Fool.com: Why Microsoft's Stock Options Scare Me [Rule Maker] February 17, 2000

RULE MAKER PORTFOLIO
Why Microsoft's Stock Options Scare Me

By Rob Landley (TMF Oak)
February 17, 2000

Forget Windows 2000. As far as I can tell, the single most lucrative product Microsoft (Nasdaq: MSFT) sells is its own stock. Microsoft receives almost as much cash inflow from the stock market as it does by selling goods and services. Here's how:

Basically, Microsoft receives cash by issuing employee stock options, after which the company then receives billions of dollars in tax deductions from the IRS for doing so. Add in the warrants it sells on its own stock, and the company made over $5 billion off the stock market last year (fiscal year ended July 1999), tax-free. For comparison, its after-tax net income was only $7.8 billion. Microsoft may not be much in the programming department, but its accountants are impressive.

Let's run through that again a little more slowly, using Microsoft's most recent annual report. As with all annual reports, the most interesting stuff is in the tables at the end. In this case, search for the $3.1 billion dollar item "Stock option income tax benefits," which occurs in the Financing section of the Cash Flows Statement (the above link will take you there). Lemme detour for a sec to explain what "Stock option income tax benefits" are.

A significant portion of the wages Microsoft pays to its employees comes in the form of stock options rather than in cash. Compared to the rest of the industry, the amount of cash Microsoft pays its programmers is at best mediocre. It attracts and retains employees via stock options.

These options give the employees the right to buy a certain number of shares of Microsoft stock at a tiny fraction of the current market price. Employees can even take an automatic payroll deduction to make the token payment to exercise each stock option as it matures, and thus effectively get shares of Microsoft stock as part of their wages (because the stock has appreciated substantially since it was granted at an exercise price equal to the market price several years prior).

Microsoft's options are "non-qualified," which means the employee is immediately taxed when an option is exercised (i.e., used to actually purchase very cheap stock). The difference between the price the employee pays for the stock and the current market price for the stock they receive is counted as taxable income on the employee's W-2 tax form for the year, as if they'd received it in cash. The cost basis for the stock is adjusted accordingly, meaning that if the employee immediately sold their newly acquired Microsoft shares they wouldn't incur any additional taxes. They've already been taxed on that income anyway, and the only new taxes to accrue are capital gains taxes if they sell the stock for a higher price than they bought it at. (Capital gains taxes apply to the extra money gained by selling an investment for more than it was purchased for. Only the amount over the original purchase price -- the cost basis -- is taxed, and this has nothing to do with options.)

Corporations pay taxes on their own income (generally 35%), but money they pay out in salaries to employees is deductible from the corporation's income. Since granting options to employees results in taxable income to those employees, Microsoft gets to deduct that taxable employee income from its own taxable corporate income, and that's where Microsoft got a tax-free $3.1 billion in cash in fiscal 1999: "Stock option income tax benefits."

But if you stop and think about it, Microsoft didn't really have to spend actual money to provide the options. It even GOT a little money from its employees, in the form of the cash the employees paid (via payroll deductions) to exercise their options. All Microsoft had to do was issue new stock certificates, which more or less involves taking a vote in a board meeting and then firing up a laser printer.

So Microsoft got $3.1 billion of tax money back from the government, which at a 35% tax rate would be in exchange for a $9 billion tax expense it never had to pay. Its employees got taxed and paid that tax out of their own cash wages, and Microsoft got the money refunded back into its corporate coffers. It even got $1.3 billion of cash BACK from its employees in that payroll deduction to exercise the options (the "Common stock issued" line item, in the same Financing table as the "Stock option income tax benefits"). Together, that's almost $4.5 billion dollars Microsoft made directly from selling stock.

This is on top of a huge cash savings from substituting shares of its stock for actual cash paid to employees in the first place. Remember, Microsoft only made a $7.8 billion net profit last year. To pay its employees an extra $9 billion in cash compensation expense, it would go $1.2 billion into the red. But it doesn't have to, as the stock market provides the money to keep Microsoft going. Microsoft prints stock, pays its employees with the stock, and the stock market provides the cash for Microsoft's employees when they sell the stock or get margin loans against it. Microsoft can print as much stock as it likes in order to pay its employees, and as long as the market keeps wanting to buy shares from those employees, then Microsoft doesn't have to spend too much of its own cash to pay its people. As of July '99, Microsoft had around $60 billion of employee stock options outstanding, and it grants more all the time.

Of course printing more stock dilutes the value of Microsoft's existing shares, but as long as the stock price keeps going up nobody seems to mind. And of course Microsoft can buy back some of its shares -- $3 billion in 1999 ("Common stock repurchased" in the same Financing table as before) -- but since it issued over $10 billion worth of shares ($9 billion taxable income over and above the $1.3 billion the employees paid for it), this buyback is a mitigating factor at best. But since a lot of Microsoft shareholders hold on to their shares and live on margin loans, the dilution doesn't increase Microsoft's share float until they do decide to sell (i.e., the stock starts going down and they have to pay off those margin loans). Meanwhile, the buybacks help keep the stock price from dipping too much.

Employee options aren't the only kind Microsoft sells. It sells another kind called "put warrants" to mutual fund managers, giving them the right to sell Microsoft shares back to the company at a fixed price (well below the price they're currently trading at, of course). Mutual fund managers with a large exposure to Microsoft stock buy warrants as insurance, giving them a guaranteed floor price they can sell out at if the stock collapses. If the stock doesn't collapse, the warrants expire worthless after a few years, and provide Microsoft with additional revenue (three quarters of a billion in 1999, "Put warrant proceeds" in the cash flows statement).

So there you have it. $3.1 billion from a tax loophole, $1.3 billion from its employees, and $0.7 billion from put warrants combine to give Microsoft over $5 billion from its own stock in fiscal 1999. And it avoided paying $9 billion in wages. All that from a company that only had $7.8 billion in net income. And as long as the stock keeps going up, they can keep doing that ad infinitum.

Maybe if Microsoft had recruited a few people from their accounting department into the programming staff, they'd have gotten Windows 2000 out on time, eh? Then again, who cares about products if you can make this much money without them?

- Oak


 




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  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 05/26/98 95 AXP 35.38 40.41  14.22%
 02/27/98 27 KO 69.11 44.25  -35.97%
 02/15/00 250 NOK 27.21 17.37  -36.17%
 04/03/01 30 JNJ 47.28 55.35  17.06%
 02/03/98 66 PFE 27.43 33.21  21.06%
 10/24/02 25 GD 79.98 63.12  -21.08%
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 08/21/98 44 SGP 47.99 18.50  -61.45%
 07/24/02 41 COST 35.89 35.91  0.06%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 05/26/98 95 AXP 3,360.87 3,838.95  478.08 
 02/27/98 27 KO 1,865.89 1,194.75  -671.14 
 02/15/00 250 NOK 6,802.85 4,342.50  -2,460.35 
 04/03/01 30 JNJ 1,418.50 1,660.50  242.00 
 02/03/98 66 PFE 1,810.58 2,191.86  381.28 
 10/24/02 25 GD 1,999.50 1,578.00  -421.50 
 02/06/98 75 TROW 2,559.06 2,319.00  -240.06 
 08/21/98 44 SGP 2,111.70 814.00  -1,297.70 
 07/24/02 41 COST 1,471.49 1,472.31  0.82 
Cash:11,132.36 
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