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February 29, 2004

Hiding in plain sight

With Martha Stewarts's trial winding down, the Rigas family trial about to get underway and former Enron CEO Jeffrey Skilling's trial being an estimated two years away, it may be a good time to focus on the next big corporate scandal.    (Eliot Spitzer, if you're reading this, you might want to take notes.)

In my view, the next "scandal" will be the public's realization that using stock options to pay employees has helped companies (and particularly tech companies) systematically overstate earnings by one third or more for many, many years.    First a bit of background, for those of you who haven't been following the issue.

Companies have long issued options to senior executives giving them the right (but not the obligation) to purchase a fixed number of shares of their company's common stock at a fixed price (usually the market price when the options were issued).     In most cases, these options expire after ten years, vest over several years (usually five) and must be exercised before the employee leaves the company.    Since the ultimate value of the options grant depends upon the future price of the company's stock (which is unpredictable) and have no current monetary value when issued because the exercise price equals the market price, APB 25 allows companies to record no expense when issuing options.    However, stock option grants do have value (as anyone who as ever purchased an exchange traded option knows) and often make up a substantial portion of total compensation for key employees.   Tech companies have particularly liked using stock options to pay employees because not only are they not a drag on profits, but they also require no use of company cash.     (In fact, the exercise of employee stock options is a source of cash as new shares are issued and sold to the employee under the option agreement.)

Sophisticated investors have long been aware that stock option grants are not reflected in the income statements of US companies and that therefore reported earnings overstate profits for companies that make extensive use of options to pay their employees (including most tech firms).     In fact, footnote disclosure of this expense item and its impact on earnings has been required by FASB Statement 123 since 1996.    However, widespread awareness within the financial world has not inoculated brokerage or accounting firms from liability in past scandals like the savings and loan collapse (where accounting fictions like "regulatory capital" were included as assets on balance sheets) or the internet bubble. 

It is unlikely, however, that the average private investor is aware of how significant options accounting is for the earnings of tech companies.    I did a quick and dirty analysis of how much reported fully diluted net income would have been reduced had employee options issuance been expensed for the ten largest components of the Nasdaq 100 Index, which collectively accounted for more than 40% of the index and $1,034 billion in market capitalization.

Options dilution effect for ten largest QQQ members

As you can see, excluding employee options as a cost of doing business increased reported net income per share by an average of 77% in 2001, 61% in 2002 and 34% last year.    For some companies, like Cisco and Ebay, for example, earnings per share were doubled or tripled due to the accounting fiction that the cost of employee options grants should not be considered an ordinary cost of doing business.

While many traditional industrial companies have also benefitted from not expensing employee stock option issuance, the impact has not been as significant.    The table below shows the same analysis for the ten largest components of the Dow Jones Industrial Average, accounting for more than 50% of the index and $720 billion in market capitalization : 

Options dilution effect for ten largest DJIA members

For some of these blue chip firms, notably tech stalwart IBM, excluding employee options expenses increased earnings by a significant 33% in 2002.   But for most of these firms, options accounting increased EPS by less than 10%, and for some firms, like Wal-Mart or Altria, expensing options would have reduced net income per share by only 1 or 2 percent.

This options-related overstatement of earnings has exacerbated the already large valuation gap between technology and traditional blue chip companies.    As of last Friday's closing prices, the DJ Industrial Average was trading at 20.2x LTM earnings, versus 53.4x trailing earnings for the Nasdaq 100 index.    If you adjusted these figures to correct for the earnings overstatement due to not expensing employee option-related compensation, the P/E for the 30 companies in the DJIA would increase to 21.6x (assuming, conservatively, that expensing employee options would reduce LTM earnings by 7%).  However, for the 100 firms in the Nasdaq 100 index, the multiple of trailing earnings would increase to a  staggering 71.6x, assuming that excluding option expenses increased earnings on average by 34%.

(P/E's for the DJIA were taken from Barron's Market Laboratory (subscription required).   P/E's for the Nasdaq 100 are harder to come by since it is a market-capitalization weighted index, meaning that the relative weightings of its component companies change daily as stock prices fluctuate.  I calculated the P/E shown based on the February 26, 2004 closing index composition weightings and EPS data from MSN Money using an Excel external data function.)

The tech-heavy Nasdaq composite index has risen a torrid 82% to 2,029 from its post-bubble October 2002 low of 1,114.    While this is down 6% from its recent high of 2,153 on January 26th, it is still very high relative to the earnings and growth prospects of its constituent companies.    If the tech slump continues (and the Nasdaq composite has closed down for six consecutive weeks), look for hungry trial lawyers and ambitious state Attorneys General to revisit this issue of employee options accounting.

February 29, 2004 at 04:56 PM | Permalink | Comments (0) | TrackBack

Psy-Ops in Afghanistan

Tim Blair has a great post on the practical application of JP-8 and four General Electric F-101-GE-102 turbofan engines with afterburner to a field problem in Aghanistan.   The punchline:

You have to picture this. Pitch black, ten killers sitting down, dead quiet and overlooking this about 30 mile long valley.

