----- Original Message ----- From: Danny Cox <[EMAIL PROTECTED]> To: <[EMAIL PROTECTED]> Sent: Friday, February 18, 2000 9:46 AM Subject: [bearslist] Microsoft's Stock Options > From: Danny Cox <[EMAIL PROTECTED]> > > > http://www.fool.com/portfolios/rulemaker/2000/rulemaker000217.htm > > > Why Microsoft's Stock Options Scare Me > > By [7]Rob Landley (TMF Oak) > February 17, 2000 > > Forget Windows 2000. As far as I can tell, the single most > lucrative product Microsoft [8](Nasdaq: MSFT) sells is its > own stock. Microsoft makes almost as much after-tax cash > income from the stock market as it does by selling goods and > services. Here's how: > Basically, Microsoft receives cash by issuing employee stock > options, after which the company then receives billions of > dollars in tax deductions from the IRS for doing so. Add in > the warrants it sells on its own stock, and the company made > over $5 billion off the stock market last year (fiscal year > ended July 1999), tax-free. For comparison, its after-tax > net income was only $7.8 billion. Microsoft may not be much > in the programming department, but its accountants are > impressive. > Let's run through that again a little more slowly, using > Microsoft's most recent annual report. As with all annual > reports, the most interesting stuff is in the tables at the > end. In this case, search for the $3.1 billion dollar item > "Stock option income tax benefits," which occurs in the > Financing section of the Cash Flows Statement (the above > link will take you there). Lemme detour for a sec to explain > what "Stock option income tax benefits" are. > A significant portion of the wages Microsoft pays to its > employees comes in the form of stock options rather than in > cash. Compared to the rest of the industry, the amount of > cash Microsoft pays its programmers is at best mediocre. It > attracts and retains employees via stock options. > These options give the employees the right to buy a certain > number of shares of Microsoft stock at a tiny fraction of > the current market price. Employees can even take an > automatic payroll deduction to make the token payment to > exercise each stock option as it matures, and thus > effectively get shares of Microsoft stock as part of their > wages. > Microsoft's options are "non-qualified," which means the > employee is immediately taxed when an option is exercised > (i.e., used to actually purchase very cheap stock). The > difference between the price the employee pays for the stock > and the current market price for the stock they receive is > counted as taxable income on the employee's W-2 tax form for > the year, as if they'd received it in cash. The cost basis > for the stock is adjusted accordingly, meaning that if the > employee immediately sold their newly acquired Microsoft > shares they wouldn't incur any additional taxes. They've > already been taxed on that income anyway, and the only new > taxes to accrue are capital gains taxes if they sell the > stock for a higher price than they bought it at. (Capital > gains taxes apply to the extra money gained by selling an > investment for more than it was purchased for. Only the > amount over the original purchase price -- the cost basis -- > is taxed, and this has nothing to do with options.) > Corporations pay taxes on their own income (generally 35%), > but money they pay out in salaries to employees is > deductible from the corporation's income. Since granting > options to employees results in taxable income to those > employees, Microsoft gets to deduct that taxable employee > income from its own taxable corporate income, and that's > where Microsoft got a tax-free $3.1 billion in cash in > fiscal 1999: "Stock option income tax benefits." > But if you stop and think about it, Microsoft didn't really > have to spend actual money to provide the options. It even > GOT a little money from its employees, in the form of the > cash the employees paid (via payroll deductions) to exercise > their options. All Microsoft had to do was issue new stock > certificates, which more or less involves taking a vote in a > board meeting and then firing up a laser printer. > So Microsoft got $3.1 billion of tax money back from the > government, which at a 35% tax rate would be in exchange for > a $9 billion tax expense it never had to pay. Its employees > got taxed and paid that tax out of their own cash wages, and > Microsoft got the money refunded back into its corporate > coffers. It even got $1.3 billion of cash BACK from its > employees in that payroll deduction to exercise the options > (the "Common stock issued" line item, in the same Financing > table as the "Stock option income tax benefits"). Together, > that's almost $4.5 billion dollars Microsoft made directly > from selling stock. > This is on top of a huge cash savings from substituting > shares of its stock for actual cash paid to employees in the > first place. Remember, Microsoft only made a $7.8 billion > net profit last year. To pay its employees an extra $9 > billion in cash compensation expense, it would go $1.2 > billion into the red. But it doesn't have to, as the stock > market provides the money to keep Microsoft going. Microsoft > prints stock, pays its employees with the stock, and the > stock market provides the cash for Microsoft's employees > when they sell the stock or get margin loans against it. > Microsoft can print as much stock as it likes in order to > pay its employees, and as long as the market keeps wanting > to buy shares from those employees, then Microsoft doesn't > have to spend too much of its own cash to pay its people. As > of July '99, Microsoft had around $60 billion of employee > stock options outstanding, and it grants more all the time. > Of course printing more stock dilutes the value of > Microsoft's existing shares, but as long as the stock price > keeps going up nobody seems to mind. Microsoft can sell more > and more stock (through its employees) at ever-higher prices > to generate more and more income with which to support the > stock price in a never-ending pyramid, er, cycle. And of > course Microsoft can buy back some of its shares -- $3 > billion in 1999 ("Common stock repurchased" in the same > Financing table as before) -- but since it issued over $10 > billion worth of shares ($9 billion taxable income over and > above the $1.3 billion the employees paid for it), this > buyback is a mitigating factor at best. But since a lot of > Microsoft shareholders hold on to their shares and live on > margin loans, the dilution doesn't increase Microsoft's > share float until they do decide to sell (i.e., the stock > starts going down and they have to pay off those margin > loans). Meanwhile, the buybacks help keep the stock price > from dipping too much. > Employee options aren't the only kind Microsoft sells. It > sells another kind called "put warrants" to mutual fund > managers, giving them the right to sell Microsoft shares > back to the company at a fixed price (well below the price > they're currently trading at, of course). Mutual fund > managers with a large exposure to Microsoft stock buy > warrants as insurance, giving them a guaranteed floor price > they can sell out at if the stock collapses. If the stock > doesn't collapse, the warrants expire worthless after a few > years, and provide Microsoft with additional revenue (three > quarters of a billion in 1999, "Put warrant proceeds" in the > cash flows statement). > So there you have it. $3.1 billion from a tax loophole, $1.3 > billion from its employees, and $0.7 billion from put > warrants combine to give Microsoft over $5 billion from its > own stock in fiscal 1999. And it avoided paying $9 billion > in wages. All that from a company that only had $7.8 billion > in net income. And as long as the stock keeps going up, they > can keep doing that ad infinitum. > Maybe if Microsoft had recruited a few people from their > accounting department into the programming staff, they'd > have gotten Windows 2000 out on time, eh? Then again, who > cares about products if you can make this much money without > them? > - Oak > > > --------------------------- ONElist Sponsor ---------------------------- > > GET A NEXTCARD VISA, in 30 seconds! Get rates as low as 2.9 percent > Intro or 9.9 percent Fixed APR and no hidden fees. Apply NOW! > <a href=" http://clickme.onelist.com/ad/NextcardCreative4 ">Click Here</a> > > ------------------------------------------------------------------------ > > To subscribe to bearslist, send a blank > message to [EMAIL PROTECTED] >
