Spartacus

Enough jackassery on gas prices

The LAT has an interesting piece on a rural Texas county whose board of commissioners called on residents to boycott Exxon Mobil until gas prices drop to $1.30 a gallon. This sounds like business as usual for politicians during an election year, but what makes this story interesting is that local people appear to be rejecting this simple-minded attempt to demonize "big oil" for the vagaries of supply and demand. In addition, the main person who stands to lose from this boycott effort is a local businesswoman and recent grandmother who owns and operates the only three Exxon Mobil branded retail stations in the County. Fortunately for her, the people of Bee County appear to have more common sense than their local pols.

Technorati Tags: Bee County, Gas price demagogues

Crash and Burn

Crashing your million dollar Ferrari under dubious circumstances appears to be a metaphor for this dude's life. (And I thought Swedes were supposed to be boring?)

Technorati Tags: Ferrari Enzo, Gizmondo, Stefan Eriksson

Underwater down at the Bayou

Gretchen Morgan has an interested feature in today's NYT detailing the alleged massive fraud at the Bayou Group, a defunct hedge fund.

Drinking the CEO Coolaid

It's not often that I write about finance and investing in this blog. However, this story is too bizarre, and too amusing, to pass up.

In a nut shell, Overstock.com CEO and founder Dr. Patrick M. Byrne appears to be having a very public meltdown in reaction to the large number of investors who have "sold short" Overstock's shares in anticipation of a sharp decline in its price. (In short-selling, investors borrow stock from their broker/dealer and sell it in the hope that they can buy it back later at a lower price and thereby profit from the stock's decline.)

I've briefly written about Overstock before, highlighting their sexy spokesbabe Sabine Ehrenfeld. But this is much more interesting.

Anyway, last week, Byrne hosted a web conference call announcing that Overstock had hired legendary tort-king John O'Quinn to sue short sellers and research firms that allegedly have been conspiring to manipulate the company's share price. His long, rambling monologue (transcript here | sign-in to listen to the call here) was more than a little bit wacky, full of references to "Sith Lords", tinfoil-lined hats, and an evil cabal of journalists, regulators and stock market operators who are working together to drive down his stock. (Click on the slide below to see what he was talking about.)

Needless to say, financially oriented bloggers like Jeff Matthews and Mark Cuban have been having a field day with this.

Personally, I've always been suspicious about anybody (other than Germans or people who practice medicine) who uses the title "Doctor" in everyday life.

Update

Bryne's ravings have earned him the coveted number one position on TheStreet.com's list of the five dumbest things on Wall Street this week.

Man bites dog

Finally, another NYT editorial that I can agree with.   This one calls on Congress to refrain from overrulling the FASB decision requiring companies to begin expensing employee stock option grants in 2005.   Their editorial cites an analysis by Fortune magazine (the business magazine of choice for mid-level corporate drones) showing that if eBay had expensed options for the five-year period from 1999 to 2003, its cumulative net income would have been $13 million rather than the $840 million it reported.   For a more comprehensive look at the earnings impact of excluding employee compensation paid in the form of stock options, see this analysis I did back in February of this year.

More on expensing options

TheStreet.com has a few interesting articles on the options expensing issue.   This one, by K.C. Swanson and Ronna Abramson highlights the negative implications for technology stocks if the FASB proposals for option expensing are adopted.   The article also has some estimates for future earnings dilution produced by Goldman which are similar to the work I did back in February.

This piece, by Troy Wolverton, handicaps the chances of Congress intervening to defeat option expensing like it did the last time FASB tried to close this particular accounting loophole back in the mid-1990s.   His bottom line?   This time, after Enron and Worldcom, no politician wants to touch accounting rules with a 10-foot pole.

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.

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 : 

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.

Somebody oughta go to jail for this one...

I'm not a big fan of Elliot Spitzer.   Like most state Attorney's General, he is an ambitious pol who spends more time worrying about how he can use the courts to advance his political career rather than enforcing the law.   I also think that his persecution of the big brokerage firms over their bubble-era stock research reports was pretty low, what with the selected leaking of internal emails and litigating via the newspapers.   However, Spitzer's announcement yesterday about hedge funds late trading in large mutual funds was pretty shocking stuff, at least to naive old me.

