<THE EVENING NEWS>
Monday, November 23, 1998
MARKET CLOSE
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HEROES

Online retailer Cyberian Outpost (Nasdaq: COOL), which refers to itself as "The Cool Place to Shop for Computer Stuff," tacked on a cool $10 5/8, or 73.9%, to $25 after the ShopperConnection "online mall" of specialty retailers had its grand opening today. Fellow mall tenants rose on the news as well, with online music seller CDnow (Nasdaq: CDNW) gaining $1 5/16 to $13 1/2 and Web-based travel services provider Preview Travel (Nasdaq: PTVL) adding $2 1/16 to $17 3/16. Rounding out the shopping network are privately held firms Datek Online, eToys, Garden.com, PC Flowers & Gifts, Virtual Vineyards, and Hollywood Entertainment's (Nasdaq: HLYW) Reel.com unit. The network, which was originally formed in October with only four members, is being launched just before Black Friday and the unofficial start of the holiday selling season stampede. The partners are hoping the new site will be the Grinch that steals online Christmas sales from multi-faceted retailer Amazon.com (Nasdaq: AMZN), which for its own part, closed up $37 3/8 at $218 today.

Today's Happiest Man on Wall Street award goes to Bennett LeBow, the chairman, CEO, and 46% owner of cigarette maker Brooke Group Ltd. (NYSE: BGL). Brooke surged $6 7/16 to $17 7/16 after Philip Morris (NYSE: MO) agreed late Friday to buy the company's L&M, Chesterfield, and Lark cigarette brands for $300 million in cash. Philip Morris rose $2 1/2 to $58 1/4 on the news. The Marlboro Man has been distributing the three brands, which are made by Brooke's Liggett subsidiary, internationally for 20 years. With that in mind, analysts are suggesting Philip Morris will use the brands as discount alternatives to its key premium cigarettes in the U.S. For LeBow, the sale provides much needed cash and will allow the company to focus on its discount and private label cigarette business. In late August, Brooke traded as low as $3 13/16 per share on fears that dwindling sales would leave the firm unable to service its $238 million in long-term debt.

Group and individual disability insurer Unum Corp. (NYSE: UNM) moved to shore up costs at its individual disability division by announcing a multibillion-dollar acquisition the company hopes will pull down expenses and combat the increased claims that hurt the unit's results last year. Unum, which advanced $4 1/2 to $52 5/8 today, agreed to merge with rival Provident Companies (NYSE: PVT), the nation's leader in individual disability insurance, in a stock swap valued at about $5 billion. The combination will create the largest U.S. disability insurer. Under the terms of the deal, each Provident share will be exchanged for 0.73 of a share of the newly created entity, which will do business as UnumProvident. Unum CEO James Orr said this summer that his company would have opportunities to acquire the disability divisions -- often less profitable than life or property operations -- of large insurers as they move to public ownership. Provident, which moved up $4 1/8 to $37 1/2 today, may be the first of many.

QUICK TAKES: Internet portal and software firm Netscape Communications (Nasdaq: NSCP) was lifted $2 3/4 to $41 15/16 after the company confirmed that it is in merger talks with online services conglomerate America Online (NYSE: AOL), although an agreement has not yet been reached. AOL rose $4 3/8 to $89 1/4 and Sun Microsystems (Nasdaq: SUNW), which is reportedly mulling a marketing deal for Netscape's e-commerce software, gained $3 13/16 to $71 5/16. For more details, check out this Foolish feature... Electrical connectors maker AMP (NYSE: AMP) jumped $3 to $48 1/8 after accepting a $51 per share "white knight" buyout offer from Tyco International (NYSE: TYC), effectively ending AlliedSignal's (NYSE: ALD) four-month-old hostile bid for the firm. See today's Fool Plate Special for an examination of the deal.

Commercial and investment bank Bankers Trust (NYSE: BT) climbed $7 to $84 1/4 after saying it is in "advanced stages of negotiations" with Germany's Deutsche Bank concerning a long-expected $8.9 billion merger. Other financial services firms were lifted as well. Donaldson, Lufkin & Jenrette (NYSE: DLJ) picked up $3 9/16 to $42 3/4, Lehman Brothers Holdings (NYSE: LEH) gained $8 13/16 to $54 1/2, Paine Webber (NYSE: PWJ) rose $8 13/16 to $54 1/2, Merrill Lynch (NYSE: MER) tacked on $4 3/8 to $76, and Citigroup (NYSE: CCI) added $3 7/8 to $48 15/16... PC and computing products maker Hewlett-Packard (NYSE: HWP) marched up $3 13/16 to $61 5/8 after Lehman Brothers raised its rating to "buy" from "outperform," citing valuation.

