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Markets: Tech Trouble
New York: July 10, 2006
By John R. Stephenson

"It's one thing for an executive to make big profits because he's improved his company, but it's a whole different thing to make big profits because he's playing fast and loose with the dating of stock options. Outside the corporate suite, Americans don't get to pick and choose their dream stock price. It's bothersome to think that after the corporate scandals of recent years, some executives are still looking for ways to cook the books for personal gain."

--Senator Chuck Grassley of Iowa - June 13, 2006

In case you haven't heard, there's a whole new scandal brewing. This latest problem involves executives at technology companies and the backdating of stock option grants.

Stock options are a form of compensation. They are a way for company insiders (executives) to participate in the upward appreciation of their company's stock. Stock options allow investors to purchase shares in a company's stock for a pre-set price. If the stock is trading above that price, then they can immediately buy the stock for the pre-set price (exercise price) and turn around and sell that stock in the open market for a riskless profit. If the stock is trading below the pre-set price of the option, then investors hold on to their options and wait for better days.

But what if the pre-set price were being adjusted downward so that executing these stock options was a sure bet for executives? Apparently that's exactly what has been happening.

For example, let's say that a company issued stock options with a pre-set exercise price of $10/share on these stock options. If the company's stock is currently trading at $15/share then this is a good deal for their executives. They can exercise their stock options, pay $10/share to buy something that is worth $15/share and have pocketed $5/share ($15-$10) in easy profits.

But what if the stock is trading below the exercise price - say, at $9.00/share. This isn't a good deal for executives since no one would buy a stock worth $9.00/share but pay $10/share for it. But what if the outstanding stock options could be backdated so that they were granted at a time when the stock was trading at $5/share. If the exercise price were $5/share rather than $10/share then the problem would be solved and their executives would be able to pocket a riskless $4/share profit ($9-$5).

At the heart of this issue is a basic problem of fairness. Most investors have no problem with company executives profiting when their stock is on fire. Presumably they did something to earn that money. But when a company's stock is in the tank, it is often because executives were asleep at the switch. Now, if these same executives are getting to play fast and loose with the timing of their stock option grants so that they can pick and choose when it is most advantageous to them to issue these things, then that is a whole different matter. Not only that, but ultimately by backdating these grants and re-pricing them accordingly, insiders are being given a huge windfall at the expense of ordinary shareholders. This is wrong.

Not only is it wrong but it is also illegal. Not in all cases, but in many. How pervasive is this? No one knows for sure, but so far some 40 companies have been identified as having problems associated with their stock option grants. CalPERS, the giant California pension plan has written to some twenty-five companies requesting clarification on their stock option practices and the SEC and shareholder lawyers are sniffing around for blood in the water.

You would think in this post-Enron world that another accounting scandal is the last thing that an executive would want. Guess again. For some, the ability to make out like a bandit is worth the risk.

Figure 1: Companies Mentioned in Current and Previous Stock Option Probes

 

So what's an investor to do? For starters, run, don't walk, from companies that even have the whiff of scandal. Problems tend to get worse, not better, with time and any company that has accounting problems or ethical problems at the top will not be improved without some serious pain.

But since most of these problems seem to be occurring within the technology sub-sector of the market, why not exit technology stocks altogether? The upside is minimal and the downside looms large. Even if these preliminary investigations lead nowhere, it is hard to see how things improve from here. For starters, this is a group that is trading at the largest price/earnings (P/E) multiple of any sector of the market.

Not only that, but technology companies are finding it increasingly difficult to make ends meet. This is one group that has had a lot of difficultly rebuilding their profit margins since the downturn in 2000. The profitability for these companies has only gotten worse as patent protections are few, if any, and the industry is constantly being forced to reinvent itself every six months and has been cannibalizing existing products and sales to do so.

While many proponents of tech stocks will point to the fact that corporate America has been putting off a wave of capital expenditures in technology that is now "just around the corner", we are skeptical. The reason? Even if this is true and corporate America will shrug off the worries about higher interest rates, this time around we have both wage and spare capacity arbitrage coming out of China which has been hitting the technology sector hard. With lots of competition and cheap prices coming from every corner of the globe, technology companies will have difficulty keeping prices and margins moving higher. What this means is that investors who bought the sizzle rather than the steak will be disappointed as future earnings disappoint and investors balk at the price they have paid for future growth.

With tougher markets ahead, it should be technology rather than other cyclical sectors (consumer discretionary, materials, industrials and information technology) that should lead the market lower. For our money, now would be a great time to lighten up on these technology companies and load up on some of the stocks with a good history of strong dividend growth.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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