Nobody loves a party pooper, but hasn't anyone
noticed that generous stock option plans result in an
overstatement of corporate earnings and a heavy mortgage on the future?
IT'S ANNUAL REPORT TIME AGAIN, and this year's reports reveal the astounding
bonanza executives are reaping
from the exercise of stock options (see story, p. 220). Cheryl Breetwor,
chief executive of ShareData, a Santa Clara,
Calif.-based supplier of employee stock plan software and services,
calls the spread of employee options the "Silicon Valley
model."
"The Silicon Valley model is working," Breetwor says. "Making chief
executives and employees stakeholders is good for
America, it's good for our competitiveness."
Warren Buffett, however, disagrees. In his recent letter to shareholders,
he wrote that after Berkshire Hathaway acquires a
company, it will often report higher employee compensation costs. Buffett:
"Their reported costs will rise after they are
bought by Berkshire if the acquiree has been granting options as part
of its compensation packages. In these cases,
'earnings' of the acquiree have been overstated because they have followed
the standard-but, in our view, dead
wrong-accounting practice of ignoring the cost to a business of issuing
options."
Buffett continued: "When Berkshire acquires an option-issuing company,
we promptly substitute a cash compensation plan
having an economic value equivalent to that of the previous option
plan. The acquiree's true compensation cost is thereby
brought out of the closet and charged, as it should be, against earnings."
Buffett isn't the only spoilsport. "The last word is not yet in on how
expensive options truly are," Scott Spector, partner in
compensation law at Fenwick &West in Palo Alto, Calif., says. Though
he adds: "People just will not work for a company
that won't offer stock incentives."
Edward Lazear is a professor at Stanford Graduate School of Business
and a senior fellow at the Hoover Institution,
specializing in labor economics. "It's difficult to show that options
provide any real incentives," he says. In fact, he argues
that options, because there is risk attached to them, cost companies
more in employee compensation than straight salary
would.
The trap here is that the cost of the options is hidden from shareholders.
Why hidden? Because of the way stock options are
accounted for in financial statements. They are not listed as a cost
and therefore result in an understating of true employee
costs and a corresponding overstatement of net profits. Options also
reduce costs another way: by cutting a company's tax
bill. When an employee exercises an option grant, the tax liability
on the transaction is transferred from the company to him.
"When something looks too good to be true-like options do-it usually
is," says Steven Hall, managing director at
compensation consultant Pearl Meyer &Partners.
The apparent free lunch is a by-product of the great bull market. David
Leach, managing director at Compensation
Resource Group in Pasadena, Calif., recalls that in the 1970s, when
stocks were in the tank, cash compensation was king.
As the market began crawling out of its hole in the early 1980s, the
trend went to bigger salaries and more generous
bonuses. Only when it was clear that a bull market was under way did
stock options become prevalent. First they were
limited to corporate chiefs; in the late 1980s and early 1990s companies
as varied as PepsiCo, Cirrus Logic, Merck and
Wendy's International began including all employees in their stock
option programs.
According to a survey by ShareData, 45% of companies with option plans
and 5,000 or more employees now grant
options to all their workers. Three years ago only 10% did. And companies
dispensing option largesse to all employees are
not limited to Silicon Valley startups. This year 37 companies do,
including Amoco, Chase Manhattan, Compaq Computer,
DuPont, Eli Lilly, Kimberly-Clark and Warner-Lambert.
At smaller companies, of course, the devotion to stock options is even
greater:74% of companies with less than $50 million
in sales offered stock option plans to 100% of their workers. Shipping
and mining concern Oglebay Norton Co. has
abandoned salary altogether for its chief executive. It bases John
Lauer's entire pay on stock incentives.
"Compensation packages are totally market-driven," says Leach. "Stock,
stock and more stock." Newish twists include
premium options-where a company's executive gets to exercise his grant
only if the stock reaches a preset premium to the
current market price.
