Fool.com: Stock Option Rebuttal [Rule Maker] February 17, 2000

RULE MAKER PORTFOLIO
Stock Option Rebuttal
...and a new name for the Cash Flow Net Margin

By Matt Richey (TMF Verve)
February 18, 2000

We've got a multipart report for you tonight. As promised last Friday, Zeke will reveal a Foolish new name for the Cash Flow Net Margin. But first, I've got a bone to pick. Based on some of the controversy surrounding yesterday's column on Microsoft's (Nasdaq: MSFT) employee stock option plan, I think a rebuttal is in order. As you know, we Fools aren't opposed to dueling on our opinions. So tonight, I'm coming to Microsoft's defense. Unlike Rob, I think employee stock option plans have some considerable financial and strategic advantages as a means of compensating employees.

Employee stock options are one of the hairiest issues investors face these days. Last night, Rob gave one take on the issue. Now, admittedly, Rob's take on this issue is entirely biased by his well-established distaste for Microsoft. While Rob's numbers were technically accurate, I believe that Rob's concern about the risk this places to shareholders of Microsoft -- or any other company that makes aggressive use of stock options as compensation -- was overblown. In essence, Rob's concern is that a company that compensates its employees with options might see its profitability deteriorate if its employees suddenly were no longer willing to accept stock in lieu of greater cash wages. For example, if Microsoft's stock turned south for an extended period of time due to, say, permanent antitrust regulation, then Microsoft would surely have to cough up more cash to pay its people. Who's going to accept a flat or declining stock as compensation?

OK, so Microsoft's model depends on a steadily increasing stock price -- point taken. But conversely, let's consider the flip side of the equation. I see three key advantages to stock options. First is that options are a tremendous way to attract and retain employees. The "retain" aspect is especially important these days with our fiercely competitive labor market. Second, broad stock ownership inside a company creates an employee base that thinks and acts like owners. The obvious benefit is an alignment of employee and shareholder interests. The third benefit is that stock option compensation reduces current cash salaries by offering employees the opportunity -- and the risk -- of company ownership. The company benefits from reduced current cash outflow (especially beneficial for start-ups), while the employees benefit from the potential to share in the wealth creation of the business. It's a win-win.

The table below shows which of our Rule Makers are most aggressive in their stock compensation. As you can see, Microsoft is actually mid-pack in its use of options as a percentage of its overall diluted sharecount. If nothing else, Rob was unjust in pinpointing his attack against Microsoft.

  EVALUATION OF OPTION GRANTS OVER PAST 3 FISCAL YEARS
     (MILLIONS -- Numbers as of most recent 10-K) 
                               
                  (1)           (2)            (1 / 2)
                Options       Current      Grants as a %
                Granted    Diluted Shares    Sharecount
Yahoo!             61           224             27.2%
JDS Unph.          21            80             26.6%
Cisco             428          3398             12.6%
Gap                50           603              8.3%
Microsoft         436          5482              7.9%
T. Rowe            10           130              7.6% 
Amer. Exp.         24           463              5.1%
Intel             164          3517              4.7%
Pfizer             51          1315              3.8%
Schering-Pl.       32          1488              2.2%
Coca-Cola          44          2496              1.8%

The above table doesn't take into account the beneficial impact of share repurchases and proceeds from put warrants -- two smart financial strategies that Microsoft and Intel (Nasdaq: INTC) both employ to mitigate the cost of options. And yes, options certainly have a cost in the form of shareholder dilution. But let's weigh that cost against the potential benefits. Consider the amazing business success (not stock success) of the likes of Microsoft, Intel, Cisco (Nasdaq: CSCO), and Yahoo! (Nasdaq: YHOO). All of these companies dominate their respective industries and are living proof that options are a key ingredient in acquiring, retaining, and motivating employees to create some of the most thriving businesses in all the world.

In sum, I think that Microsoft is only doing what many other companies -- including companies that Rob likes -- are doing. It's true, of course, that if a critical mass of the technical professionals decide at some point in the future that they aren't willing to accept stock options as compensation, then there are a whole lot of companies that will take a big hit on the income statement, Microsoft included. I just don't assign this risk much weighting, and I think that this particular risk, as with all the risks inherent in investing in technology companies, must be weighed against the potential rewards. We in the Rule Maker port obviously continue to believe that the potential rewards of owning the stocks in this portfolio outweigh the risks going forward.

That's more than enough about options for a Friday. Here's Zeke with a much more amusing message...

Hey Fools! It's a special day today in the Rule Maker portfolio. That's right, today we're going to announce the winner of our contest to name our newest official Rule Maker criterion, formerly known as the Cash Flow Net Margin. For those of you who until now have been oblivious to this momentous event, please click back to last Friday's article. This has been a great learning experience for all of us Fools involved in the Rule Maker Portfolio, and I'd like to share with you what I've learned:

I've learned that we will never again run a general reader response contest over the message boards. Because of the mass of responses, meaningful discussion on the Rule Maker Strategy board was rendered basically impossible for about four days, for which I apologize to all of those Fools who nevertheless attempted to carry on as usual. In the future, we will either set up a temporary e-mail address, a temporary message board, or just have everybody mail their responses to Bill Mann (just kidding, Bill!).