Essentially, what these guys were doing was buying or selling mutual fund shares after the markets closed at 4pm in a way that was not available to other shareholders.   (If a typical investor put in a buy or sell order after 4pm, the trade would be executed at the next day's closing price; the hedge funds were allowed to trade using today's closing price.)   If there was market moving news announced after the close, these hedge funds could profit from this information by buying or selling at the "old" prices, thereby locking in profits at the expense of the ordinary shareholders in the fund.   As Spitzer aptly put it, this was like allowing "betting on a horse race after the horses have crossed the finish line".   This is about as clear-cut a case of stealing from small shareholders that I've ever seen.   And, to add insult to injury, the mutual fund companies were allowing this to take place because they were getting paid to do so.   Outrageous.

Today's WSJ has the best coverage of the story, with a clear explanation of what was being done here and here.  (Subscription required.)

If I owned funds from any of the mutual fund companies implicated in this mess (Bank of America, Janus, Strong and Bank One), I'd be pissed as hell.   I would also cash out of these funds pronto, as a matter of principle.

Seniors with sense

I noted with approval that U.S. District Judge Milton Pollack dismissed one of the numerous class action lawsuits against Merrill Lynch seeking damages for "fraudulent" research published during the tech bubble.   In a scathing opinion, Judge Pollack concluded that:

The record clearly reveals that plaintiffs were among the high-risk speculators who, knowing full well or being properly chargeable with appreciation of the unjustifiable risks they were undertaking in the extremely volatile and highly untested stocks at issue, now hope to twist the federal securities laws into a scheme of cost-free speculators’ insurance.  Seeking to lay the blame for the enormous Internet Bubble solely at the feet of a single actor, Merrill Lynch, plaintiffs would have this Court conclude that the federal securities laws were meant to underwrite, subsidize, and encourage their rash speculation in joining a freewheeling casino that lured thousands obsessed with the fantasy of Olympian riches, but which delivered such riches to only a scant handful of lucky winners.  Those few lucky winners, who are not before the Court, now hold the monies that the unlucky plaintiffs have lost—fair and square—and they will never return those monies to plaintiffs. Had plaintiffs themselves won the game instead of losing, they would have owed not a single penny of their winnings to those they left to hold the bag (or to defendants).

Notwithstanding this — the federal securities laws at issue here only fault those who, with intent to defraud, make a material misrepresentation or omission of fact (not opinion) in connection with the purchase or sale of securities that causes a plaintiff’s losses.  Considering all of the facts and circumstances of the cases at bar, and accepting all of plaintiffs’ voluminous, inflammatory and improperly generalized allegations as true, this Court is utterly unconvinced that the misrepresentations and omissions alleged in the complaints have been sufficiently alleged to be cognizable misrepresentations and omissions made with the intent to defraud.  Plaintiffs have failed to adequately plead that defendant and its former chief internet analyst caused their losses.  The facts and circumstances fully within this Court’s proper province to consider on a motion to dismiss show beyond doubt that plaintiffs brought their own losses upon themselves when they knowingly spun an extremely high-risk, high-stakes wheel of fortune.

If only we had a couple of hundred more Federal Judges like Milton Pollack, there would no be litigation crisis in this country.

But what really threw me for a loop was this sentance from Matthew Goldstein's piece on TheStreet.com: "One thing is for sure: Pollack, a 96-year-old semiretired judge, has shown a dislike for lawsuits alleging that investors lost money on stocks because of misleading or fraudulent research." [Emphasis added]   Nahhh...  Must be a typo; the guy can't be 96 years old.   But he really is 96; in fact he's almost 97.   Even more bizarre, there are lots of other octogenarians and nonagenarians active on the Federal bench.   In fact, one judicial branch administrative official estimates that semi-retired, volunteer judges perform 15% to 17% of all the work in the Federal Court system.   Amazing.   If only more of them could be like Judge Pollack.

Arggh!

Yesterday, my largest short position, Amazon.com, announced better than expected results.   Today, its rediculously overvalued stock traded up more than $3 per share, or 13%.   Ouch.   Oh well, and just when I was getting used to be back in positive territory for the year.   Sigh.