The Stock Scandal You Haven't Heard About Yet
It’s worse than Enron’s off the books debt. It’s larger in dollar terms than WorldCom. The next scandal to rock investor confidence will be even more shocking than Adelphia’s admission that it invented half a million customers – while siphoning billions in cash to the insiders. Smart investors will go short.
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…
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.
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.
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.
for The Daily Reckoning
July 16, 2002
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.
But what’s bad news for other investors can be great news for you. Sell Maxim short.
The Porter Stansberry Investment Advisory
"Did you see that," asked a French colleague around lunchtime, smiling. "The euro is now stronger than the dollar."
For the first time in more than 2 years, the dollar fell below the level of the euro. Economists and analysts say it was inevitable. They also say a gentle decline in the dollar would not be a bad thing. But the dollar has already fallen more than 15%…what’s to stop it from falling 15% more?
Major trends, like ocean liners, tend to take a long time to get underway. (We’ve been waiting for the dollar to drop for the last 2 years). But once they gain speed, they can be very hard to stop.
Is this a great bear market, or what?
Yesterday morning, Eric reports, investors almost panicked. The Dow fell more than 400 points. But then, they pulled themselves together, gathered up their illusions…and bought the dip!
Man oh man…we have friends, relatives, loved ones who’ve come to the conclusion that this bear market has gone on too long…too far…that stocks have got to be a buy now.
Since there’s so much "negativity" in the news, and so many experts have come to realize that stocks may not do so well over the next few years, these people believe that buying stocks is now the contrarian thing to do!
Not that Mr. Bear couldn’t take a much needed vacation…and not that stocks couldn’t skyrocket for a few weeks. But at present prices, equities are far from cheap. And most investors are far from where they will be when stocks finally do hit their bear market bottom. Now, they’re wondering, hoping that the worst is over and pining for the good times they took for granted. Like a lonely woman stuck in a fading romance, they keep a cell phone close at hand…waiting for a call.
But when the end finally comes, they will not even notice; they’ll have stopped caring long ago.
Eric…more details, please…
Eric Fry on Wall Street…
– Mr. Market – ever the thrill-seeker – took a death- defying bungee jump yesterday. He leapt out into thin air and cascaded 440 Dow points…Then suddenly, the dive jerked to a halt and snapped back nearly 400 points.
– At the close of trading the Dow had lost only 45 points to 8,639. The Nasdaq, likewise, dropped precipitously in the morning, before bouncing back to finish the day with a 9-point gain at 1,382.
– The dollar was not so fortunate – its bungee cord snapped. The greenback dove against both the euro and the yen, sending the dollar below one euro for the first time in more than two years.
– "One euro bought $1.0030, compared with $0.9914 late Friday in New York," Bloomberg reports. "The dollar declined almost 15 percent in the past five months to touch its weakest level since Feb. 23, 2000, at $1.0087 per euro." Gold meanwhile, jumped $4 to $319.90 per ounce.
– Investing in stocks these days is nothing if not stomach-churning. But most investors would probably prefer fewer thrills and chills. The stock market losses have been piling up for so long that there is plenty of misery to go around.
– Over the weekend, I spoke with three different friends of mine who are professional investors – one is a retail stockbroker, one is the president of a brokerage firm and one is the president of an institutional equity- trading firm. While all three gentlemen are comfortably surviving the tumultuous times on Wall Street, they all know plenty of folks who are not. They shared numerous tales of massive investment losses and severe financial duress.
– One of my friends mentioned an associate of his whose portfolio value has collapsed from more than $1 million to something around $50,000…I would’ve been shocked by this story, except that I’ve already heard dozens of identical stories over the past few weeks.
– Another of the professional investors told me that an acquaintance’s portfolio had shriveled from $15 million to $1.5 million over the last two years. "He’s still got $1.5 million," my friend says, "but he’s as poor as he could possibly be, because he can’t get over the fact that he used to have $15 million."
– Investment success is rare these days. But, if you’ll permit a bit of crowing…I’m delighted to report that Apogee Research continues to recommend winning investment ideas on both the long side and the short side of the market.
