FOOL ON THE HILL
An Investment Opinion
The Trouble With Options Bill Mann (TMF Otter)
October 25, 1999
Many prestigious investment banks in the country have reported rising difficulty in attracting the best and brightest coming out of the nation's top universities. The reason is simple: the attraction to companies offering potentially lucrative stock options. The explosive wealth generated by Internet companies and legends of Silicon Valley secretaries holding millions in stock is a powerful enticement. In a free market economy, people whose efforts create wealth for their companies should rightly derive direct personal benefit.
Options are valuable, a powerful incentive to management and employees since they are encouraged to align their best interests with the shareholders'. But just like every other tool, options have the potential for abuse. Beware, dear Fool, of a company falling over itself to grant huge portions of its total shares to its management and employees. During a time of market appreciation these options will have the effect of diluting your total potential returns; during a market downturn, far more sinister forces can come into play.
Philip Fisher noted many years ago the danger options present to the individual investor:
"Probably most costly of all to the investor is the abuse by insiders of their power of issuing stock options. They can pervert this legitimate method of compensating able management by issuing to themselves amounts of stock far beyond what an unbiased outsider might judge to represent a fair reward for services performed."
Let's explore the risk factors over-exuberant option granting can cause investors. First and most simply, options increase the float of shares outstanding, thereby diluting earnings per share of the stock. A rational options program will, at any one point, reserve no more than 5% of the current outstanding float for options. A look at the current 10-K for Merrill Lynch (NYSE: MER), for example, shows that its management and employees have unexercised options equaling 52% of its total float. More than half! And generally accepted accounting practices (GAAP) do not require the company to list the value of these options as an expense.
As Warren Buffett said in the most recent Berkshire Hathaway (NYSE: BRK.A) annual report, "If options are not a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where should they go?" Under GAAP rules, options can be granted by companies without being included as a salary expense on the balance sheet. Simply speaking, the company can pay its employees millions of dollars with zero effect on the bottom line.
This means that the management can pay themselves enormous pay packages weighed heavily in options without impacting the bottom line of the company. The cost comes in the form of share dilution, affecting the shareholders by lowering EPS. Companies get to compensate employees in a way that allows them to ignore the cost on their balance sheet. This would seem to be a simple choice for management: pay themselves in cash and count it as a G&A expense, or pay themselves in options and ignore the cost.
The second risk factor comes in the form of repricing, which is truly a "heads I win, tails you lose" proposition. Last September, when the share prices of many companies fell by 25% or more, many options were priced higher than the actual current share price. To combat this, certain companies took the opportunity to reduce the per share cost of their options, a charge which is reflected upon their balance sheet. This would be similar to your getting a rebate at company expense on your stock because its value decreased after you bought it.
This, of course, is absurd. Equity investments are not insured, and erosion of asset value is a risk we each face. Repricing removes the raison d'etre for options in the first place: executive compensation based upon performance. Further, it builds a new wall between shareholders and managers -- even if properly accounted for, repricing is a benefit to the management at direct expense to shareholders. If only we had the same tool to write off losses!
The next and perhaps most sinister risk is dilution of shareholder equity and hidden costs. Let's take Citigroup (NYSE: C) for example -- not because their options program is especially bad, because it is not. What is remarkable about Citigroup? Its CEO, Sandy Weill, earned a total of $240 million in options for 1998. This extraordinary amount was not paid for by the company; they don't even have to list it as an expense. Rather, it was paid by the Citigroup shareholders in per share profit dilution. Currently, Citigroup has set aside 166 million option shares, or 7.4% of all outstanding shares. Relatively speaking, this is not high. Fifteen of America's 200 largest companies have set aside more than 25% of their total shares for employee options, and 93 of the same companies have granted their CEOs option packages in excess of $10 million.
Does this mean that the amount of shares is going to increase faster than revenues? One of the major Foolish tenets in evaluating a company is to determine shareholder friendliness by ensuring that the number of total shares does not increase too quickly, as rapid gains in shares issued cause company earnings to be spread across an increased number of shares. Citigroup repurchased $840 million of its own shares last year, undoubtedly a good thing. But factoring in the lucrative package to Mr. Weill means that only $600 million of that money went to actually retiring shares. However, relative to many of the largest companies, Citigroup's options program is fairly benign to shareholders, since the total percentage of equity is low.
There is also the Immutable Law of Unintended Consequences. This law has yet to be tested, since the Golden Age of the Stock Option (the '90s) has thus far only coincided with the greatest market rise in history. With the rapidly rising market, the wealth created through options is thus far paper wealth, as holders of these options have been only too happy to hold on and let them accumulate value. But what happens during a prolonged downturn? Are these option holders going to exit the market en masse in order to lock in their returns?
Corporations' current dependence upon options means that we have the highest percentage of shares distributed in closed market environments (i.e., not at competitive market pricing) in history. We have yet to reach that point, but Wisdom has long since preached for diversification to hedge against downturns. Will a decline become exponentially heightened because employees fear maintaining too much of their net worth in one company? We are fortunate in many ways not to have suffered a long downturn this decade, but there will be a point in the future when the stock markets do not rise. How will the existence of billions of dollars of options shares change how the market reacts?
So watch those options, they're listed in every company's 10-K and 10-Q. Make sure that you take the time to determine the percentage of "live options" versus the total float of the company. If the percentage seems high, the company's management may have their hands in your pocket. Options are a valuable tool to force management to keep their eyes on the performance of the company, but they comprise yet another tool ripe for abuse.