Minimally invasive endoscopy surgical instruments designer Circon Corp. (Nasdaq: CCON) jumped $3 13/16 to $14 1/2 after disposable specialty medical products maker Maxxim Medical (NYSE: MAM) agreed to buy the company for $205 million in cash and $38 million in assumed debt... Online computer training services provider Computer Literacy (Nasdaq: CMPL) added another $1 1/8 to $21 1/16 after the company sold 3 million shares in an initial public offering late last week at a price of $10 per share... Home improvement products retailer Lowe's Companies (NYSE: LOW) moved up $1 11/16 to $41 1/4 after agreeing to buy Eagle Hardware & Garden (Nasdaq: EAGL) in a stock swap valued at about $1 billion. Eagle's 32 stores in the western U.S. will bolster Lowe's presence in that region. Eagle added $5/16 to $27 13/16.

Natural gas and electric utility Cilcorp (NYSE: CER) surged $7 9/16 to $61 after international power plant operator AES Corp. (NYSE: AES) agreed to buy the company for about $885 million, or $65 per share... Aerospace and industrial products supplier Coltec Industries (NYSE: COT) jumped $1 15/16 to $19 7/8 after agreeing to merge with aircraft systems and industrial and consumer products maker B.F. Goodrich Co. (NYSE: GR) in a stock swap valued at $20.13 per Coltec share, or $2.2 billion including assumed debt... Mutual fund manager and Cash-King Portfolio holding T. Rowe Price Associates (Nasdaq: TROW) gained $2 7/8 to $38 1/8 after Morgan Stanley Dean Witter raised its rating to "outperform" from "neutral." Fellow fund firm Franklin Resources (NYSE: BEN) received a similar upgrade, sending its shares up $4 3/8 to $44 7/8.

Biopharmaceutical company Oxigene Inc. (Nasdaq: OXGN) jumped $2 1/8 to $10 1/16 after researchers at the University of Florida announced the results of a study showing that the company's Combretastatin cancer drug "increased significantly" the tumor cell killing effects of radiation when the two therapies were used together to treat solid tumors in animals... Network software developer Novell Inc. (Nasdaq: NOVL) rose $1 3/16 to $18 on optimism ahead of its fiscal Q4 earnings report, which is expected tomorrow after the close of trading... Business software firm Computer Associates (NYSE: CA) added $3 1/2 to $44 3/4 after enhancing its Open License Program aimed at small- and medium-sized businesses to include more product lines, savings for clients licensing multiple products, and a new upgrade protection program.

Micro-positioning and precision optical products supplier Axsys Technologies (Nasdaq: AXYS) eyed a $4 gain to $14 7/8 after the company received a $15 per share cash buyout offer late Friday from a group led by current Chairman and CEO Stephen Bershad... Internet service provider (ISP) EarthLink Network (Nasdaq: ELNK) moved up $4 3/4 to $56 3/4 after becoming the official and exclusive ISP of PC and computing products retailer CompUSA (NYSE: CPU)... Telecommunications network installer Dycom Industries (NYSE: DY) rang up $2 9/16 to $40 9/16 after reporting fiscal Q1 EPS of $0.50 versus $0.37 (pro forma) last year, topping the Zacks mean estimate of $0.43.

Marketing information services provider NFO Worldwide (NYSE: NFO) tacked on $1 to $8 1/4 after agreeing to buy German-based European market research firm Infratest Burke for about $151 million, including assumed debt... Cranberry grower and processor Northland Cranberries (Nasdaq: CBRYA) advanced $5/8 to $11 3/4 after receiving a favorable mention in the latest edition of Barron's... Private mortgage insurer Amerin Corp. (Nasdaq: AMRN) gained $2 11/16 to $23 9/16 after agreeing to merge with rival CMAC Investment Corp. (NYSE: CMT) in a stock swap valued at about $606 million, based on CMAC's closing price today.

GOATS

An improved outlook for the semiconductor sector in the coming year is coupled with guarded optimism, according to one industry executive. "Although the semiconductor industry has reported the first signs of recovery," said John Dwight Jr., CEO of PCD Inc. (Nasdaq: PCDI), "we believe that caution on the part of our customers has contributed to a decline in our sales." PCD, which makes electronic interconnects for chip makers such as Altera (Nasdaq: ALTR) and Micron Technology (NYSE: MU), saw its stock fall $1 to $12 today on Friday's late news that the company expects fourth-quarter earnings to fall below analysts' $0.23 per share figure. The company anticipates reporting EPS of between $0.13 and $0.16, and Dwight hopes for a turnaround in Q2. In a cost-cutting move, PCD laid off several workers last week, according to reports, but Dwight said he doesn't see further cuts at this point. The cutbacks will not result in a charge.

