With stock option grants increasingly seen as a magic elixir for motivating employees, keeping the cost from hurting shareholders has required more and more financial alchemy. The latest trick? As they buy shares in the open market to soak up the dilution from option grants, more and more companies have launched put-warrant and other derivatives-based programs to reduce the cost.
Not surprisingly, technology firms that have granted massive amounts of employee stock options have been particularly heavy users of this tactic, with Microsoft Corp. and Dell Computer Corp. among the heaviest. And more companies can be expected to join the crowd as long as stock options remain the incentive of choice.
The financing technique typically involves private contracts with investment banks. In return for granting the bank the right to sell, or "put," company shares back to the company at a predetermined price at a set time, the company receives a premium. If, as has been the case until recently, the shares blow past the exercise price before the exercise date and stay there, the put warrants expire worthless. The company simply pockets the premium for selling them, and it owes the government no income taxes on that money.
It gets better. Many companies also have simultaneously bought call options on their stock, which give them the right to purchase their stock at a certain price. If the stock runs up, these call options, financed from the premium income on the puts, allow the company to buy back its stock at a price lower than the market's.
Since Microsoft instituted its put-warrant program in 1995, it has pocketed premiums worth $2.1 billion and reduced the cost of its buyback program by an average $2.74 a share. Dell contends that its program, which includes both selling puts and buying calls, has helped drive down the average cost per share of repurchased stock to $6. The stock is currently selling at around $38 a share.
But what happens when stock prices go down instead of up? Therein lies the rub. If puts expire in the money--that is, a company's shares fall below the strike price of the warrant--the company has to buy back its shares above the current market price. Moreover, notes Robert Willens, a tax and accounting analyst at Lehman Brothers Inc., if
an issuer chooses to settle the contract with its own stock in order to preserve cash, it will have to issue new shares to honor the put obligation, thereby creating even more dilution than the buyback program was intended to offset.
Granted, there's little or no evidence yet of such an unhappy outcome, despite the recent sell-off in technology shares. But critics say it may be only a matter of time before such programs implode. "It turns into a death spiral," notes Michael Murphy, editor of the California Technology Stock Letter.
The Prime Candidate
Consider Microsoft. The company has seen its stock pummeled in recent months, yet by the end of June, Microsoft had 157 million put warrants outstanding, with strike prices ranging from $70 to $78 a share. In mid-August, the company's stock was trading in the mid-$70s. The expiration dates for these contracts range anywhere from September 2000 to December 2002. If the stock were to fall below the strike prices of the individual puts on the day they expire, Microsoft would find itself having put warrants exercised against it.
The shares covered by the contracts currently represent 2.8 percent of outstanding issuance. Assuming an average strike price of $74 a share, that approach could cost the company $11.6 billion over the life of the contracts.
Microsoft declined to comment, but analysts note that with $23.8 billion in cash on its books and $9.1 billion a year in cash flow in fiscal year 2000, the company can easily handle the potential problem. "Even if Microsoft had to buy back every share, it could do it," says Joseph Beaulieu, a senior analyst who tracks the company for Morningstar, a mutual-fund and stock rating firm in Chicago.
Still, for Microsoft to reallocate almost half its current cash hoard when it's making deals hand over fist is not something investors are likely to easily overlook. And given the pace at which the company has been granting employee stock options lately, Microsoft is likely to increase its use of put warrants in the not too distant future. Last April, with its stock foundering, Microsoft gave employees a special grant totaling 70 million options. In July, the company issued about 55 million more options as part of its annual employee stock option grant. (As of June 30, the company had 832 million vested and unvested options outstanding.) Yet, for almost eight months this year, the company was unable either to buy back stock or issue new put warrants, because of its $1.5 billion acquisition of Visio in January. The acquisition was accounted for using the pooling-of-interests method, under which companies cannot engage in other transactions involving their own stock for six months. That's one reason Cisco Systems Inc., a recent devotee of pooling, does not use these types of derivatives programs to complement its stock buyback efforts. But with Microsoft's six-month wait over, the company announced on August 7 that its board had approved a new stock repurchase program.
No Backing Down
Despite the pressure on their shares, bankers don't expect tech companies to pull back from using put warrants to offset the costs of their stock buyback programs. "The magnitude of stock repurchases will continue to be large," asserts Ken Farrar, a managing director of Salomon Smith Barney. Moreover, he says, "given the pullbacks in valuation and increased volatility, we feel this actually is an opportune time for these instruments," at least for companies with solid prospects. Not only are strike prices on new warrants lower--so if a company is forced to buy back stock it's buying it cheaper--but also the prices paid to these companies for selling puts are as much as 25 percent higher than they were 18 months ago, according to Farrar.
