Friday’s Labor Report, Stock Options and Fair Treatment of Equity Investors

December 6th, 2010 by hackel Leave a reply »

The payroll data from the Department of Labor released last Friday suggests economic growth will remain sluggish, despite otherwise suggestions from the recent blip in the stock market. As CT Capital has shown in the past, it is credit, not the level of stock prices that pinpoint turns in the economy—both recession and expansion.

If stocks were to retreat, expect stock based compensation, specifically its purpose and accounting, that could come to the forefront, along with the massive expenditures corporations spent repurchasing shares to offset dilution from exercised employee stock options.

Stock based compensation, an integral part of employee retention plans, can have a significant impact on cash flows and is partly responsible for the vast cash build that has taken place across a wide spectrum of companies—regardless of market size. The decision to issue stock options, does however, impact reported results even though no cash may change hands.

Almost all firms that re-price underwater (a stock price below the exercise price) options do so to avoid a penalty to earnings while allowing employees to cash in on lower priced stock. For the investor and security analyst, re-pricing impacts the number of shares to be purchased to offset dilution and in this respect can be a positive event for the company, assuming the total number of higher priced shares is not eventually replaced, and the firms’ free cash flows hold up or grow. In reality, as long as the firm is doing well, additional options are awarded each year.

Under Black Scholes or Monte Carlo models, a stock way out of the money has little intrinsic value. When a firm re-prices its options one for one at a lower price, the new award will intrinsically have greater value; hence the charge to earnings will be greater. To avoid this penalty, when re-pricing, firms typically cut down the new number of shares so that the intrinsic values are roughly equal, but executives will be happier since at least the new awards can be monetized. After all, a little of something is better than a lot of nothing.

Contact us to subscribe to CreditTrends to see additional commentary, including analysis and discussion on Intel (INTC), Altair (ALTI) and Google’s (GOOG) approaches to re-pricing.

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 Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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