Stock Options and Fiat Currency

Stock options are promoted by their supporters as the most effective way to align executive and employee interests with those of shareholders. They are supposed to transform executives from fly-by-night plunderers in the mold of former Tyco or WorldCom executives into rational leaders who make prudent, long-term-oriented decisions with shareholder capital.

But are options really as great for all parties as many have assumed? The stock option “backdating” scandal has implicated several (mostly technology) companies over the past few months. The SEC and other federal authorities are currently investigating more than 50 companies suspected of illegal, undisclosed options backdating practices, and the first criminal charges relating to these practices are expected shortly.

The practice of backdating options is not illegal as long as it is disclosed to shareholders. This fact is often used as a reason to downplay the seriousness of the issue. You’d think that shareholders wouldn’t tolerate the use of accounting sleight of hand to compensate executives while bypassing the traditional “selling, general, and administrative” line in the income statement. But abuse of stock options has been allowed to perpetuate for years. In all my reading of the backdating scandal coverage, I have yet to see a thorough analysis of the real victims of this scandal: shareholders.

Simply put, backdating a stock option grant amounts to ripping off shareholders by shortchanging the company treasury. Shares are issued to option holders at artificially low prices and the company gets an artificially low amount of capital in return for its shares. Backdating is perpetrated by “cherry-picking,” after the fact, the lowest points the company stock traded throughout the previous year when calculating the exercise price of option grants.

The exercise price of an option is crucial because it is the price the executive or employee option holder must pay to the company when exercising options in return for newly issued shares. If the exercise price were $0, then options would be nothing more than free stock grants, and treated as such in the eyes of recipients.

But the great majority of public companies issue options with an exercise price equal to the market price at the date of grant. This practice requires at least a nominal investment on the part of the option holder if he or she wishes to exercise. The CEO’s conflict of interest between short-term personal wealth maximization and long-term shareholder interests tends to tilt in the shareholders’ favor.

Compensation Committee Looks out for Executives

But long-term executive/shareholder interest alignment gets thrown out the window when unforeseen circumstances cause a temporary crash in a company’s stock. Executives can profit quickly at shareholders’ expense in such instances. Instead of using excess cash to buy back stock at a short-term discount, a long list of blue chip companies used the post-Sept. 11 market decline to dilute shareholders. A recent Wall Street Journal article entitled “Executive Pay: The 9/11 Factor,” describes the sequence of events (my emphases):

“A Wall Street Journal analysis shows how some companies rushed, amid the post-9/11 stock market decline, to give executives especially valuable options. A review of Standard & Poor’s ExecuComp data for 1,800 leading companies indicates that from Sept. 17, 2001, through the end of the month, 511 top executives at 186 of these companies got stock option grants. The number who received grants was 2.6 times as many as in the same stretch of September in 2000, and more than twice as many as in the like period in any other year between 1999-2003.

“Ninety-one companies that didn’t regularly grant stock options in September did so in the first two weeks of trading after the terror attack. Their grants were concentrated around Sept. 21, when the market reached its post-attack low. They were worth about $325 million when granted, based on a standard method of valuing stock options.

“The 91 companies included such corporate icons as Home Depot Inc., Black & Decker Corp., and UnitedHealth Group Inc….”

The mind-set of Stryker’s compensation committee stands out as the least shareholder friendly among this article’s list of blue chip companies:

“At Stryker Corp., a Michigan maker of orthopedic products, onetime stock option committee member John Lillard said he didn’t regret the decision to award options nine days after the attack. ‘If you believe the company is going to do well, and here is an external event that is affecting the market, and you’ve made a decision to reward executives, you go ahead with it,’ Mr. Lillard said. ‘Life goes on.’ …

“At Stryker…post-9/11 stock option grants to several executives appear to have been initiated by the chairman and CEO at the time, John W. Brown. They were dated Sept. 20, 2001, at the bottom of a sharp ‘V’ pattern in the share price.

“Mr. Brown would ‘periodically tell us if he thought the stock was attractive,’ and then the board would decide whether to award options, said Mr. Lillard, the former member of Stryker’s stock option committee. ‘We didn’t just sit down after Sept. 11 and say, ‘Gee, how can we take advantage of this?’ Mr. Lillard said. Besides, he added, no one could have known whether the stock would rebound immediately or continue to slide.

“Mr. Brown said that for the past 10-12 years, the company, to compensate for a relatively small number of options given to executives, has tried to ‘pick what we think would be the low point of the year. That’s what we’re gunning for.’

“Stryker’s option grant came on the lowest closing stock price for the second half of the calendar year. Mr. Brown said he believes that he called both members of the stock option committee on Sept. 20 to recommend they choose that day to grant options. He added that he couldn’t remember a time when the board didn’t follow his advice.”