– Apogee, to which (as you may know) I contribute some of my time and effort, currently sports a portfolio of recommendations featuring far more winners than losers. (Yes, it’s true, there are some losers on occasion.) But six out of eight of its current buy recommendations are in the black, showing an average gain of more than 7%. And all five of its current short-sale recommendations are showing profits – up 21.4% on average.
– In all, 11 of its 13 picks are positive, with average gains of more than 12%. What’s the secret? There is one, but it’s an open secret: Buy low, sell high. Unlike its Wall Street counterparts, the gang at Apogee never bought into the New Era hype. It never believed that Cisco Systems at 80 times earnings was a "strong buy."
– The staff at Apogee doggedly focus on finding solid, undervalued investments to buy. And, as it also recommends short-sales, Apogee works equally hard at finding flawed companies, whose shares are likely to fall. On both scores, it has succeeded most of the time.
– For example, Apogee determined that Silicon Valley Bancshares (SIVB) was a high-risk stock. "SIVB’s earnings profile is severely constrained by its fleeing deposit base and its shrinking loan growth in the near term," Apogee concluded, after completing its initial examination, "SIVB’s net interest margin has plummeted at a time when falling short rates should have boosted the margin."
– On March 19th they recommended selling short Silicon Valley Bancshares above $31. The stock closed yesterday at $23.53. Subscribers who followed their recommendation have gained nearly 25%.
– Investing is difficult in the best of markets…Being well informed improves the odds. It’s true, our office is on Wall Street…but please don’t hold it against us.
Back in Paris…
*** Nobody fudges numbers more than the government. "Exaggerated earnings, disguised liabilities, off-budget shenanigans – they are all there in the government’s ledgers on a scale even the biggest companies could not dream of matching," says the Houston Chronicle. "WorldCom Inc. executives brought America’s second largest long-distance phone company to the brink of bankruptcy after using improper accounting to pad earnings by $3.8 billion.
"Last year, when Congress was faced with a similar need to bolster the bottom line, lawmakers simply voted to shift the date by which corporations had to make a quarterly tax payment. The result: $33 billion in revenue badly needed to cover the costs of President Bush’s big tax cut."
*** And talk about missing estimates! The Feds now say the next 10 years may not produce the $5 trillion in surpluses that they had expected. Instead, the latest surplus guess is $827 billion. Daily Reckoning readers are urged not to take the latest number any more seriously that the first one. The next 10 years will not produce a surplus at all, but an enormous deficit.
*** "I heard about a new ad campaign being launched by the Ad Council – you know, the folks who brought us Smokey the Bear," wrote our friend Porter Stansberry yesterday. "The new Ad Council campaign will try to remind Americans that ‘Freedom’ is the most important quality of America and that if you lived other places – or if America was like other places – you wouldn’t have this ‘Freedom.’
"Despite the obvious problems with an ad campaign that’s trying to convince Americans to value something that doesn’t have any meaning to them, what’s even funnier and more disturbing is that the ads themselves are wonderfully misleading.
"For example, one ad has three men sitting together at a table. One man begins complaining that taxes are way too high. I feel sympathy for him when he says that taxes take half his income right out of his paycheck. I feel the same way. Then his friends begin urging him to calm down, as if the tax complainer has lost his mind. Again, I feel sympathy for the guy complaining about taxes because when I complain about taxes people also treat me like I’ve lost my mind. But it turns out that the ad is supposed to show us that America isn’t really like this, that we don’t have to complain about taxes because we’re ‘free.’
"The other ad I previewed shows a man approaching a librarian’s desk asking for a list of books. He says that he’s looked on the shelves but none of the books are there, where are they? The librarian reminds him that the books are no longer available and then, in a suspicious tone reminds him that they’ve been banned. She alerts the guard and begins pressuring the book seeker for his name. Again, the ad is supposed to remind people that this doesn’t happen in America because we’re ‘free.’ But again, the truth is that this is exactly what is happening in America today. As part of the post- 9/11 legislation empowering the FBI to prevent terrorism, the government can now access people’s library card borrowing history without informing the owner of the library card. If you’re reading the ‘wrong’ books, you can be arrested."