What companies do not like to do is remind shareholders though it is
obvious to people like Buffet tthat options are highly
dilutive. According to Pearl Meyer &Partners, shares allocated
for management and employee equity incentive plans at the
200 largest companies last year rose to 13.2% of shares outstanding,
up from 6.9% in 1989 (see chart, p. 215). "We used
to advise companies that an allocation of 10% was too much dilution,"
says Steven Hall of Pearl Meyer, "but we blew
through that level years ago."
Options dilute per-share earnings because they increase the divisor
applied to net profits to figure per-share earnings. If
exercise of options increases the number of shares outstanding by 10%,
that results in 10% dilution. Thus a 20% increase in
net earnings produces an increase of only 9% in earnings per share.
What this means is very clear: Though the options don't count as cost,
they are a mortgage on future earnings. We are not
talking about a handful of companies putting future earnings per share
at serious risk. Scott Spector, the lawyer in Palo Alto,
says options grants at the Silicon Valley companies he advises are
up to 24% of total shares outstanding, versus 15% three
years ago. Last year 72 of the top 200 U.S. companies went to shareholders
for approval of new or amended stock option
plans. For the past several years only 50 companies had been asking
for such approval. Among the 200 largest companies
in America, 14 of them now have options allocations greater than 25%
of their shares outstanding (see table, p. 216). These
include Delta Air Lines, Merrill Lynch, J.P. Morgan and Transamerica
Corp.
To the degree that options are used as incentives to attract and keep
talented workers, they are, properly speaking, a labor
cost. But accounting standards do not require a company to run the
costs of issuing these options through its income
statement as an expense. Thus, companies that count on options to recruit
and keep employees are understating labor costs
and overstating earnings.
An in-depth study of the impact of employee stock options on the 100
largest U.S. companies was recently released by
economic advisory firm Smithers &Co. in London. It was prepared
by Smithers' Daniel Murray and Andrew Smithers, and
John Emerson, accountant with the firm Robson Rhodes. The study took
six months of sleuthing. "The data were very
difficult to get," says Smithers. "It's only in the footnotes to the
financials in a company's 10-K. But we found the amount of
hidden costs at these companies is significant."
Here's their astonishing conclusion: If the 100 companies had charged
the costs of option programs to their income
statements, their profits in 1995 would have been on average 30% lower
than those actually reported. In 1996 full-cost
accounting for options would have resulted in earnings 36% lower than
stated.
Put another way, profits in 1996 would have been up only 11% over the
previous year, rather than the 23% these 100
companies claimed. Presumably, the overstating would have been even
worse in 1997.
Would the market have risen 20.3% in 1996 if the 100 biggest companies
had reported earnings gains of only 11%?
Doubtful. Based on his group's findings, Smithers figures that the
current P/E multiple on the S&P 500 is 35, not the 28
usually shown.
But the real drama emerges when Smithers examines individual companies
to see how their earnings would fall if options
were expensed as an employee cost rather than capitalized, as they
essentially are now. Eleven companies of the 100 would
have shown a loss in 1996 had they run the cost of options through
the income statement (see table, p. 216).
These are big-name companies: Bristol-Myers, Dell, Hewlett-Packard,
Monsanto, Time Warner and others. And according
to Smithers, another 13 companies-including Coca-Cola, Gillette, Merrill
Lynch, Sun Microsystems and Waste
Management-would have seen their 1996 profits cut more than half had
they treated options as a compensation expense.
Smithers &Co. hastens to make clear that it cannot guarantee the
precision of its numbers, because the nature and
availability of the data required it to make a number of assumptions.
But if it erred at all, they believe they erred on the
conservative side.
Smithers comes up with its figures by adding together the estimated
value of options that were exercised during the year and
the estimated cost of immunizing the company against future increases
in its stock price, which would have the effect of
upping its total option costs. The estimated immunization cost covers
two factors: the difference between the share price and
exercise price on existing options and costs associated with net new
option grants.
One way to cover the cost of delivering options to workers, says Daniel
Murray, is to buy the equivalent amount of listed
options in the open market at the time of the option grant. This would
immunize the company against price increases in the
stock, and prevent earnings dilution.
