Description
I recommend a short position in 5 overvalued stocks (MXIM ADBE VRTS MERQ VRTY).
SUMMARY
These 5 companies share the following characteristics:
Annual Option Grants OVER 5% of basic shares outstanding
Price/Sales Ratio over 5
Price/EPS over 30
Rev Growth under 20%
Historically Under Perform the NDX between June-October
Insider Selling
STATUS OF FASB DELIBERATIONS
Some technology companies that are heavy option issuers have tried to maintain a debate over whether options should be expensed. However, the FASB already made a preliminary decision by unanimous vote that options expense will be included in financial statements in 2004. The remainder of this year will be spent not on debate over whether to expense options, but on the rules for valuing option grants. A final rule is expected in April 2004. Here’s an informative overview:
http://www.fasb.org/full_text.pdf
MARKET IMPACT OF EXPENSING STOCK OPTIONS
Some have argued that there will be no impact because the information is already disclosed in 10-Q footnotes. And every responsible shareholder reads those, right?
The overall impact on reported profits will be minor because most companies do not issue a lot of options, but I believe that the impact has not been efficiently reflected in the share prices of heavy option issuers. Analyst and media coverage of these companies almost never mentions their option expense. Popular databases do not incorporate the option expense in their earnings data and forecasts. Most companies provide no commentary about their option issuance.
As the new FASB ruling approaches, I believe that in coming months analysts will release more commentary on options expense at individual companies. The high costs at MXIM, ADBE, VRTS, MERQ, and VRTY will come under scrutiny and investors will recognize that these companies do not generate sufficient value for shareholders.
POTENTIAL CHANGES IN OPTION ISSUANCE
Some companies have prepared for options expensing by cutting back on their issuance and changing the terms of their option plans. The companies in my basket have either not made significant changes OR are planning to reduce grants to a level that would still be very high relative to their growth and income. These stocks are overvalued prior to consider of options expense. Just consider how they would look with additional costs at even ½ or 1/3 of the FAS 123 fair value estimates in recent SEC filings.
To the extent that options issuance has a favorable impact (lower cash compensation, better employee retention, and higher productivity), a sharp decline in options issuance would have an unfavorable impact (required higher cash compensation, higher employee turnover, and lower productivity). The companies in the basket cannot simply stop issuing options without making other changes that will become apparent on the income statement.
VALUING STOCK OPTIONS
Companies disclose the “fair value” of options expense in financial statement footnotes. Several factors affect and distort these disclosures:
1) Price. The expense is based on the company’s share price and if that price is overvalued then it’s unlikely that the options will ultimately be as costly as calculated. For example, many options issued in the bubble era are worthless (although many companies have restored their value via option exchange or re-pricing programs).
2) Implied Volatility. Tech stocks typically have high implied volatility. The market assumes a significant probability of a large increase in share price. But if the stock is significantly overvalued at the time of option issuance then the probability of significant further increase seems unlikely. High volatility assumptions probably overstate the fair value of options issued by companies in my basket.
3) Vesting. The current calculation of option expense is recognized ratably over the vesting period. This creates a lag as the currently reported number can include the impact of grants made in previous years.
The FAS 123 fair value calculation is useful in comparison to a company’s reported sales and GAAP income, but is not a conclusive answer. In compiling this study I relied more heavily on a simple calculation of current year option grants as a % of basic shares outstanding. This makes it easier to make comparisons over different time periods and between different companies.
A company’s share price should appreciate with future earnings. Granting options equal to 5% of the shares is equivalent to giving away 5% of all future earnings in perpetuity. And the companies in this basket make those grants EVERY YEAR. The accumulating dilution makes it extremely difficult for long-term shareholders to earn a fair return.
Many cash rich companies offset the dilution of their option programs by repurchasing stock in the open market. The Net Repurchase Cost (calculated as Purchase Cost – Proceeds from option exercise – Tax benefit of options issuance) effectively represents value transferred from the company to employees via the options program, but never recognized as an income statement expense.
SEASONALITY
This is not a pure value catalyst, but every little bit helps. This table shows the % change from the first close in June to the lowest close between July 1 and October 31:
NDX ADBE MXIM VRTS MERQ VRTY 5 stks avg
% chg 02 -30.6% -52.7% -50.3% -44.2% -51.8% -11.9% -42.2%
% chg 01 -38.8% -43.7% -36.3% -73.4% -68.9% -45.9% -53.6%
% chg 00 -14.6% -6.0% -15.5% -31.2% 0.6% -35.6% -17.5%
% chg 99 6.8% 15.1% 15.9% 5.9% 8.6% 17.0% 12.5%
% chg 98 -3.1% -37.8% -29.8% -32.2% -25.5% -34.0% -31.8%
These stocks have performed poorly during this period on an absolute basis and also relative to the NDX.
RISKS
1) Nobody cares. This becomes a question of timing. Examination of the cash flow and/or dilution related to the options program exposes the failure to generate shareholder value and ultimately that failure will be reflected in the share price. However, if analysts and investors don’t anticipate the FASB rules by making this study then the impact on share price will be delayed.
