Column

‘THE PATH BACK TO SANITY’

DONALD COXE July 28 2003
Column

‘THE PATH BACK TO SANITY’

DONALD COXE July 28 2003

‘THE PATH BACK TO SANITY’

Column

Microsoft’s dramatic decision to end stock options marks the end of two eras

DONALD COXE

MICROSOFT (nicknamed Mr. Softy by traders for its ticker symbol of MSFT) shook up the overlapping worlds of technology and finance this month. The company’s announcement that it was ending its employee stock option program is Microsoft’s most significant event since it opened its Windows to the PC market. The company that enriched more people with options than any other employer has signalled the end of two eras.

First to go was the era of rapid sales growth for large-capitalization tech stocks. That ended with the recession which arrived shortly after the millennium. The company that accounts for about 10 per cent of the market capitalization weight of Nasdaq, roughly equal to the combined value of Intel, Dell, Applied Materials, Sun Microsystems and Amazon.com now, in effect, admits it sees no chance of a return to the days when the computer market could generate enough growth to justify high priceearnings ratios and stock options.

Second to go (eventually) will be the era of massive mendacity in corporate reported earnings through the Big Lie of stock options. The oppressed minority of us in the financial analyst community who have been exposing this legalized large-scale fraud over the past five years can feel better about the future. Not only did Nasdaq trade at its peak in March 2000 at the anoxic level of 351 times reported earnings, but those earnings were vastly overstated because tech companies insisted that options were free. This has never been their approach to corporate taxes: the techs deducted option costs from their corporate income taxes, which meant reported earnings per share showed, in effect, option costs at far below zero. Microsoft, which reported earnings of US$1.41 per share last year, would have stated US98 cents with options included. Nasdaq companies aren’t alone. UBS’s accounting analyst has been complaining that “the quality of earnings for the Standard & Poor’s 500, from an accounting standpoint, is the

worst it has been in more than a decade.” Perhaps things are now looking up.

How substantial have been the personal option profits that never showed up in earnings statements? Goldman Sachs estimates that Microsoft people cashed US$50 billion in option gains from 1993 through 2002. California, currently in fiscal collapse, reported that its residents paid capital gains taxes on US$85 billion in stock option gains in the year 2000. Naturally, the state government spent all that money and budgeted for even bigger capital gains tax revenues for future years. Why not? Wall Street’s shills and mountebanks said tech stocks had nowhere to go but up.

What should an investor think of the honesty of management that insists the costs of options that made CEOs and other insiders

THOSE OF us analysts who have been exposing this legalized large-scale fraud over the past five years can feel better about the future

rich beyond the dreams of Croesus should not be reported to stockholders, but should be deducted from taxable income when the company reports to government? Such luminaries as Warren Buffett, former Federal Reserve chairman Paul Volcker and former Securities and Exchange Commission chairman Arthur Levitt argue forcefully that this practice was at the root of the excesses of the 1990s that triggered the stock market crash and recession.

Writing in Britain’s Financial Times after Microsoft’s options announcement, columnist John Plender summed it up. “Everyone could delude themselves that options came free. Not unnaturally, they were dispensed like confetti to chief executives and employees. American executives could then rejoice in the perverse fact that this invis-

ible cost yielded a visible credit to the profit and loss account because it was taxdeductible. By some estimates, more than 90 per cent of share repurchases (made by publicly traded companies) in the market’s peak year of 2000 went to managers and employees. So corporate balance sheets now carry a legacy of excess leverage [debt]. The likes of WorldCom and Enron were merely pathological extremes. Everyone was up to something. And where stock options continue to be used, everyone still is. Let us hope that Microsoft’s move is a milestone on the path back to sanity.”

Microsoft will now be a “normal” company that pays its employees in ways that show up in earnings statements, and pays dividends to stockholders. Gates & Co. sit on US$46 billion in cash, which earns roughly US$500 million at current low short-term interest rates. Since President George W. Bush won his battle to slash taxes on dividends to the same low rate (15 per cent) as the tax on capital gains, that other phony argument of Nasdaq companies will have to change. It no longer washes to say, “We don’t pay dividends, which are heavily taxed, because we use the money to buy in stock, which means bigger capital gains for stockholders.” That oft-cited line was another Big Lie, because managements used their companies’ treasuries to buy back stock to hide the scale of stock option issuance. This seemingly plausible line of defence for tech company CEOs is now crumbling, three years too late to save the savings of millions, and the global economy. And reality is infectious: Citigroup, the giant global bank, last week announced it will move away from stock options and buybacks, freeing up money for bigger dividends.

The rest of Silicon Valley is reacting in horror to Bill Gates’s conversion. It’s spending millions of dollars in lobbying its mostly Democratic supporters in Congress to try to prevent a change in the accounting rules to show the costs of options. But the Gates of Redmond shall doubtless prevail.

There is joy, we are assured, in heaven when one sinner repents. There must have been a glorious celebration within the Pearly Gates when Bill Gates fessed up. The truth shall make you free—which is that options never were. 171

Donald Coxe is chairman of Harris Investment Management in Chicago and of Toronto-based Jones Heward Investments. dcoxe@macleans.ca