In a separate calculation, Smithers &Co. assumes that companies
would borrow the funds necessary to buy the options on
the shares dedicated to employee option plans; interest expense is
estimated at 5% a year. A company interested in fully
accounting for the cost of its options each year thereafter would have
a recurring expense as it issued new options and went
into the open market to hedge against them. Smithers figures that the
average expense to fully hedge employee option
positions at the 100 companies analyzed would have amounted to 21%
of earnings in 1997.
From January 1987 to June of last year Dennis Beresford, now an accounting
professor at the University of Georgia, was
the chairman of the Financial Accounting Standards Board. During his
tenure, FASB tried to figure a better way to account
for the costs of burgeoning stock option plans on a company's financial
statements. "It's hard to argue that they're any
different from cash compensation or any other employee costs," says
Beresford. "FASB felt it was a cost."
The board tried to come up with a standard that would require companies
to run option costs through their P&L. But the
effort became political roadkill after the BigSix accounting firms
and much of corporate America lobbied heavily against it.
"The argument was: reduced earnings would translate to reduced stock
prices," recalls Beresford of the brutal battle that
finally buried the idea in 1995. "People said to me, 'If we have to
record a reduction in income by 40%, our stock will go
down by 40%, our options will be worthless, we won't be able to keep
employees. It would destroy all American business
and Western civilization,' " he says. The bull market was more important
than accurate financial reporting.
What the accounting board did come up with was a way to signal to shareholders
the diminishing effect of stock options on
earnings. But investors have to comb through the footnotes to a company's
financial statements to find the data. There,
companies now report how their earnings might be affected by options
held by employees.
But FASB 123, as it's called, leaves lots of room for interpretation.
As a result, investors can't be certain that all companies
are valuing their options the same way. For instance, two semiconductor
companies with the same option plans and number
of options outstanding, can come up with wildly different results.
Complains Cheryl Breetwor of ShareData: "There are
significant flaws in the standard. This muddies the waters."
Indeed, Dell Computer, in its most recent annual report, says its pro
forma option costs in fiscal 1997 amounted to only $22
million pretax. This, even though it issued almost 43 million shares
at a weighted average fair value of $3.73 each.
So the options frenzy mounts as more and more businesses count on a
rising market to keep employee costs down and
reported earnings rising.
Following Warren Buffett's lead, FORBES took the fair value, as reported
in company proxies, of top executives'
unexercised, but in-the-money options. To see what would happen if
the costs of the packages were included as an
employee expense, we compared that value to the company's cash flow.
The results were dramatic: The companies in the table on page 215 would
have to devote 50% or more of current year's
cash flow just to pay the fair value of the in-the-money options held
by executives.
Defenders of options reply that this is all theory. In the real world,
they argue, having options encourages managers to think
like owners.
Well, it does give management an incentive to talk up the stock price,
but does it make them real owners? Hardly.
Option-holding employees have a different piece of paper than ordinary
shareholders have. Unlike shares, options can be
repriced downwards. At Novell, Apple Computer, Bay Networks and Advanced
Micro Devices, shareholders have
recently been asked to approve lowering prices on employees' options.
But investors who bought a stock at $30 only to see
it go to $14 can't renegotiate the price. Shareholder groups like Lens
Investment Management in Washington D.C. and
Institutional Shareholder Services in Bethesda, Md. are trying to focus
shareholder attention on this issue. Patrick McGurn,
vice president at ISS says: "If a company has a history of repricing,
we recommend investors vote against its option plan."
It is not at all uncommon for management to run a company into the ground.
After the stock collapses they grant themselves
options at the lower price. When the stock recovers they make a fat
profit, while shareholders have taken a round trip to
nowhere.
