- Yesterday Coca-Cola, one of the most respected companies
in the world, announced that it would begin expensing options. Any company
that wants to keep its good name will soon follow.
-
- In the long run, that's a good thing for investors. But,
in the short run - as companies are forced to come clean with options expenses
- investors will be shocked to realize that most of the fastest growing
companies in the market were actually not growing at all.
-
- What today are the most expensive stocks in the market,
will suffer enormous devaluations as investors come to understand the shell
game that was being played with options and share buybacks.
-
- If you haven't already, check your portfolio for "options
printing" companies and make sure that the companies you own have
really been making money. You can begin with what I suspect will easily
become the "poster child" of such shareholder abuses.
-
- Once the most highly respected - and the most profitable
- company in Silicon Valley, this company will soon find itself in the
middle of the next national scandal...and the focus of media, investor
and political scorn.
-
- Its CEO, once regarded as the best CEO in America, will
see his reputation...well, return to the mean. And investors in a company
that once posted a 9,000% return to shareholders will see their investment
wiped out.
-
- But first, if you'd like to understand the next big scandal
to sweep Wall Street - a scandal that will make the others pale by comparison
- you have to understand in some detail how the cost of granting stock
options is represented to shareholders.
-
- Options accounting is considered arcane and a minor financial
detail today. In fact, the SEC only requires companies to report their
options expenses as a footnote. But you'll soon see a lot more focus on
these numbers...
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- A stock option granted by an employer is the right for
an employee to buy a share of the company's stock at today's price. Normally
this right extends out into the future - ten years, for example. In theory,
options align the employees' interests with the shareholders. But experience
is proving quite the opposite. Employees, including CEOs and other executives,
don't have any downside. If the stock crashes, he doesn't lose a penny.
If the stock soars, he's a millionaire.
-
- The prevalence of these kinds of plans, not to mention
the size of the grants given to senior managers, explain why companies
during the bubble were being run in such a risky fashion - the managers
had nothing to lose. But here's the real scandal. And what management
likes about this kind of compensation...it's free. The cost of granting
options doesn't appear on the income statement.
-
- Trouble is, as Warren Buffett said recently, if options
aren't compensation, what are they? And if compensation isn't put on the
income statement, where do you put it?
-
- Consider: if options grants don't show up as compensation
expense, they never appear on the income statement. And if a company uses
free cash flow to buy back all of the shares granted via options, there's
never any record of the extra costs.
-
- Options allow executives to hide the effect of their
enormous compensation packages from the bottomline. For example, the CEO
of the company I'm going to warn you about today - where options have gotten
out of control - realized over $57 million in compensation from exercising
options in 2001. That was more than 25% of his company's net profits for
the year.
-
- Meanwhile, on the income statement, only his $300,000
salary counts against earnings.
-
- On average, over the last six years, this CEO made $32
million per year. Almost none of that expense showed up on the income statement.
Companies would never dream of paying executives so much money, except
for the fact that investors don't see the effects of this compensation
on earnings.
-
- According to current GAAP accounting standards, this
company produced outstanding EPS growth - 168% over five years. Even in
2000, when the market tanked, this company still grew earnings by 21%.
-
- Because of this growth and its status as a leading big
cap stock, you can understand perhaps why the stock still trades at outlandish
prices: 78 times earnings and over 10 times sales.
-
- But, if you deduct the expense of options grants using
the Black-Scholes method to determine the value at the time of issue, you
see an entirely different picture.
-
- After you expense the value of the options granted, instead
of 168% growth over five years, earnings only grew 39% over five years.
Hardly remarkable, especially for a high tech company with great position
in the market. After all, there was a high tech boom, remember?
-
- Accurate accounting also shows that, like most companies
in the sector, this firm had a sizeable decrease in earnings in 2001. As
should be reported to shareholders, earnings after stock compensation fell
by 29% in 2001.
-
- You have to wonder how the market would price this "growth
stock" if shareholders knew that really,counting all costs to shareholders,
the earnings per share didn't grow by 21%, they fell by 29%! My guess is
that, if the market realized that this company's earnings were actually
decreasing, the shares might not trade at 78 times earnings. Maybe 7 times.
Or maybe 8 times. But not 78 times.
-
- Here's what else the market apparently doesn't recognize
about this company: options expenses are rising. Employees' options that
will vest in the next ten years now equal more than 25% of the entire capital
stock of the company. If employees choose to exercise their options, there
will be a 25% tax on earnings growth as the number of shares grows. To
keep this outlandish executive compensation off the minds of investors,
the company has to prevent dilution - new shares - at all costs.
