Aligning Interests? Yeah, Right

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The recent decision by Cisco Systems (Nasdaq: CSCO) to shorten its assumption for how long it will take employees to exercise their stock options from 5.6 years to 3.3 years would deeply decrease the estimated value of those options granted in 2004, from $1.3 billion to just more than $1 billion. At present this makes little difference in Cisco's reported financial performance -- its footnoted expense for options will decrease by about $300 million. Ah, but this gets interesting when, as expected, the Financial Accounting Standards Board (FASB) approves a proposal that requires companies to count stock options as an expense on their income statements starting in June 2005. In such case, over the course of five years the company would be able to report earnings that were approximately $170-$190 million higher post-tax than it would under the old assumption.

By the way, that's just the benefit for a single year's worth of employee stock options. Count on Cisco issuing tens of millions more next year, the year after, and so on. The difference in reported earnings by shortening the assumed vesting is therefore potentially substantial. Keep in mind that Cisco has done nothing to change its options program, unlike companies such as Apple (Nasdaq: AAPL), Intel (Nasdaq: INTC), and Microsoft (Nasdaq: MSFT), which have either shortened vesting periods or scrapped stock options altogether.

The company claims that it has undertaken an extensive analysis of actual employee behavior in exercising options. We've no reason to doubt that this is the case. But if this is true, doesn't it blow a hole in the anti-expensers' argument (fatuous at any rate as no one is talking about banning options) that stock options are an important tool to give long-term ownership to employees to align their interests with shareholders? If Cisco's actual holding term average is 3.3 years, that means its employees held onto their options for an average of 243 days after they vested before rushing to cash 'em in. Cisco's options have nine-year lives and vest 20% the first year, then 1.67% each month through the fifth year. That's not the imprimatur of a group interested in long-term alignment, ownership, or anything of the sort. These options are, in Wall Street parlance, "a source of funds" from the moment they vest.

This is not illegal. None of it is. But it's just another sign of the bankruptcy of the argument that options given to employees should be treated as anything other than cash-equivalent compensation. There's no alignment going on here at all, but don't expect even the numerical proof of such, provided by Cisco itself, to cause the company to change its rhetoric one iota on the benefits of unexpensed stock options.

See also:

• Phil Weiss' "Cisco's Options Excess"
• Whitney Tilson's "Stock Options Hurt American Competitiveness"
• Bill Mann's "Begging the Options Question"

Bill Mann owns shares of none of the companies mentioned here. He is among the vanguard of the movement to pronounce the word "router" like "rooter." He is a member of the User's Advisory Council of the Financial Accounting Standards Board.