VideoWith stock option grants increasingly seen as a magic elixir for motivating employees, keeping the cost from hurting shareholders has required more and more financial alchemy. The latest trick? As they buy shares in the open market to soak up the dilution from option grants, more and more companies have launched put-warrant and other derivatives-based programs to reduce the cost.
Not surprisingly, technology firms that have granted massive amounts of employee stock options have been particularly heavy users of this tactic, with Microsoft Corp. and Dell Computer Corp. among the heaviest. And more companies can be expected to join the crowd as long as stock options remain the incentive of choice.
The financing technique typically involves private contracts with investment banks. In return for granting the bank the right to sell, or "put," company shares back to the company at a predetermined price at a set time, the company receives a premium. If, as has been the case until recently, the shares blow past the exercise price before the exercise date and stay there, the put warrants expire worthless. The company simply pockets the premium for selling them, and it owes the government no income taxes on that money.
It gets better. Many companies also have simultaneously bought call options on their stock, which give them the right to purchase their stock at a certain price. If the stock runs up, these call options, financed from the premium income on the puts, allow the company to buy back its stock at a price lower than the market's.
Since Microsoft instituted its put-warrant program in 1995, it has pocketed premiums worth $2.1 billion and reduced the cost of its buyback program by an average $2.74 a share. Dell contends that its program, which includes both selling puts and buying calls, has helped drive down the average cost per share of repurchased stock to $6. The stock is currently selling at around $38 a share.
But what happens when stock prices go down instead of up? Therein lies the rub. If puts expire in the money--that is, a company's shares fall below the strike price of the warrant--the company has to buy back its shares above the current market price. Moreover, notes Robert Willens, a tax and accounting analyst at Lehman Brothers Inc., if
an issuer chooses to settle the contract with its own stock in order to preserve cash, it will have to issue new shares to honor the put obligation, thereby creating even more dilution than the buyback program was intended to offset.
Granted, there's little or no evidence yet of such an unhappy outcome, despite the recent sell-off in technology shares. But critics say it may be only a matter of time before such programs implode. "It turns into a death spiral," notes Michael Murphy, editor of the California Technology Stock Letter.
The Prime Candidate
Consider Microsoft. The company has seen its stock pummeled in recent months, yet by the end of June, Microsoft had 157 million put warrants outstanding, with strike prices ranging from $70 to $78 a share. In mid-August, the company's stock was trading in the mid-$70s. The expiration dates for these contracts range anywhere from September 2000 to December 2002. If the stock were to fall below the strike prices of the individual puts on the day they expire, Microsoft would find itself having put warrants exercised against it.
The shares covered by the contracts currently represent 2.8 percent of outstanding issuance. Assuming an average strike price of $74 a share, that approach could cost the company $11.6 billion over the life of the contracts.
Microsoft declined to comment, but analysts note that with $23.8 billion in cash on its books and $9.1 billion a year in cash flow in fiscal year 2000, the company can easily handle the potential problem. "Even if Microsoft had to buy back every share, it could do it," says Joseph Beaulieu, a senior analyst who tracks the company for Morningstar, a mutual-fund and stock rating firm in Chicago.
Still, for Microsoft to reallocate almost half its current cash hoard when it's making deals hand over fist is not something investors are likely to easily overlook. And given the pace at which the company has been granting employee stock options lately, Microsoft is likely to increase its use of put warrants in the not too distant future. Last April, with its stock foundering, Microsoft gave employees a special grant totaling 70 million options. In July, the company issued about 55 million more options as part of its annual employee stock option grant. (As of June 30, the company had 832 million vested and unvested options outstanding.) Yet, for almost eight months this year, the company was unable either to buy back stock or issue new put warrants, because of its $1.5 billion acquisition of Visio in January. The acquisition was accounted for using the pooling-of-interests method, under which companies cannot engage in other transactions involving their own stock for six months. That's one reason Cisco Systems Inc., a recent devotee of pooling, does not use these types of derivatives programs to complement its stock buyback efforts. But with Microsoft's six-month wait over, the company announced on August 7 that its board had approved a new stock repurchase program.
Reader Comments» Post a comment