Shareholder interests aside, the vast spread of option programs may
also be causing us to underestimate inflation. Fed
watchers know that Alan Greenspan pays close heed to wage costs as
he scours the horizon for signs of inflation. Are these
costs understated? At Smithers &Co., Daniel Murray believes that
incomes from employment in the U.S. have been rising
around 2.5% faster than published figures state. Greenspan is certainly
aware of the danger. Minutes from the Federal
Reserve meeting of Dec. 16, 1997 say: "Employers were continuing their
efforts to attract or retain workers . . . by means
of a variety of bonus payments and other incentives that were not included
in standard measures of labor compensation."
Sounds like stock options to us.
But the game goes merrily on. "Companies realize that dilution is not
affecting their stock's price one bit," says Scott
Spector. Not yet, that is. "But the mortgage on the future is a problem
that people haven't yet addressed," he adds.
The great bull market in stocks and options
Stock options weren't always the way to wealth for CEOs. Not long ago,
cash was king and options rare. But as the equity
market took off in the 1980s, so, too, did option grants. Now they
are the single biggest contributor to the growth in stock
market billionaires. At many companies, option grants today extend
to every employee. Options are now as American as
apple pie.
EARLY 1970s: CASH IS KING The go-go years were gone, inflation was coming
and CEOs wanted cash, not stock.
Thomas Wyman at CBS and Donald Kendall at PepsiCo led the way.
PHOTOS (COLOR): Wyman and Kendall
EARLY 1980s: SALARY AND BONUS Stocks were stirring, but CEOs preferred
salary and bonus. Three big names
in big pay: Harold Geneen of ITT, Charles Bluhdorn of Gulf & Western,
David Mahoney of Norton Simon.
PHOTOS (COLOR): Geneen, Bluhdorn, Mahoney
MID-1980s: OPTIONS MANIA BEGINS Institutional investors want CEOs to
be stakeholders. Options are the
answer. Disney's Michael Eisner and Steve Ross at Warner Communications
begin to use options as replacement for cash.
PHOTOS (COLOR): Eisner and Ross
LATE 1980s: MEGAGRANTS AND OPTIONS TO ALL Grants get bigger and go deeper
in employee ranks. Tony
O'Reilly of Heinz snares one of the first megagrants: options on 400,000
shares. PepsiCo gives options to all full-time
PHOTOS (COLOR): O'Reilly and PepsiCo
1990s: STOCK OPTIONS DOMINATE CEO PAY Companies like Eckhard Pfeiffer's
Compaq, Gordon Eubanks'
Symantec, offer options to all staff. Monsanto's Robert Shapiro gets
premium options--exercise price well above market.
PHOTOS (COLOR): Pfeiffer, Eubanks, Shapiro
A gold mine for the top brass
The value of all in-the-money options, unexercised, by top executives at Forbes 800 companies approaches $11 billion.
Value of Forbes 800 executives' unexercised, but
in-the-money stock options ($billions)
1994 - $2.4
1995 - $2.5
1996 - $4.5
1997 - $6.6
1998 - $10.6
Source: Forbes.
Mortgaging the present
Companies worried about the dilution to existing shareholders of generous
option grants can always buy back the equivalent
number of shares. At the Forbes 800 companies below, it would be difficult.
The fair value of top executives' unexercised
but in-the-money options is equal to at least 50% of its current cash
flow. Deleted from the list were companies with
negative cash flow.
A = Company/business
B = Ticker
C = Chief executive
D = Market cap ($bil)
E = Options value ($mil)
F = Cash flow ($bil)
G = Option value as % of cash flow
A
B
C
D
E
F G
Outdoor Systems/advertising
OSI Arturo Moreno
$4.3
$236.3 $97.5
242%
NGC/natural gas services
NGL Charles Watson
2.2
26.9 16.7
161
Kansas City Southern Ind/railroad
KSU Landon Rowland
5.2
67.9
61.1 111
America Online/on-line services
AOL Stephen Case
7.9
90.6 117.5
79
Consolidated Stores/retail
CNS William Kelley
4.6
120.3 165.1
73
Qwest Communications Intl/comm servies QWST
Joseph Nacchio
7.9
22.5 34.8
65
Mirage Resorts/gambling
MIR Stephen Wynn
4.1
204.2 322.1
63
TIG Holdings/insurance
TIG Jon Rotenstreich
1.4
31.1 52.0
60
The Stanley Works/hardware
SWK John Trani
5.0
180.0 30.5
59
Eli Lilly/pharmaceuticals
LLY Randall Tobias
71.8
68.5 124.7
55
Source: Forbes
The dilution effect
Shares allocated for management and employee stock incentive plans at
the 200 largest U.S. companies has almost doubled
in the past eight years.
