Cisco's Stock Option Excess

Hello again. It's been awhile since I last appeared in this space; it's nice to be back. Those of you who are wondering where I've been or what I've been up to over the last several months can get some idea by reading this discussion board post.

During my absence I haven't kept quiet when it comes to corresponding with companies. Today I thought I'd share part of an ongoing conversation that I've been having with Cisco's (Nasdaq: CSCO) director of investor relations on several topics including its use of stock options, which I consider bad practice for its investors.

My discussion about stock options with Cisco began in early May after I learned Cisco had opted to capitalize on one of the latest fads related to stock options; i.e., its decision to make a special options grant to employees. When the stock price of a company that relies on stock options as a significant element of compensation falls, the company has a few choices as to what it can do about the situation: 

1. Reprice some or all of its employees' outstanding options.
2. Issue a special option grant leaving the existing options intact.
3. Do nothing.

From an accounting perspective, the second and third alternatives have the same impact on earnings as an initial stock option grant -- none. (See this article for more information on income statement treatment of stock options.) Companies generally shy away from repricing options since it often results in a charge to earnings. As a result, most companies pick one of the last two options.

It's important to note that Cisco isn't the only company to take this step. Two other Rule Maker Portfolio holdings -- Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT) have done the very same thing.

Cisco chose to issue new lower-priced options to employees that received option grants over the last two years. It seems the vast majority (if not all) of these options are now underwater. I understand options are viewed by many as an important part of compensation, and that there could be some retention issues without the granting of options. But, when carried to excess it's a practice I just don't like. All shareholders that bought Cisco stock during this period do not receive a similar benefit.

Additionally, existing shareholders see a dilution of their stock ownership, and the ultimate increase in the number of outstanding shares negatively impacts all financial metrics calculated on a per share basis.

When I sent a note to Cisco voicing the above concerns, here's what I was told by the director of investor relations:

With regards to stock options -- I am sure you have heard our management team say that Cisco will not be repricing its employees' stock options. At the same time, you are obviously aware that Cisco does intend to implement employee option programs as a compensation and retention tool. Your concern about dilution is a common one, and I submit that increased shares outstanding due to employee stock options does, in fact, impact earnings, to a degree. However, I would argue that employees -- who are also shareholders -- only gain when shareholders gain, as increased shareholder value at Cisco is a shared priority between employees and shareholders. Also, just for the sake of my argument, shares only become outstanding when the options are exercised, which requires a rise in stock price, which we all would welcome, both shareholders and employees alike.

Personally, I don't see any difference between issuing new options in a special grant to supplement those that are underwater and repricing. I actually view the special grant as a deceptive means of avoiding the financial statement impact of repricing.

As for the employees being shareholders, that's a valid point. But these same employees were shareholders when the options that are underwater were granted, and that hasn't led to anything other than losses over the last year and a half.

In later correspondence Cisco said the following:

To return to the issue of employee stock options, please note that the stock option program has two purposes: 1) alignment of employee and shareholder interests, and 2) retention. While I do understand your concern over the dilutive impact of options, I still argue that the benefits of this option program over the long-term outweigh the dilution. With this said, I can tell you that we are looking at ways to balance the dilutive impact from stock options.

At least some comfort can be taken from that last sentence. But, I continue to believe that Cisco is failing to fully consider the impact of stock options on its results.

In a recent and excellent Fool on the Hill column, Bill Mann discussed the Warren Buffett approach to valuing stock options: Take the number of options granted times the exercise price and divide the result by three. I ran numbers for Cisco for the last three years and found that Cisco's results would have been much worse if it had been forced to take the cost of exercised options into account when measuring earnings.

         Reported earnings  Adjusted earnings

1998         $1,812.6          $872.6
1999         $2,486.0          $671.3
2000         $3,783.1          ($1,340.0)

The bottom line is that the more I read about Cisco's employee option program the less I like it. I fully understand the issue that options are part of what keeps workers with a company, but if used to excess, then they're not good for the shareholders.

Additionally, stock options have greatly skewed Cisco's cash flow over the last few years. I'll discuss this issue more fully in a future column, when I'll examine the unusual decline in Cisco's cash flow benefit from employee stock option exercise from the end of the second quarter to the end of the third quarter. That decline may not bode well for Cisco's future results.

By the way, Cisco reports fourth-quarter earnings later today. For a preview, see the Fool's Breakfast News.

Note: After much debate, the Rule Maker team has decided not to invest this month's $500 installment in any company. We're keeping the money in our account to await a better opportunity.

Phil Weiss and his family reside in northwestern New Jersey. Despite the concerns discussed above, at the time of publication he owned shares of Cisco, Intel, and Microsoft. The Motley Fool is investors writing for investors.