In fact, CFOs of tech companies insist they remain attracted to the market. "It [still] makes sense if you have a volatile stock and an aggressive stock option program," says Nathan Sarkisian, senior vice president and CFO at Altera Corp., a manufacturer of programmable logic devices in San Jose, California. He, too, sees a silver lining when the underlying stock falls in value and the company has to repurchase shares under the put contract. "To the extent we repurchase at lower prices, it's actually attractive," says Sarkisian.
That sentiment is echoed by Bill Porter, CFO and senior vice president of Cadence Design Systems Inc., also in San Jose, which uses both puts and calls as part of its buyback program. If a put warrant is exercised against the firm, it simply means Cadence ends up buying back more shares than it would have using a call option, he notes. Given that the put program is part of the company's strategy to stem dilution, that's not a negative.
However positive the effect is, it will pale in significance if the stock price fails to rebound. Finance executives need their share prices to go up so they can reap the premiums those contracts generate when they expire worthless. To increase the odds of that happening, Altera enters into put warrant contracts only when it thinks its stock price is about to rise. The company sold 500,000 put warrants for $2.4 million in premiums in the fourth quarter last year and another 750,000 puts worth $7 million in premiums in this year's second quarter. Several of these contracts have either expired unexercised or were substantially out of the money this summer. "We picked a good time to do these," Sarkisian notes. Altera's stock has more than doubled this year, to about $58 a share.
For weaker companies, the risk posed by these programs can be daunting. Those whose share prices get hammered after writing such contracts would have stock put back to them at prices well above the market. And they could find the cost onerous if cash flow isn't strong enough to pay for shares should the warrants expire in the money. In that case, they'd either have to borrow or issue stock to pay for the shares. And in a falling market, either approach would be especially unattractive.
Borrowing to buy back shares put to it as the stock continued to fall would further erode such a company's already questionable financial strength, while issuing more and more shares to do the job would produce more and more dilution. "Basically, you're buying fewer shares with more stock," notes Michael Murphy. That pattern would continue until the put warrant contracts ran out. "One would hope these companies are managing exposures to no more than 2 to 3 percent dilution," Murphy adds. At almost 3 percent of its total outstanding even before it got back into the market, Microsoft, for one, was near the top of that range. And while the company's prospects are hardly weak, growth is slowing and the government wants to split the software giant in half.
Financial executives need to be aware of another risk: the ongoing drive by the Financial Accounting Standards Board to put hedging instruments on the balance sheet. Currently, transactions in a company's own stock, such as put warrants, are generally treated as equity instruments and reported as shareholder equity. Last March, however, a FASB task force proposed redefining these instruments as assets or liabilities, which would have required companies to mark most of the contracts to market every quarter. Because of the volatility that would add to earnings, such a requirement would kill these strategies, notes Chris Innes, a managing director at Banc of America Securities LLC, even if it did nothing to diminish companies' need to deal with the dilution from stock option grants. "The basic need to hedge stock options won't go away," he says.
Not surprisingly, bankers and finance executives have been lobbying FASB and other parties to maintain current accounting treatment for these contracts, and with some success. In a proposal issued as EITF 00-19 in July, the FASB task force laid out a tentative model under which these contracts would continue to be treated as equity instruments and reported in shareholder's equity. At press time, the task force was scheduled to meet again to reach a final decision. While finance executives expect the issue to be resolved in their favor, they'll have a lot more explaining to do to investors if it isn't.
A study by Bear, Stearns & Co. found that option grants consumed an average of 6% of corporate earnings last year, compared with 4% in 1998 and 3% the year before. Using information supplied in annual-report footnotes, Bear, Stearns has identified 10 companies that spent more than $600 million on such compensation last year.
|Company||Pro Forma Pretax Stock Option Compensation*|
|Morgan Stanley Dean Witter||692|
*in $ millions Source: Bear, Stearns & Co.
A Different Battle in Seattle
Microsoft came close to having to pay off expiring put options written on its stock last June. As of the previous quarter, 163 million warrants were outstanding, at prices ranging from $69 to $78 a share. The expirations ranged from June 2000 to December 2002. For about a week in early June, Microsoft's stock traded below $69 a share; however, it closed the month substantially above that price, and the company continues to boast that it has never had a put warrant exercised against it.
But if Microsoft's stock fell enough during the next two years, the company could be on the hook for all of the 157 million put warrants it has issued. In settling those contracts, the company could pay for the shares in any one of three ways, each of which has a slightly different effect on Microsoft's finances, because of the way these contracts are currently accounted for.
The company could simply pay the difference between the exercise price of the contracts and the price of the stock in cash, in which case the shares would not be retired and Microsoft would outlay a small amount of cash. The second scenario would have Microsoft issue new shares worth that difference in price, which would be more dilutive. Finally, it could take back the shares themselves for cash and retire them, which would mean no dilution, but a big hit to the balance sheet.