Begging the Options Question

Here's something I find a little funny about the debate over stock options. One of the first things detractors invoke is the need to "retain the best talent." Yes, this is an information-based economy, and yes, companies should compensate their knowledge workers at a level that prevents them from going elsewhere.

But the last time I checked, the pink-slip parties in Silicon Valley were still pretty well attended.

There's also a deep concern about knowledge jobs being shipped overseas, primarily to the waiting arms of Indian companies like Infosys (Nasdaq: INFY  ) and Wipro (NYSE: WIT  ) . The same holds for overseas satellites set up by U.S. companies like Microsoft (Nasdaq: MSFT  ) , which has a large complex of programmers at work in Bangalore. And it's not just technology.

On Wednesday, MSNBC released a report detailing the move by some U.S. investment banks to hire Indian stock analysts in order to reduce research costs. By so doing, J.P. Morgan Chase (NYSE: JPM  ) , Goldman Sachs (NYSE: GS  ) , and others can pay the going Indian rate for analysts, around $25,000 a year, instead of the six-figure salaries commanded by employees performing the same function in New York.

This morning, I had two articles open on my desktop offering interesting counterpoints to one another. The first, an executive comment by Bob Bailey, CEO of PMC-Sierra (Nasdaq: PMCS  ) , offered the same warmed-over homilies explaining how expensing stock options is a threat to the American Way. Deeply threaded through his opinion is the idea that retaining knowledge workers is the critical challenge facing U.S. corporations today. I totally agree. Our economy has transformed almost completely from manufacturing to information services.

The second, by SmartMoney.com's Lawrence Carrell, begins with this little piece of wisdom: "Does a degree in, say, computer technology, sound attractive the day after Hewlett-Packard (NYSE: HPQ  ) announces an additional 1,300 job cuts? If so, you might have a future at DeVry (NYSE: DV  ) ."

To retain or disgorge?
On the one hand, we have a CEO saying that they need to do everything they can to retain their workers, and that forcing companies to expense the cost of employee stock options would undermine their ability to do so.

On the other, we see a multi-year trend undermining the very need to attract workers -- technology companies have been laying them off hand over fist. Add in that the same (or similar) work can be done overseas for dramatically less, and I really have to wonder who Bailey thinks he's fooling.

There's no need to "retain" folks -- if anything, there's a need to cut back on high-cost employees. For each employee with a job at PMC-Sierra, there are several more, out of work or underemployed, who would be willing to do the same job for less money.

It doesn't really work that way, however. Economics tells us that employee salaries are among the least responsive to downward shifts in the demand curve. Employers simply do not make a habit of cutting wages.

Instead they employ fewer people at the same salary. This happens for a variety of reasons, including collective bargaining, public pressure, and employee morale. All are legitimate concerns, of course, but let's not kid ourselves that the problem facing U.S. companies is employee retention. Seriously, where else are the employees going to go? India?

Supply and demand
PMC-Sierra could fire every single one of its employees and have someone else sitting in the same seat tomorrow -- someone who is just as competent and willing to do the same job for 20% less. And that's without looking overseas. That's no knock on the fine people who work there -- that's reality. Those jobs are knowledge-based, but commodities nonetheless.

A glance at PMC-Sierra's filings backs this up. As of December 2000, the company employed 1,726 employees; two years later it had 1,099. In research and development, the lifeblood of a technology company, PMC-Sierra lightened its employee base by 37%, or 404 workers. This is not a company with employee retention problems, nor is it alone in the knowledge sector. Jobs in Silicon Valley are extremely hard to come by.

Meanwhile, PMC-Sierra has, over the last five years, managed to generate negative free cash flow absent the effect of those stock options -- stock options that diluted existing shareholders by more than 30% over the same period.

What you have is a CEO crowing about the benefits of stock options and the democratization of ownership, while his company, in an environment friendly to that theory, is destroying shareholder wealth. And yet we see that employees and insiders at PMC-Sierra were able to cash in options to the tune of hundreds of millions of dollars during that stretch. Can we say that options had the effect of aligning interests at all?

News flash: The markets don't care
There's a brutal calculus to markets, both the stock market and the one for goods and services. If PMC-Sierra's products are made too expensive by its operating decisions, including its (admirable) desire to keep its employee base in North America, its customers will go elsewhere. In this light, employee retention may not be in the best interest of shareholders.

As argued when Microsoft moved from options to restricted stock, employees whose options end up deep underwater are unlikely to be happy. With restricted stock, even if the price drops, you still have the benefit of ownership and -- except for companies that completely collapse -- something of some value.

Mr. Bailey wonders aloud: "What will be the eventual cost to the U.S. economy if it loses its competitiveness to Asian rivals? The fact is our Asian business partners are well educated on the benefits of capital markets. They are now offering stock options at close to zero tax rates to entice skilled American-trained technologists to relocate to Taiwan, Hong Kong, and Mainland China."

What he's not saying is that the salaries in these locales are fractions of those in the U.S. I sincerely doubt that an exodus of currently employed workers is flooding back to Asia to take advantage of stock options. Our competitiveness is predicated on offering superior products at lower prices. None of this has anything to do with expensing stock options. Neither the stock market nor the market for goods gives a rip about that. Companies can either produce goods that have a price and quality that attracts demand, or they cannot.

Employee retention is an admirable goal when it makes economic sense. It does not make sense in situations where companies are destroying wealth rather than creating it. Hiding behind an accounting convention does not change economic performance. To turn the question around on Mr. Bailey: What has been the cost to America to date in destroyed equity investment in companies that reported profitability, but really had none, thanks to existing accounting guidelines?

The big valley transfer
PMC-Sierra has managed to transfer nearly 30% of its equity to employees in the past five years, with a net negative financial effect to shareholders. Kenneth Broad, a portfolio manager at Transamerica Investment Management in San Francisco, says that the tech industry is "afraid of the ugly truth: after taking options into account, much of Silicon Valley's economic miracle is really just a giant wealth transfer machine."

I'm not prepared to go that far -- clearly innovations from Microsoft, Intel (Nasdaq: INTC  ) , Cisco (Nasdaq: CSCO  ) , and the like have changed how the world does business. But for every additional dollar invested in Silicon Valley, these companies must be able to provide more than a dollar back in real return. If dependence on stock option accounting and favored tax status for compensation are the linchpins, then this industry is already doomed, and so is the prospect of retaining these jobs at all.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Really, Bill's just torqued that Paul got voted off Cupid this week. He owns none of the companies mentioned in this article. To find companies that are generating positive cash flow without the need for accounting tricks, check outTom Gardner's Hidden Gems. The Fool is investors writing for investors.


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