FOOL ON THE HILL
An Investment Opinion
Options Overhang, Part I: Avalanche, What Avalanche? Louis Corrigan (TMF Seymor)
August 18, 1999
The mainstream financial press brought us two articles this week on the potential dangers of the employee stock options overhanging this market. The first article initially seemed like an interesting macro take on the issue, but it quickly turned into such a shockingly misleading and inaccurate piece that it disgraces the New York Times. The other article, in the Wall Street Journal, detailed a stock-specific dynamic that anyone invested in a hot market sector like the Internet needs to understand. Today I'll stick with the eye-poking; next week, I'll return for the backslapping.
Gretchen Morgenson's Sunday Times column was aptly entitled "Rumblings of an Avalanche" because it stirred up fears of impending disaster due to the
raft of stock options granted to executives and other employees at top Nasdaq companies. Morgenson suggested that when the market was rising, options-rich employees had been happy to kick back and count their paper profits. Yet the experts she approvingly quoted seemed to think a significant market downturn could unleash an avalanche of insider selling that might batter tech stocks when they were already falling.
That could devalue unexercised options and ultimately convince employees that they would rather have a bigger pay raise today than more options for the future. In turn, this would increase reported operating expenses and hurt corporate earnings, further damaging stocks. Bad news all around.
As most of you know, high-tech companies reward employees with stock options. Indeed, options grants have become a more prized form of compensation than salary and benefits because they allow employees to profit from their company's rising stock price. Typically, an employee will receive an incentive stock option grant that gives her the right but not the obligation to buy the company's stock at a fixed price anytime in, say, the next 10 years. The options usually "vest," or become exercisable, over a period of 4 to 5 years, either in equal amounts (20% per year) or on an accelerating schedule (say, 10% after one year, 15% the next year, 20% the next, and so on). Options align the employee's interest with those of shareowners since the options will only rise in value if the stock does.
Employers like to dispense stock options partly because they create "golden handcuffs" that encourage presumably talented employees to stick around. After all, an employee who leaves a corporation before her options vest sacrifices however much the options might be worth. And in today's markets, that value could be substantial. The beauty of options is that they create this powerful incentive without requiring the company to make any cash payments. Moreover, accounting practices do not require companies to expense the full cost of options grants, and this distinguishes them from normal salary expenses. This accounting convention benefits the company's reported earnings and thus helps drive stock prices higher. (For some critical scrutiny of this otherwise virtuous circle, check out the links listed below to Warren Gump's series on options accounting.)
Morgenson offered some impressive stats to support her gloom-and-doom scenario. According to First Call's Bob Gabele, the companies comprising the Nasdaq 100 index -- including giants like Microsoft (Nasdaq: MSFT) and Cisco (Nasdaq: CSCO) -- made options grants between 1994 and 1998 that will allow employees to buy a stunning 4 billion shares of stock. That stock was recently worth some $220 billion, or 9% of the Nasdaq 100's total market value. A table that accompanies the article (presumably based on Gabele's work, though unattributed) shows a "snowballing" trend indicating that "annual stock-option grants as a percentage of shares outstanding at 200 big companies" rose from a little over 1% in 1993 to around 2% in 1998.
Now, Morgenson doesn't mention how much these employees would have to pay to exercise these $200 billion worth of options -- and they certainly do have to pay something. She also doesn't mention how many of the options behind this total are vested and thus can be exercised today. In other words, my guess is that it's simply not true that employees of the Nasdaq 100 have walked away with 9% of these companies' aggregate market value over the last four years, or that what they have received came gratis. Thus, I suspect it's also not true that the employees of "200 big companies" walked away with an additional 2% of these companies' total market value in 1998. I'd call Morgenson's handling of these data unclear and a bit misleading, but tame compared to what follows.
For her specific example, Morgenson turned to Cisco's FY98 annual report, which she said indicated that the networking behemoth had outstanding options covering some 1.56 billion shares with an average exercise price of just $25.23 -- well below Cisco's closing price Friday of $63.56. The implication was that with so many in-the-money stock options outstanding, stocks like Cisco could be very vulnerable to massive insider selling. That's because insiders might grow fearful that their paper profits would disappear, so they would opt to buy Cisco shares at their exercise price (average: $25.23), and then immediately sell them on the market for the going rate. In an already falling market, that could really rock a stock.
