise price of the stock. The employer, in our example Microsoft, gets a tax deduction for the exact same amount and gets to call it "compensation expense" on the tax books. This amount can be pretty staggering. In fact, in fiscal year 1997 Microsoft recorded $2.274 billion in compensation expense, which pretty much offset (in cash flow terms) what was paid out for the buyback. Bill Parish, founder of Parish & Company (one of those agitators that we were talking about), has published numbers for Microsoft through fiscal year 1998, which fully reflect the impact of these treatments. Here are some of the numbers:

Financial Highlights       YE 6/95   YE 6/96   YE 6/97   YE 6/98
(000,000)
Cash & Short Term $4,750 $6,940 $8,966 $13,927
Revenue $5,937 $8,671 $11,358 $14,484
Operating Expenses $3,899 $5,612 $6,400 $8,070
Reported Net Income $1,453 $2,195 $3,454 $4,500
Compensation Expense $511 $1,006 $2,274 $4,434
Remaining Option Liability $6,997 $9,025 $22,719 $37,745
Liability as % Net Income 482% 411% 658% 839%

As can be seen, in fiscal year 1998 over 50% of the operating expenses at Microsoft could be accounted for through the compensation expense tax deduction. The remaining liability is calculated by taking the stock price minus the average exercise price, multiplied by the option shares outstanding -- and this amount is pretty hefty as well.

So what are the implications of all this? That can be a tough question to sort out when the accompanying reporting issues begin to get murky, but it seems like the following question should at least be asked -- "Can a company achieve the same financial results without the use of options as it could with their exercise?" Interested investors should assess the data themselves and then become either "options agitators" or "pro forma number watchers." In either case, the deliberations will result in a better informed stock purchasing community.

Correction: In the "Fool on the Hill" column on October 23, we incorrectly stated that electronics contract manufacturer Jabil Circuit (NYSE: JBL) had announced earlier in the year that it had won a contract to manufacture laptop PCs for Gateway Inc. (NYSE: GTW). While Jabil is manufacturing new products for Gateway, it does not manufacture notebooks for the company. We confused two different customers. Apologies for the error.


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