Shares authorized for management and employee
stock option plans as percent of shares outstanding*
'89 - 6.9%
'90 - 7.5%
'91 - 8.3%
'92 - 8.7%
'93 - 9.3%
'94 - 9.8%
'95 - 11.0%
'96 - 11.8%
'97 - 13.2%
* Calculations are based on weighted average shares outstanding on a fully diluted basis.
Sources: Pearl Meyer & Partners, Inc.
Mortgaging the future
These companies have option allocations greater than 25% of their shares outstanding.
A = Company/business
B = Total allocation*
C = 1996-97 grant rate*
A B C
Delta Air Lines/airline
55.47% 1.24%
Merrill Lynch/brokerage
53.95 6.44
Morgan Stanley Dean Witter/brokerage
51.22 3.87
Microsoft/software
44.83 4.45
Bankers Trust/banking
43.09 8.79
Lehman Brothers Holdings/investment banking 42.58
10.08
Dell Computer/computers
38.68 5.73
Travelers Group/financial services
37.06 5.88
ITT Industries/defense
36.96 1.76
JP Morgan/banking
31.89 3.91
Warner-Lambert/pharmaceuticals
29.14 1.50
Transamerica/financial services
27.93 2.45
Time Warner/entertainment
26.01 2.19
BankAmerica/banking
25.57 2.70
* Percent of weighted average shares outstanding on a fully diluted basis.
Source: Pearl Meyer & Partners, Inc.
The high cost of employee stock options
If stock options were an employee cost, what would happen to corporate
earnings? The economic consulting firm, Smithers
& Co., in London, recalculated the profits of the 100 largest U.S.
companies for 1996, adjusting them for the value of their
executives' stock option plans. Results? The 11 companies, below left,
would have shown losses after the adjustment. The
13 companies, at right, would have seen their profits cut in half.
A = Company/business
B = Reported earnings ($mil)
C = Earnings adjusted for stock option costs ($mil)
A B C
Bristol-Myers Squibb/consumer goods $2,850
$-2,582
Cisco Systems/networking
913 -656
Dell Computer/computers
498 -862
Eli Lilly/pharmaceuticals
1,524 -1,648
Hewlett-Packard/computers
586 -30
Intel/semiconductors
5,157 -281
Microsoft/software
2,825 -10,175
Monsanto/chemicals
385 -597
Texas Instruments/semiconductors
63 -68
Time Warner/entertainment
191 -312
Unocal/oil and gas
36 -52
A = Company/business
B = Reported earnings ($mil)
C = Earnings adjusted for option costs ($mil)
D = % of over-statement
A B C D
Chase Manhattan/banking
$2,461 $631
390%
Coca-Cola/soft drinks
3,492 1,686
207
Computer Associates Intl/software 261
47 550
Gillette/personal care products
949 127
749
MBNA/banking
474 211
225
Merrill Lynch/brokerage
1,619 353
459
Oracle/software
603 157
384
Schlumberger/oil services
851 249
342
Sun Microsystems/computers
620 205
302
Textron/aerospace
253 74
340
Walt Disney/entertainment
1,534 689
223
Warner-Lambert/pharmaceuticals
787 228
345
Waste Management/solid waste mgmt 192
60 320
PHOTO (COLOR): Berkshire Hathaway's Warren Buffet
PHOTO (COLOR): Andrew Smithers (left), Daniel Murray
~~~~~~~~
By Gretchen Morgenson