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- Who controls dilution? Why...the same executives who
make millions on options. In fact, executives now use even more cash than
provided by operations to buy back shares of stock - no matter how expensive
the stock is! - just to prevent the real cost of options compensation
from ever being reported to shareholders.
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- For example, this company made $223.8 million from operations
in the last six months of 2001, according to its most recent filing with
the SEC. But, during the same period, it repurchased $354.4 million of
its own stock...which was trading at prices that today look, well, slightly
expensive: 20+ times book value, 100+ times sales and 140+ times earnings.
-
- Did management truly perceive that its shares were undervalued
and the best place to spend $350 million? Or...were the executives engaged
in a conspiracy to prevent shareholders from seeing an accurate accounting
of its expenses - particularly executive compensation? The answer, at
least to me, is obvious. But there's more.
-
- If management thought its shares were attractive enough
for the company's money...why are the same shares not attractive enough
for management to even hold?
-
- In the last six months, management has sold nearly 1
million shares of stock. And, despite 20 years of large-scale option grants,
insiders own less than 1% of the total shares outstanding. Incredibly,
the founder and CEO of the company in question currently don't own a single
share of stock. Nor, according to SEC filings, do five of the company's
Vice Presidents.
-
- If stock options were truly meant to align the interests
of management and shareholders, the management would at least hold some
of the shares they're granted. But, these managers don't. Instead they
cash out of every single share.
-
- What's more, the company I've been describing to you
is in the highly competitive analog semiconductor field. It's been the
dominant company in this sector for a long time. Rapidly changing technology
requires huge capital investment for research and investment. Yet, while
the company spent $350 million on its own stock in the last six months
of 2001, it only parted with $250 million on research and development -
for all of 2001.
-
- If you were looking for stocks to sell short in this
market, you'd start by looking for large growth companies - heavily bought
by index funds - that aren't growing anymore and are still hugely overvalued.
-
- It's always hard for big companies to maintain large
percentage growth gains to profits, simply because their markets become
saturated and the numbers get so big. That's why companies over $10 billion
typically trade at lower valuations than stocks below $1 billion. Not always
though...
-
- In the U.S. public equity markets there are only eight
companies over $10 billion in market capitalization whose shares still
trade in the stratosphere of valuation. By any measure these stocks are
incredibly expensive - more than 10 times sales, 50 times earnings and
five times book value.
-
- The eight stocks are: Ebay, Taiwan Semiconductor ( TSM
) , Serono SA, Paychex, Microsoft, Maxim Integrated Products and Immunex.
-
- Out of these, four have net profit margins less than
20%: TSM, Immunex, Ebay and Maxim. And, out of all of these dominant growth
companies only two have negative short-term growth expectations: Immunex
and Maxim.
-
- But only one - Maxim Integrated Products - is not yet
already a part of my victim's portfolio of recommended short sales. In
a happy coincidence, the company I've been describing to you today, the
poster child for excessive options compensation, is Maxim Integrated Products.
-
- The stock, in time, will become the prime example of
the excesses of the 1990s in Silicon Valley. The executives got rich and
today's shareholders are holding the bag. They just don't know it yet.
-
- Good Investing,
-
- Porter Stansberry for The Daily Reckoning
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- P.S. When the truth about options compensation and share
buyback programs finally comes to light, the resulting carnage on Wall
Street will be bigger than anything we've seen to date. Bigger than WorldCom,
bigger than Tyco and bigger than Enron.
-
-
- It will hit the most expensive stocks in the market -
the firms thought to be robust growth companies. There will be total carnage.
-
- Maxim spent $503 million buying back its own stock in
the last five years. If it still had that money today, it would have 50%
more cash on hand than it does right now. And it might really need that
money... sales over the last three quarters are down 41% and net profits
are down 46%.
-
- P.P.S. What's more, if you're looking for evidence of
corporate arrogance, you'll find no better example than Maxim. CEO John
Gifford's employment contract stipulates that he gets to name his own cash
bonus each year. He also nominated Eric Karros - a professional baseball
player - to the board of directors in 2000 at the peak of the bubble.
-
- Naming your own bonus ... nominating professional sports
heroes to your board...these are the kind of things that show how much
hubris this company's senior management has become imbued with. And it's
the kind of thing that the newspapers will eat up once the story breaks.
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- But what's bad news for other investors can be great
news for you. Sell Maxim short.
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