2) Second half recovery. The administration wants the economy to recover. The Fed wants the economy to recover. Everybody wants the economy to recover. If it happens then these companies would receive a cyclical increase in sales and profits that would buoy their stocks. This risk can be balanced by long positions in undervalued cyclicals such the energy companies and retailers that have been featured by VIC. Growth investors can also consider biotechnology and medical device companies that issue far fewer options than information technology companies.
3) Corporate event. Short positions can be killed by a major corporate development such as a takeover, new product innovation, or important legal victory. Hopefully these companies are sufficiently large and overvalued that a takeover is very unlikely. And hopefully their business is well enough established that they are unlikely to be transformed by a major new product success or unexpected innovation.
BASKET VALUATION
I will check the success or failure of this idea based on the following starting value:
Stock Shares Price Value
MXIM 0.5167 $38.71 $20.00
ADBE 0.5658 $35.35 $20.00
VRTS 0.7669 $26.08 $20.00
MERQ 0.5281 $37.87 $20.00
VRTY 0.9886 $20.23 $20.00
TOTAL $100.00
----------------------------------------------------------------------------------------------
MXIM
(If these tables post awkwardly then I’ll try to correct them in the comments)
MXIM MXIM FY03E FY02A FY01A FY00A
Sales ($mm) 1200 1025 1577 1376
Pro-f Income ($mm) 310 259 335 373
GAAP Income ($mm) N/A 259 335 373
FAS 123 Exp ($mm) N/A 172 130 80
YE bas shrs O/S (mm) N/A 320 330 322
Option Grants (mm) 14-20 18 23 14.6
Options O/S (mm) N/A 94 89.3 83.2
Net repurch ($mm) N/A 615 -102 16
Option Grants as % of Basic Shares O/S 5.6% 7.0% 4.5%
Options O/S as a % of Basic Shares O/S 29.4% 27.1% 25.8%
Current Price $38.71
Current Year Est P/Sales Ratio 11.0
Current Year Est P/E Ratio 42.5
TTM Insider Sales (Trades) 24
TTM Insider Sales (mm Shares) 1.1
10-Q disclosure shows that the fair value of 2003 option issuance is running unchanged from 2002.
During the past 3 years Maxim spent $529mm to repurchase stock, yet shares outstanding INCREASED by 10 million. The share repurchase money (representing most of the company’s profit) was effectively transferred to employees via the stock options program, but never recognized as an income statement expense.
According to Maxim’s chairman: “The potential damaging long-term effect on our nation's economy and lifestyle resulting from the forced expensing of stock options should be taken very seriously.”
----------------------------------------------------------------------------------------------------------------------------------------
ADBE
ADBE ADBE FY03E FY02A FY01A FY00A
Sales ($mm) 1200 1165 1230 1266
Pro-f Income ($mm) 249 232 286 285
GAAP Income ($mm) N/A 191 206 288
FAS 123 Exp ($mm) N/A 184 176 92
YE bas shrs O/S (mm) N/A 232 236 241
Option Grants (mm) 7-12 12 19.2 19.2
Options O/S (mm) N/A 57.8 54.3 45
Net repurch ($mm) N/A 189 351 11
Option Grants as % of Basic Shares O/S 5.2% 8.1% 8.0%
Options O/S as a % of Basic Shares O/S 24.9% 23.0% 18.7%
Current Price $35.35
Current Year Est P/Sales Ratio 6.9
Current Year Est P/E Ratio 33.3
TTM Insider Sales (Trades) 20
TTM Insider Sales (mm Shares) 1.1
Adobe makes well-known high quality products, but in recent years the company has generated neither growth nor value for shareholders.
During the past 3 years Adobe spent $551mm to repurchase stock, yet shares outstanding decreased by only 5 million. Most of the share repurchase money (representing most of the company’s profit) was effectively transferred to employees via the stock option program, but never recognized as an income statement expense.
ADBE issued no options in 1Q03 but is currently conducting an exchange offer that will convert approximately 12mm old out of the money options into 6mm new at-the-money options.
In recent months ADBE has tried to appease shareholder concerns about options dilution by explaining that its new option plan will not increase the number of options available for issuance (conveniently, the current exchange program will add 6mm options to the pool). And ADBE has said that annual option issuance will not exceed 3% of shares outstanding, but ADBE is referring to net issuance (Grants – Expirations - Cancellations). The expiration or cancellation of an old out-of-the money option and issuance of a new at the money option clearly dilutes shareholder value. For example, in 2002 Adobe issued 12mm new options at an average exercise price of $28.77 and cancelled 4.7mm options at an average exercise price of $45.20.
The fair value of grants equal to 3% of outstanding shares would eliminate a substantial part of Adobe’s earnings and the more probable level of 4-5% would be worse.