News of a reorganization for bank holding company Republic Bancshares' (Nasdaq: REPB) underperforming mortgage banking operation came too late for investors today, as the company's stock fell $2 5/8 to $13 5/8. Republic said it expects to report operating losses in Q4 and full-year 1998 primarily because of lagging loan sales and high marketing costs at the mortgage banking division. The company anticipates Q4 losses of between $0.96 and $1.26 per share, well below Wall Street's current projected loss of $0.13 per share. For full-year 1998, Republic now sees losses of between $0.11 and $0.43 per share, compared with analysts' estimated profits of $1.17 per share. The reorganization is expected to be completed in Q1 1999.

QUICK CUTS: Cable TV operator Cablevision Systems (AMEX: CVC) whiffed today, losing $3 1/2 to $44 on reports that it will buy "Boss" George Steinbrenner's stake in the New York Yankees for somewhere between $550 and $650 million... Asynchronous transfer mode (ATM) switching products maker FORE Systems (Nasdaq: FORE) switched off $1 5/16 to $15 3/16 after it announced a partnership with network supplier TimePlex Group to resell FORE's switches as part of TimePlex's wide-area network solutions... Bookselling giant Barnes & Noble (NYSE: BKS) was shelved $2 1/4 to $26 3/4 after J.P. Morgan cut its rating on the company to "long-term buy" from "buy."

The American depositary receipts of Hoechst AG (NYSE: HOE) and Rhone-Poulenc SA (NYSE: RP) retreated today -- Hoechst's by $5/8 to $47 1/16 and Rhone-Poulenc's by $1 9/16 to $50 3/8 -- on reports that a German newspaper will say the companies are "fine-tuning" a merger-of-equals transaction that would form a global pharmaceutical and agricultural products giant. Rumors of such a deal have circulated for weeks... Several oil stocks slipped today as oil prices fell. Among the movers, contract driller Atwood Oceanics (NYSE: ATW) sank $13/16 to $22 7/8 while Transocean Offshore (NYSE: RIG) lost $1 3/4 to $28 9/16, oilfield services firm BJ Services (NYSE: BJS) lost $1 11/16 to $15 3/4, Noble Drilling (NYSE: NE) slid $1 1/8 to $13 9/16, Schlumberger (NYSE: SLB) slumped $1 9/16 to $49 7/8, offshore service vessel operator Tidewater (NYSE: TDW) shed $1 7/16 to $25 1/2, and oil exploration and production company Triton Energy (NYSE: OIL) was drilled $1/2 to $10 3/16.

Industrial chemicals and sealants maker W.R. Grace (NYSE: GRA) steamed away $1 1/16 to $16 7/16 after it said it expects "a number" of nonrecurring charges in Q4, possibly in the $50 million range... Notebook computer modems maker Xircom Inc. (Nasdaq: XIRC) lost $3 5/8 to $31 29/32 after Morgan Stanley Dean Witter downgraded the company to "neutral" from "outperform"... Hotel real estate investment trust (REIT) Patriot American Hospitality (NYSE: PAH) gave back $7/8 to $6 1/2 on news that it won't declare a third-quarter dividend in favor of a dividend payment in January that will keep it within the Federal guidelines for remaining a REIT... Temporary employment services firm Manpower Inc. (NYSE: MAN) laid off $1 3/8 to $23 7/8 after it released the results of a national survey in which 23% of respondents expect to increase staffing in Q1, down from 24% last year.

Electronic display developer Planar Systems (Nasdaq: PLNR) dove $1 1/2 to $8 after it said full-year 1999 net income is expected to be "substantially below its previous expectations" because of industry-wide sales weakness. The company believes the drag on earnings will be felt most in Q1, during which four analysts surveyed by First Call currently expect EPS of $0.20... Oral transmucosal drug delivery company Anesta Corp. (Nasdaq: NSTA) leaked $1 3/16 to $20 1/4 following Friday's announcement that it registered with the SEC for a proposed public offering of 2 million shares, about a 21% boost to the total outstanding shares.

Safeskin Corp. (Nasdaq: SFSK) washed away $2 to $20 7/16 after Barron's said the disposable latex and synthetic glove maker could see its share price fall amid increased competition that could hurt sales and profits... Drug developer Centocor (Nasdaq: CNTO) tumbled $3 3/16 to $42 3/4 today. The company lost $4 15/16 Friday after warning doctors of complications that may affect patients who stop and then resume treatment with its Remicade drug for Crohn's Disease... Information technology education and training company Learning Tree International (Nasdaq: LTRE) was pruned $13/16 to $8 7/16 after Legg Mason cut its rating on the firm to "market perform" from "outperform"... Onyx Pharmaceuticals (Nasdaq: ONXX), which reported "encouraging" progress in the development of an anticancer treatment, fell $1 3/8 to $7 1/4 today.

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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