So both the CEO and compensation committee are clearly in favor of giving Stryker shareholders as little cash as possible for each option granted to the CEO. I recall reading somewhere that the board is supposed to represent shareholders’ interests, not the CEO’s! I’ll have more to say about this practice using one of the “poster boy” option abuse companies. But first, on the same page of the July 15 Wall Street Journal is another article quoting an early whistle-blower in the backdating scandal. He suspects that it will turn out much worse than what has been exposed in the media thus far (emphasis added):

Early Innings of Backdating Scandal

“Erik Lie, a University of Iowa business professor whose work helped fuel regulatory inquiries into backdating, is expected to release fresh research this weekend showing anomalies that suggest a huge cohort of companies may have played games with their options grants. In his new research paper, which analyzes options prices and share movements, Dr. Lie estimates that 29% of the nearly 8,000 firms studied had backdated or otherwise manipulated grants to top executives at some point between 1996-2005.

“The paper, authored by Dr. Lie and Randall Heron of Indiana University’s business school, examined almost 40,000 grants during that period. It found evidence of manipulation involving 23% of those grants between 1996-2002, when a new rule required executives to report grants within two business days of receiving them — making backdating far more difficult to achieve. Afterward, the number of suspicious grants dropped in half.

“‘This scandal is much bigger than what we currently are seeing in the media — though it looks pretty big in the media,’ Dr. Lie says.”

Broadcom: A Case Study in Option Abuse

Broadcom Corp. (BRCM), a communications chip company, stands out as one of the best examples of how an excessive option plan can dilute shareholder interests. The tech bubble of the late 1990s was a time when top-notch engineers and programmers routinely demanded generous stock option packages as inducement to sign on with public companies. These companies met their demands, and were allowed to do so by shareholders who were far too distracted in their quest to find tech companies with the best growth prospects.

By the market bottom in 2002-2003, scores of tech companies were left with unhappy employees holding worthless options with triple-digit exercise prices. Shareholders weren’t happy, either, when they realized how they had been ripped off by giving a huge portion of the company’s future away to option holders:

While it was caught up in the options frenzy of 2000, Broadcom made some grants with suspiciously perfect timing (for option holders, not stockholders). The Wall Street Journal describes how the company now faces a significant charge and earnings restatement relating to the unfolding backdating scandal:

“Broadcom Corp. said it expects to take a charge against earnings going back to 2000 for at least $750 million, in one of the biggest restatements yet in the growing scandal over stock options practices…

“[The company] said it is taking the earnings hit primarily because options that were dated at a quarterly low in May of 2000 were ‘not completed’ until later, in the summer of that year. Companies are supposed to account for options grants on the date they are granted.

“Broadcom said this accounting issue didn’t amount to backdating — which is choosing a favorable price from a date prior to the time when the options were actually awarded.”

Even if the 2000 grant didn’t amount to backdating, the fact remains that Broadcom has been among the most aggressive option issuers among all public companies.

Options Dilute Shareholders’ Claims

The number of suspicious options grants may well have declined greatly since the 2002 ruling requiring executives to report grants within two business days. But this does not address the key issue of shareholder dilution. In the table below, containing information drawn from footnotes of Broadcom’s 10-K filings, the numbers highlighted in orange represent the rate of annual shareholder dilution. The pace of options issuance — as a percentage of year-end shares outstanding — has decelerated to a 4-6% annual rate from a 15-20% rate.

4-6% is the new hurdle for long-term earnings-per-share growth just for existing shareholders’ claims to maintain their current value, and 4-6% real growth is about what one should expect from even the best companies over a generational time period. Why pay a high multiple for EPS with zero real growth? Isn’t that basically an infinite-duration bond with the business risk of a high-tech company constantly battling obsolescence?

Broadcom shareholders should also take heed that the company has a precedent of “re-pricing” options. Several tech companies felt compelled to re-price options with bubble-level strike prices after the 2000-2002 burst. Broadcom issued many options in 2000 when its stock was above a split-adjusted $100 per share. These options are worthless unless the stock climbs above $100 before expiration, and that isn’t likely to happen. These re-pricing initiatives are always done in the name of improving employee morale, but few mention the cost to shareholders.

The blue highlight in the options footnote chart shows a wealth transfer from stockholders to option holders in the range of $49 million. 49 million options with strike prices in the range of $32 were tendered in exchange for options with strike prices in the range of $22. This ultimately amounts to $49 million less for future company operations or capital expenditures:

Another way to look at this table is to calculate the percentage of future free cash flow pledged to option holders. Highlighted in yellow, this number is now 22% — not insignificant. This percentage is calculated by dividing the 121.8 million options outstanding by the 545.3 million shares outstanding as of March 2006 (source: Broadcom 10-Q). The “weighted average exercise price per share” of $19.85 means that over the course of the option vesting schedule, 121.8 million new shares will be granted to option holders in exchange for an average price of $19.85.