-----------------------------------------------------------------------------------------------------------
VRTS
VRTS VRTS FY03E FY02A FY01A FY00A
Sales ($mm) 1600 1507 1492 1187
Pro-f Income ($mm) 272 256 291 255
GAAP Income ($mm) N/A 57 -642 -628
FAS 123 Exp ($mm) N/A 294 285 152
YE bas shrs O/S (mm) N/A 412 404 393
Option Grants (mm) 14-20 25.9 21.3 19
Options O/S (mm) N/A 72.4 59.6 54.8
Net repurch ($mm) N/A -75 -343 -262
Option Grants as % of Basic Shares O/S 6.3% 5.3% 4.8%
Options O/S as a % of Basic Shares O/S 17.6% 14.8% 13.9%
Current Price $26.08
Current Year Est P/Sales Ratio 6.8
Current Year Est P/E Ratio 40.1
TTM Insider Sales (Trades) 7
TTM Insider Sales (mm Shares) 1.1
Veritas shareholder reports highlight the company’s pro-forma results and cash generation. Cash and equivalents increased by $986mm in the past two years. Curiously, $418mm of this increase resulted from the stock option program. The company repurchases no stock while receiving exercise proceeds and tax benefits. Veritas CEO explains: “It would be inaccurate, in my view, to see Veritas last year as a company that lost money. In fact, if you look at Veritas last year, we generated roughly $100-plus million dollars in cash every quarter. I just think that the rules are way too confusing.”
10-Q disclosure shows that the fair value of 2003 option issuance is running slightly ahead of 2002 (Veritas can’t stop granting options because they are an important source of cash flow!). Issuance will moderate when the new plan approved by stockholders becomes effective - the company forecast issuance of approximately 14mm options in the year following approval. The fair value of these grants will eliminate VRTS earnings.
-----------------------------------------------------------------------------------------------------
MERQ
MERQ MERQ FY03E FY02A FY01A FY00A
Sales ($mm) 478 400 361 307
Pro-f Income ($mm) 80 63 54 65
GAAP Income ($mm) N/A 65 34 65
FAS 123 Exp ($mm) N/A 106 97 51
YE bas shrs O/S (mm) N/A 85 83 81
Option Grants (mm) 3.3-6 6.1 5.6 8.3
Options O/S (mm) N/A 22.3 19.6 17.4
Net repurch ($mm) N/A -23 -15 -37
Option Grants as % of Basic Shares O/S 7.2% 6.7% 10.2%
Options O/S as a % of Basic Shares O/S 26.2% 23.6% 21.5%
Current Price $37.87
Current Year Est P/Sales Ratio 7.1
Current Year Est P/E Ratio 42.6
TTM Insider Sales (Trades) 2
TTM Insider Sales (mm Shares) 0.2
10-Q disclosure shows that the fair value of 2003 option issuance is running slightly ahead of 2002.
The recent proxy forecast reduced issuance of stock options. MERQ’s net issuance (Grants – Expirations – Cancellations) is expected to be 3.3mm for each of the next three years. The fair value of these grants will continue to eliminate most or all of MERQ’s net income.
------------------------------------------------------------------------------------------------------
VRTY
VRTY VRTY FY03E FY02A FY01A FY00A
Sales ($mm) 103 94 145 96
Pro-f Income ($mm) 14 1 33 19
GAAP Income ($mm) N/A 1 34 33
FAS 123 Exp ($mm) N/A 78 101 58
YE bas shrs O/S (mm) N/A 35.8 35.2 31.6
Option Grants (mm) N/A 7.2 8.4 6.6
Options O/S (mm) N/A 19.3 16.3 12.7
Net repurch ($mm) N/A 5.5 -30.4 -10.6
Option Grants as % of Basic Shares O/S 20.1% 23.9% 20.9%
Options O/S as a % of Basic Shares O/S 53.9% 46.3% 40.2%
Current Price $20.23
Current Year Est P/Sales Ratio 7.5
Current Year Est P/E Ratio 53.2
TTM Insider Sales (Trades) 15
TTM Insider Sales (mm Shares) 1.3
Verity option grants are so high that management is basically stealing from themselves. The company had 12mm options available for grant at 5/31/02, but with the recent share price advance nearly all outstanding options are in the money. I expect a big increase in insider selling and basic shares outstanding. Exercises also replenish the pool of options available for grant. Verity could continue its current pace of option grants for another 2-3 years without any new shareholder authorization.
---------------------------------------------------------------------------------------------------------
DISHONORABLE MENTION
These stocks were not included in the basket but share similar unattractive characteristics: FDRY, CSCO, SEBL, ADI, KLAC, RNWK and RMBS. Some large non-technology companies appear overvalued by traditional metrics, but I could not find any with comparably high option issuance.
Catalyst
1) Heavy use of stock option compensation will draw more attention as FASB sets rules for required option expensing in 2004
2) Traditionally weak seasonality
3) Excessive valuation by traditional metrics (price/sales, price/earnings etc…)