All of a sudden, way out (below our level) you see a set of four 200ft white flames coming at us. The controller says, "Ah ... guys ... you might want to plug your ears". Then a B-1, supersonic, 1000ft over our heads, blasts the sound barrier and it feels like God just hit you in the head with a hammer.

He then stands it straight up with 4 white trails of flame coming out and disappears.

  • Cost of gas for that: Probably $50,000

  • Hearing damage: For certain

  • Bunch of ragheads thinking twice about shooting at us: Priceless.

February 29, 2004 at 03:02 AM | Permalink | Comments (0) | TrackBack

Remember those vouchers for Iraqi oil given to Saddam's foreign friends?

Well, the NY Times seems to believe that they were for real.   Read Susan Sachs' 3,800 word feature on how it all worked.

I look forward to hearing more about this little scandal...   I wonder if it is only a coincidence that Chirac and his government appear to have remarkably quiet over the last few months?

February 29, 2004 at 02:49 AM | Permalink | Comments (0) | TrackBack

February 27, 2004

R.I.P. Comanche

Ralph Peters has an excellent column in today's NY Post lauding the Army brass for biting the bullet and killing the Comanche attack helicopter program.   While the Comanche was a highly capable machine, at a projected $60 million each, it was just too costly for its modest advantages over the current generation of attack helos.   The Pentagon made a wise decision to kill it now, even though it had already invested $8 billion in development.

Peters goes on to say that the next big-ticket defense program that should get the axe is the F-22 Raptor, the stealthy air superiority fighter being developed to replace the F-15.   I am not so sure I agree with Peters on this one.   While he's right that $180 million is a lot to pay for a single aircraft, the cost of being unable to maintain air superiority in any future conflict would be far greater in terms of both money and lives.   Also, while the US currently enjoys overwhelming air superiority against all current or anticipated foreign threats, the F-15 fleet is aging and will become too expensive to maintain over the next 20 years.   I suspect the Air Force is wise to continue funding F-22 development and low-rate procurement, even though we could use the $60 billion in the fight against Islamist terror.

February 27, 2004 at 12:03 PM | Permalink | Comments (0) | TrackBack

February 26, 2004

It's the war, stupid

Mark Steyn has another masterful piece in this week's UK Spectator. Here are some excerpts:

America, it’s said, is divided into September 11th people and September 10th people. I’m in the former category. I’m a single-issue guy. All the other stuff can wait. Not all of us single-issue guys are Republicans. There’s a category called ‘9/11 Democrats’, though nobody’s quite sure how many there are. They include, up to a point, the Blues Brother Dan Aykroyd, who’s campaigning for his dream ticket of Bush ’04/Hillary ’08. ‘Let this administration finish this war and this fight against terrorism,’ he says. ‘If Bush is re-elected, then Hillary is set up to run for President in 2008. I’ll be there with my band to help her. Then we’ll have the glory days back for the Democrats.’

Sounds good to me, at least the first part. But most Democrats see no need to wait, and the most salient feature of the party’s primary season is the marginalisation of the war...

The other day Kerry drew a distinction between himself and Bush in the war on terror. ‘I think there has been an exaggeration,’ he said. ‘It’s primarily an intelligence and law-enforcement operation.’ But fighting terror through intelligence and law enforcement means not fighting it at all. As the Clinton administration demonstrated, there are always more reasons not to do something. Intelligence is unreliable and not always actionable, and, when it is, it’s highly perishable: in a risk-averse, legalistic environment, by the time you’ve run what you’d like to do past the lawyers it’s too late to do it. As for fighting terror through law enforcement, nobody’s interested. The Saudis don’t mind if Washington sends in commandos to kill the guys. But they’ve no desire to see them on the witness stand talking about which princes they met when. So a legalistic approach means it’s over: it’s not possible to fight it that way.

Be sure to read the whole thing.

February 26, 2004 at 10:10 PM | Permalink | Comments (0) | TrackBack

Schröder could save German soldiers' lives by sending them to Iraq!

David's Medienkritik has some useful perspective on the rate of US military suicides in Iraq:

SPIEGEL ONLINE – a medium where seriousness and objectivity still count, with the exception of Mondays through Sundays – has succeeded in yet another brilliant journalistic performance. In the series “biased journalism against Bush” a truly gifted anti-American SPIEGEL writer, Dominik Baur, was allowed to print the following on 20 February 2004:

Suicides among Occupation Troops
Increasing numbers of soldiers are proving not to be able to deal with serving in Iraq. Hundreds have already been sent home, dozens have escaped through suicide. …

Suell, Small and Williams are three of 22 US soldiers who committed suicide the past year in Iraq. The suicide rate among soldiers stationed in Iraq is thus 13.5 for every 100,000 soldiers – noticeably more than in the rest of the US Army (10.5 to 11.)… (emphasis added)

Suicide among soldiers is, of course, not a topic the US Department of Defense gladly talks about. (our translation)

“Increasing numbers of soldiers…”: Right, the number increases with each suicide. After all, there hasn’t been a Resurrection in around 2000 years. Irresistible logic from SPIEGEL ONLINE.

