Within the world of CEO’s, the issue of dilution
generally splits the group into two camps - those who are concerned
with dilution and those who don’t care about it. As an investor
you should be pleased that among the party that worries stands Warren
Buffet.
Just what is dilution? Here is a perfect example -
the chip company Intel (INTC). The basic share count declined by 234
million shares during 2001 to 2003, a result of $12 billion in stock
repurchases. During those three years, Intel bought back 492 million
shares at an average price of $24.46, while 237 million options were
exercised for an average price of $14.05, including the company's tax
benefit. The company also issued 21 million new shares from acquisitions.
This is how the bottom line reads: 234 million shares
were repurchased for the benefit of stockholders and 237 million shares
were handed over to employees with an average loss of $10.41 per share.
Put another way, $2.5 billion in shareholder wealth was transferred to
employees. $2.5 Billion. That is quite an incentive plan. I thought plush
paper in the washroom was nice enough.
You might think that this rather large and substantial
expense would appear as a compensation expense in Intel's financial statements.
It’s not, because it is considered neither cash nor an expense. Instead,
it's buried deep in the footnotes of the 10-K. Were it to appear on the
income statement, reported net income for last year would have been 16%
lower. Furthermore, the stock's trailing P/E ratio would be worse as well.
This is where the CEO camps are split. Warren Buffett
has stated that the costs associated with stock options should be treated
as a cash expense on the books. And to his credit, when he moves into a
company, the options plan is usually one of the first things to go. The
other camp likes things they way they are. And by an 88-9 vote, U.S. senators
made these CEO’s, some of their largest campaign contributors, ecstatic
by affirming that stock options would remain expense-free. Mr. Buffet declared
this to be “survival of the fattest.”
Back to Intel and the CEO Craig Barrett…In addition
to his salary of $610,000 with a bonus of $1.5 million received 1.35 million
options in 2003 (131% more than the previous year), worth an estimated
$14.4 million. It doesn’t take a rocket scientist to figure out in
which camp Mr. Barrett pops his tent.
I don’t want you to think that I’m singling
out Intel. And don't think for a moment that it's the only company that
does this. In 2003 alone, Oracle (ORCL) transferred $170 million to employees,
Cisco (CSCO) $182 million, and Harley-Davidson (HDI) zapped a cool $20
million. Don’t think about what these amounts would have added to
your dividend, it’ll make you mad.
Put this idea into the back of your mind and remember
that when a company issues a large amount of stock options to employees,
there is a real cost. You can’t find the cost of these programs on
the books, not in earnings or cash flow. It comes out of shareholder funds—our
funds.
If you take anything away, remember... Stock buybacks
are not always an effective tool for enhancing shareholder value. Normally,
they reduce outstanding shares and increase the ownership percentage
of existing stockholders. But, buybacks are often used to mask the dilutive
effects of stock option grants and quietly, subtly, transfer shareholder
wealth to employees. So, the next time a company speaks about the benefits
of a buyback to shareholders, look to see which camp songs they’re
singing.
