Rogue Missives Friday, July 18, 1997

Part 5:
A Dynamic Worth Considering

Of course, investors could hardly fail to miss the spate of huge stock buybacks -- $125 billion worth last year, by some reports. Some cash machines, like DELL COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>, have actually been buying up more shares than must be re-issued to cover options. Others have been merely repurchasing shares to prevent dilution. Corporate buybacks are, in fact, a visible sign of the cost of generous options packages. The reason is simple. While stock options allow a company to pass out stubs now rather than cash, those stubs eventually come due. What wasn't subtracted from earnings along the way in the form of labor costs eventually gets subtracted from earnings per share in the form of stock dilution. In order to keep dilution from putting a hit on earnings, a firm must buy back those shares.

A Dynamic Worth Considering

The dynamic is worth considering. Intel, for example, had issued millions of options exercisable at about $5 a share. To forestall dilution, Intel must actually go into the market and purchase those shares for $80, or whatever the going rate is. Intel no doubt buys many of these shares from its own employees, using the $5 per share in cash the employees paid, plus a whole lot more from the corporate coffers. Another way of looking at it is that the company's ownership is being slowly transferred from the current shareholders to the current and former employees. That's not necessarily a bad thing. Still, as a recent article in Fortune so aptly put it, "In effect, companies are buying expensive stock on the open market and selling it to employees for a whole lot less." Of course, the cash Intel is using belongs to shareholders, who have little alternative unless they want to see the firm's EPS diluted. Just treading water becomes expensive.

Nonetheless, there is a kind of virtuous circle here. By keeping a huge chunk of labor costs off the balance sheet, companies become profitable more quickly and report deceivingly large profits. (In the first quarter, for example, Microsoft reported a billion dollars in earnings but spent about $2 billion on stock repurchases.) But all of this is for the good in that it permits venture capitalists to take a company public earlier than they might have under a different accounting regime, and thus recycle their money into other new ventures more quickly. It also allows companies to raise and conserve their cash when they most need it, and offer key employees financial incentives for making a risky venture work.

Such apparently robust earnings strike the fancy of investors, who benefit from a rising share price. And then, even when options are exercised and shareholders risk dilution, the growing corporation has the money to buy back shares, keeping demand for the stock high and perhaps fueling still more investor interest. Why muck up such fortuitous results by altering the accounting standards? On the other hand, one can see the elements of a potential pyramid scheme in all of this, as the options come back to bite a company that can no longer finance this deferred compensation without shareholder value simply sinking beneath the waves of options.

What the recent FASB accounting changes do is permit investors to see the options hit to earnings and to reconsider the valuation models they use in light of what now must be seen as different earnings measurements. The additional information may confuse many investors. Still, because earnings are the key to stock appreciation, we ought to approve of any new disclosure that allows us, as part owners of a business, to have a better understanding of where our money is going.

--Louis Corrigan ([email protected])

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