“22” then are “dozens.” Hmm… one has to ask which calculators they are using over at SPIEGEL ONLINE.

And they don’t gladly talk about it at the US Department of Defense? Could that possibly be similar over at the Bundeswehr (German Army)? Just search at the site www.bundeswehr.de for the term “Selbstmord” (in English: suicide.) When I searched, the word only came up in connection with Islamist attacks. Otherwise, the Bundeswehr – like probably every other army in the world – wants to prevent reporting on suicide to prevent the danger of copy-cats.

Speaking of the Bundeswehr – how high is the suicide rate among our German soldiers?

Suicide among men serving in the Bundeswehr
“According to an internal report, the Bundeswehr lost 88 soldiers to suicide within 2 years.”
“The Tagesspiegel” 14 August 2000.

Among circa 250,000 active Bundeswehr soldiers that brings us to a rate of around 17 suicides per year per 100,000 soldiers.

Or to put it differently: Duty in the US Army in Iraq presents a lower suicide risk than service in the German Bundeswehr… Alright then Bundeswehr: Time to hurry on down to Iraq!

BTW: a suicide rate of 13,5 per annum per 100,000 is within the bottom third of the European countries! Very remarkable: France's average is 19.25...

February 26, 2004 at 04:19 PM | Permalink | Comments (0) | TrackBack

February 25, 2004

The real voodoo economics

Robert J. Samuelson has a great column in today's WaPo on the "phony jobs debate".   Here is the essence of his argument:

We are having a ferocious jobs debate, most of it fraudulent. If presidents could easily create jobs, the unemployment rate would rarely exceed 3.5 percent. But all they can usually do is influence the economy through taxes, spending and regulatory decisions -- and hope that job growth follows.  In our market system, private employers play the pivotal role. They will add jobs only if: (a) demand justifies new workers; (b) labor costs aren't at unprofitable levels; and (c) they think healthy economic conditions will last. Electing a president based on job creation makes as much sense as selecting a doctor based on palm reading.

The jobs rhetoric captures politics' casual cynicism. John Kerry and John Edwards must grasp a president's modest job-creating powers; otherwise, they wouldn't be fit for the White House. Their jobs obsession is dishonest expediency. They know President Bush is vulnerable. To be fair, the deceit is bipartisan. The Bush administration is ready to claim credit for almost any good economic news.
I'd written a brief note on the same topic a year and a half ago, and have been meaning to revisit the issue.   Now I don't have to...

February 25, 2004 at 06:23 PM | Permalink | Comments (0) | TrackBack

What's a missing $5 billion among friends?

Claudia Rosett has an interesting column at the Opinion Journal.com trying to make sense of the UN's figures for the Iraqi Oil-for-Food program (also known as the "oil-for-palaces" program in certain quarters).   Her conclusion?

When David Kay recovers from his weapons hunt, there's another Iraq-related quest I'd like to send him on. It's time a top intelligence team went scavenging for the real numbers on the United Nations' Oil-for-Food Program--that gigantic setup through which the U.N. from 1996 through 2003 supervised more than $100 billion worth of Saddam Hussein's selling of oil and buying of goods.

And, no, I am not talking about anything as exotic as the list of alleged bribe-takers from Saddam Hussein, published Jan. 25 by the Iraqi newspaper Al-Mada, and now under investigation. I speak simply about the U.N.-supplied numbers on Oil-for-Food's operations. Over the past 18 months, I have periodically tried to get these figures to add up. I am starting to believe the words of an unusually forthright U.N. spokesman, who at one point told me, "They won't."

I suspect there is a real scandal here, involving billions of dollars in misappropriated funds.   Too bad the likely bad guys aren't members of the Bush administration or "fat cat" US corporations or the mainstream press would be over this like a cheap suit.

February 25, 2004 at 10:42 AM | Permalink | Comments (0) | TrackBack

But other than that, Mrs. Lincoln, how did you like the play?

A classic correction from the WSJ posted at Ombudsgod.

February 25, 2004 at 10:16 AM | Permalink | Comments (0) | TrackBack

Spongmonkeys? WTF?!

The good folks at the Sadly, No! blog recently alerted me to a disturbing new threat to life on earth as we know it:

We thought we were the only ones extremely disturbed by this (and that), but luckily it's not just us.

Living as I do, in a spider hole, I had been blissfully unaware of these vile beasts until now.


Here is a new link to the charming Spongmonkeys, who have apparently been heartlessly replaced by a vile talking infant, who is no doubt willing to work cheap.

February 25, 2004 at 09:44 AM | Permalink | Comments (7) | TrackBack