Don't panic yet, though. The first problem with this argument is that recent history offers no evidence to support it. Quite the contrary. Cisco's stock got absolutely hammered last fall, losing 41% of its value from the August high to the October low. Yet, no avalanche ensued, or at least not the kind that buries the village and the cows and the Jagermeister. Indeed, the stock has more than tripled off its October low since then.
This at least suggests that Morgenson, and possibly the experts she interviewed, misconstrues how Cisco's employees think about their stock options. (Indeed, as will soon become obvious, Morgenson doesn't really seem to understand options at all. But that's not surprising given that the Times probably doesn't grant stock options to columnists -- happily, the Fool does). My guess is that Cisco's employees see the options grants as a cross between compensation they deserve but are deferring, and a performance bonus that they can earn. It's not money they need today. It's more akin to investment capital.
What would you do if you owned long-term options in Cisco, one of the greatest value-creating vehicles the world has ever seen? Well, it depends on your particular situation, of course. Unless your options expire within the next year or you want to buy a house in the next few months, I think you would take note of the daily stock movements but you wouldn't sweat them. That is, you would act like any other long-term investor who owns a stake in one of America's best companies.
Besides, assuming you would be exercising deep in-the-money options, cashing out would force you to take an enormous tax hit on the capital gains, or the difference between the options' exercise price and the price at which you sell the stock. That alone would encourage a Cisco employee to stay the course unless she thought the business was really turning sour. I may be wrong, but I'd be surprised if you could find a single Cisco employee who thinks that.
But Morgenson doesn't just greatly exaggerate the supposed repercussions of this options "avalanche." She actually gets the numbers wrong. Really wrong. Really, really wrong. The avalanche is more like a snowball. Woah, look out!
If you turn to Cisco's FY98 10-K filing, it quickly becomes obvious that the 1.56 billion shares Morgenson references is not the number of shares behind Cisco's options grant but Cisco's total shares outstanding as of July 25, 1998. I'm not kidding. The actual employee options then outstanding -- listed under section 9, "Employee Benefit Plans" -- covered just 215.7 million shares. On average, these options didn't expire for 6.6 years. Moreover, options for just 77.7 million shares were actually exercisable at that time, contrary to Morgenson's general contention regarding the Nasdaq stocks that "most options grants are exercisable now." Furthermore, the average strike price of these exercisable options was just $14.55.
Of course, Morgenson also didn't bother to adjust her numbers for Cisco's recent 2-for-1 stock split! So the 215.7 million shares granted via options at the time would now amount to 431.4 million. Their average exercise price is not $25.23 as Morgenson indicated but just $12.62. In turn, the adjusted exercisable options grant would now be 155.4 million shares with an average strike price of just $7.28 per share. And Cisco's split-adjusted sharecount would now be 3.12 billion.
Given that Cisco's fiscal year ends in July, these FY98 numbers are now pretty stale. However, Cisco has yet to file its latest 10-K, so good updates aren't readily available. Yet, the current fully diluted sharecount is 3.45 billion. Chances are pretty great that Cisco's total numbers of options outstanding and exercisable have risen a bit in the last year. Still, they're certainly a mere fraction of the numbers Morgenson used.
There's no question that Cisco has issued a lot of employee stock options. These days, nearly all of the most dynamic and successful companies do, and not just to the big enchiladas. And there's no question that a steep market slide would make holders of exercisable options spend a few moments thinking about the long-term viability of Cisco and the state of the U.S. economy. But the folks sitting on options that exercise at $7.28 per share aren't going to freak out if Cisco falls a bit, or even substantially. Moreover, Cisco was the only company Morgenson cited, so it's presumably her strongest example. Yet in this case, the example just unravels the tenuous logic of her whole argument.
Now, I don't mean to pick on Morgenson. She's a veteran reporter who has done a lot of great work, and every reporter occasionally gets things wrong. But her "Market Watch" is a high-profile column read by the million-plus folks who sit down every week with their Sunday Times to review the state of the world. In this case, they found news that just wasn't fit to print. Anybody who read the column was left needlessly worried about an avalanche that's more fiction than fact.
Next week, I'll take a look at E.S. Browning's piece from Monday's Wall Street Journal. For more eye-poking of the Wise, try this special tour of their Disaster '98 cover stories. For an insightful analysis of options accounting, see Warren Gump's series:
5/5/99: Optionmania II: Impact
5/7/99: Optionmania III: Takedown