I've learned that our community is amazingly responsive. I reviewed over 400 e-mails concerning last Friday's article, of which I would guess about two-thirds were from readers participating in our little contest. The other one-third consisted of readers alerting me to a stupid little error I committed in last Friday's article: Not once, but TWICE, I wrote that one should divide cash flow into sales. For those of you who, in addition to reading the text also looked at the formula, you probably know I should have said to divide cash flow by sales. Thanks to all the mathematically inclined who spotted this error.

Finally, I learned that despite some really great suggestions by our Foolish readers, sometimes it's best not to try to get too fancy. Now, I know that I'm going to get flamed for the rest of my life for this, and I tried like crazy to get Matt to be the one to break it to you, but we are actually not going to use any of the suggestions that were offered by our community. Nope, it seems to us, after much discussion, that the best name for our new Rule Maker criterion is one of the first ones that we came up with, back before I had the bright idea to have this contest. Henceforth, loyal Fools, the Cash Flow Net Margin will be officially known as the "Cash King Margin." Light on the tongue, intuitive, and, even better, a reference to the portfolio's original Cash King moniker.

Before you all head over to the message boards to hurl invectives at me, I would like to say that we are going to award the mystery prize for the name that we all agreed would have been the second choice. Even though in the end we won't use the name, this reader will hopefully be too excited with the fabulous prize to flame us, or worse yet, call for legal representation. In addition, we'd like to share with you our top 10 list of the most original and/or funniest suggestions, as well as provide a little insight into why those particular names were rejected in the end. For their participation, and because of the howling laughter that some of these suggestions inspired here at Fool HQ, these readers will also receive a small consolation prize, a Fool ballcap. Without farther ado, here's the top 10 funniest or most original suggestions:

10. Dough Flow, submitted by DickieZee -- Nice rhyme, but having two Flows would be confusing.
9. CPA Bypass, from powder2 -- Funny, but sounds too much like surgery.
8. Ka-Ching Margin, by Koalabeer -- We liked this one, but couldn't bring ourselves to do it.
7. Verve Ratio, cunningly submitted by markandsusanv -- Matt lobbied real hard for this one.
6. Foolish Flush, from RA Street -- Sounds like something requiring a plumber.
5. Green Stream, from meghall -- Rolls off the tongue nicely.
4. Lick My Cash, submitted by Manny Hall -- Do I really need a reason?
3. Gravy Ratio, from tprince3 -- I liked it; everybody else was reminded of dog food.
2. FaCTS, from alonr -- Free Cash To Sales ratio; Good acronym, extra vowel annoying.
1. Passion Ration -- Huh? Sounds more like a cocktail, but minisimon obviously needs some encouragement, so we're sending a ballcap out of the kindness of our hearts.

Thanks to everybody who participated. The runner-up name, one that we were oh so close to selecting, was Cash Cow Margin, entered by powerfade. Our lucky not-quite-winner will receive a free one-year subscription to our new Foolish Premium Research! That's right, powerfade will be getting at least 60 research reports to enjoy over the next 12 months, including 15 beefy initial coverage reports on the companies that Fools wanna know about, including AOL, Dell, Nike, Cisco, Amazon, Amgen, EMC, Yahoo!, Wal-Mart, Apple, and more. Every quarter, powerfade will receive timely updates on these companies, and we expect to extend coverage to even more companies over the course of the next year. For those of you who are interested, you can click on our new Foolish Research Tab and download the first report, covering Amazon.com, for free.

Next week, our own Rob Landley will be taking over to help us better understand Intel's business through a special week-long series on microprocessor evolution and design -- which will give me the opportunity to hide for two weeks.

I'll be back in two weeks to explain why we don't pay a lot of attention to current valuation in the Rule Maker Portfolio, and to offer some ideas about how you can take valuation into account when making your Rule Maker investment selections.

Have a great weekend!


 




Rule Maker Portfolio

  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  AXP AMERICAN EXPRESS COMPANY 0.11 0.27% 40.41 
  KO THE COCA-COLA COMPANY 0.00 0.00% 44.25 
  NOK NOKIA CORP. (0.15) (0.86%) 17.37 
  JNJ JOHNSON & JOHNSON (0.15) (0.27%) 55.35 
  PFE PFIZER INC 0.07 0.21% 33.21 
  GD GENERAL DYNAMICS CORPORATION 0.53 0.85% 63.12 
  TROW PRICE T ROWE GROUP INC 0.10 0.32% 30.92 
  SGP SCHERING-PLOUGH CORPORATION (0.21) (1.12%) 18.50 
  COST COSTCO WHSL CORP NEW (0.29) (0.8%) 35.91 
      
  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%
 02/06/98 75 TROW 34.12 30.92  -9.37%
 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 
Total:30,544.23 


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Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.