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10/10/2003
03:21 PM
William Schaff
William Schaff
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Taking Stock: Stay Wary About The Repricing Of Options

Given recent headlines, you'd expect more companies to avoid actions that outsiders may interpret as self-serving. Repricing of employee stock options is one such area I've been watching.

"Why is repricing options bad?" you ask. One of the reasons to offer options is that they are, in theory, a long-term incentive to employees to work hard to increase shareholder value. The incentive comes from the fact that if the stock goes down, the option is worth less as the option's expiration approaches. Unfortunately, lowering the price--called the strike price, the point at which the option becomes worth something--sends employees the wrong message. Management is saying, in effect, if the stock goes up, you'll get rewarded, but if the stock goes down, don't worry, we'll make it all better for you later. Yet there's a big downside for the current shareholders, since it dilutes their share of earnings by increasing the number of shares outstanding.

For example, just recently, Quest Software said it would allow current employees who are options holders to convert, at a specified ratio, options that are above a $14 strike price to options with a strike price equal to the closing price of the company's shares on the date of the new grant. If all employees choose to take advantage of this exchange, I estimate that an additional 5 million-plus shares will be added to fully diluted share count. The current share count is 93.6 million shares, so this represents more than 5% more shares than shareholders could have reasonably expected to see. Since total earnings/profits are divided by total shares, this also will dilute current earnings per share by 5%. First Call consensus earnings for the company is only 23 cents for the full year, so the dilution in the current year is probably only 1 cent to 2 cents. However, it's not the magnitude that's the issue but the fact that it was repriced at all.

I understand that many companies use the argument that they have to reprice their options to retain quality employees. However, in the current environment--and, maybe for some time--a stable job with benefits would be an attractive job option for many IT professionals and programmers. Yes, the environment could change, but the reality is that the job market has become a buyer's market.

What makes me suspicious in this case is that the insiders have control of the vote. So even if other shareholders were to argue against repricing, they could be outvoted by the CEO, Vincent Smith, and board member and former president David Doyle, who control almost 51% of the shares outstanding. This makes the proxy vote useless for the minority shareholders; dissent isn't an option. The only good thing we can say about the repricing is that it excludes officers and board members.

Unfortunately, dilution is still dilution. As this issue comes up more and more, especially as the tech market gets rolling again, tech investors need to stay wary. Fortunately, you can still fight back by voting down an option-repricing program, as Mercury Interactive shareholders recently did. Remember, it's your money they're giving away.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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