Now, lest you think that sounds like a fair deal for shareholders (after all, 121.8 million shares times $19.85 = $2.418 billion in new capital), you must compare the cost of this capital raising strategy with the alternative: a secondary offering. As I explained in my last Whiskey essay, selling stock in the open market at a high price can be a cheap way to raise capital while minimally diluting existing shareholders’ claims.

I ran this comparison, using the “consolidated statement of shareholders’ equity” from Broadcom’s 10-K, and the results are highlighted in yellow in the table below. Over the past three years, option exercises provided a grand total of $611 million less in capital than if the company had conducted secondary stock offerings in equal installments at the end of every month. While this is just a theoretical estimate, it is conservative, because I am not including the tech bubble years, when the gap between strike and market prices was far wider. Also, management teams usually wait for a significant run in the stock before issuing a secondary, rather than doing so at average prices over a long period:

There is nothing illegal or necessarily immoral about paying deserving executives and employees very well. It’s just that shareholders, like voters, tend to avoid doing much to defend their interests (and by voters’ interests, I am referring to the freedoms granted by the Constitution). Other than a few activist hedge fund managers, the investment community is not doing much to stop abusive, dilutive options and compensation practices.

Broadcom shareholders cannot really do much about it. They have continually elected a board of directors that dilutes their interests as avidly as Congress abuses citizens’ freedoms or the Federal Reserve dilutes the dollar’s purchasing power. This is unlikely to change much, considering that the company’s co-founders control the board through dual-class stock and super-voting rights. They should expect the trade-off of a permanent discount on their stock resulting from this share structure. Potential shareholders beware that you will be buying a stake in a semi-public company that is clearly not run 100% for your benefit.

Nevertheless, Broadcom appeals to growth investors given the valuation the market has given the stock of this communication chip company. At its current price of $27.40, the stock trades at a multiple of 548 times 5 cents 2005 EPS (pro forma for SFAS 123, or how EPS will be calculated in 2006). But everyone from executives to sell-side analysts recommend you back out this new expense when calculating earnings potential. After all, since it’s impossible to precisely calculate options expense using the Black-Scholes model, why do it at all? Well, I hope I have just demonstrated the importance of expensing option grants. It remains a major component of the company’s long-term cost of capital and determines the number of shares that ultimately “share” future free cash flow.

Broadcom is likely to tone down option issuance even further since the company started expensing options at the beginning of 2006 (required by GAAP). The 5 cents per share in diluted, pro forma 2005 EPS will increase significantly, with smaller option grants in 2006. This table from Broadcom’s 2005 10-K displays the huge effect options expensing would have had on EPS over the last three years. The difference between “as reported” and “pro forma” represents options granting expense in those years:

Inflation Dilutes Savers’ Purchasing Power

Dilution resulting from stock options clearly has a large effect on existing shareholders. This dilution directly parallels inflation diluting savers’ future purchasing power. Inflation can be measured by dividing the amount of money and credit created in a given year by the total existing supply of money and credit. Holding the supply of goods and services constant, the added supply of money and credit will exert pressure on asset prices, goods, and services in fairly unpredictable fashion. Just as a share in Broadcom is a claim on the company’s future free cash flow, a U.S. dollar is a claim on the current and future supply of goods and services.

Contrary to popular belief, recessions initially exert pressure on published CPI numbers if the supply of goods and services contracts more quickly than the supply of money and credit. It is only until default rates pick up and credit becomes rationed that pressure on CPI is eased. However, you can expect that the Fed will have long reversed course and even reach for its “emergency measures” toolbox if fears of another Great Depression pop up again. Whether these measures ultimately work depends entirely upon the U.S. dollar’s reserve currency status; you should not automatically assume the status quo, but, instead, consistently monitor the situation as it unfolds. This is the only way to successfully navigate these tumultuous Fed- and in/de/stagflation-obsessed times.

Chairman Ben Bernanke is likely to be menaced by persistently high core CPI numbers while housing and consumer spending is clearly slowing. Whether or not you believe in the necessity of the Fed to “manage the economy” (I do not), you must at least acknowledge that its task of managing inflation expectations has rarely been more difficult than it is now. The Fed is facing increasing pressure to “pause,” but risks being exposed — at least in the eyes of the general media and public — for the inflation-promoting institution that it is. Perhaps this exposure will occur at a pace similar to the exposure of stock option dilution. If so, you will want to have a position in gold bullion, not Broadcom stock.

Best regards,
Dan Amoss, CFA
July 21, 2006