TFTF

What Expensing Options Will Do

August 1, 2002

What would real profits be for NASDAQ companies if options were expensed? What would the stock price be for the biggest companies in America if investors started to price them based upon correct earnings figures? I give you the numbers in today's E-letter, plus we look at why the dollar is rallying, the economy and more. It should all make for interesting reading.

Bubble, Bubble, Boil and Trouble

I have been writing for the past several weeks about the affect that new and more realistic accounting standards would have on earnings, and thus on stock prices.

A recent 100+ page in-depth report from Bear Stearns suggests that the aggregate operating income for the S&P 500 drops by 12% for 2001 when adjusted for the fair value of employee stock options. 12% doesn't seem like that big a deal. It's not until you slice and dice the numbers a little differently that some rather grim statistics emerge.

I was curious as to what affect the expensing of options would have on the NASDAQ in particular. The NASDAQ is heavily weighted with companies that liberally use stock options. The S&P 500 is mainly populated by firms which are far more conservative. In fact, the bulk of the options expenses in the Bear study come from a small percentage of the companies in the S&P 500, so the effect on those firms will be far more pronounced. By and large, these are also the largest NASDAQ companies.

We did a simple spreadsheet. We analyzed the 15 largest NASDAQ companies, which represent about 37%, give or take, of the $2 trillion NASDAQ index. We input their 2001 pro forma profits, their real profits, the fair value of the options expense and then let the computer tell us what affect this would have on their Price to Earnings ratio (P/E). (I rely upon the Bear Stearns report for the pro forma earnings and options expenses. The rest is from Yahoo/Finance, or company reports.)

(Please note that my results are approximations and not exact, as different firms use different calendar years, may expense items differently, or may have had a particularly bad 2001. Further, we are comparing current share prices to 2001 earnings, so if earnings significantly improve in 2002, there could be a material difference in the numbers for that company. )

But as an example, Microsoft had pro forma (operating) earnings of $11 billion, and real bottom line earnings of $7.3 billion. They also had $3.3 billion of option expense. At today's price, they have a P/E of 34. Option expenses reduced their income by 46%. This would increase the P/E to 63, based upon 2001 earnings.

For the group of 15 firms, total 2001 pro forma earnings added up to $25 billion. Real earnings were about half, or $13 billion. But total option expenses for the 15 firms were $12.5 billion. That means pro forma income was cut in half, and real, Honest-to-Pete profits were a mere $423 million, give or take a few million.

Earnings Before Interest and Hype

These 15 firms have a total market cap of roughly $750 billion (the total value of their stock). That means the combined P/E ratio based upon 2001 earnings which deduct option expenses, and using their stock price today, is a little north of 1,789!

I should note that Comcast and Cisco do bring the average down. If you take away their $4.8 billion losses (after option expenses), the P/E after options expenses is a far more reasonable 142.

I should also note that if you take away Microsoft, the combined earnings of the remaining 14 is a NEGATIVE $3.5 billion. That means 14 of the largest NASDAQ firms could not combine to make a profit, if you deduct the expense of their options. Seven of these firms had negative earnings once options were deducted.

Now, let's think through a few implications of these numbers.

1. There are clearly many large companies currently selling product at a loss, if you consider options as an expense. Since it is likely, in my opinion, that the accounting industry will soon require firms to deduct option expense, this is going to seriously impact corporate strategy.

As a CEO, you cannot realistically expect your stock price to rise if you cannot show profits. That means you are going to have to cut costs, raise product prices or stop giving options. If you have been using stock options as a substantial part of employee compensation, you are in a bind. You are not going to have happy employees if their total compensation goes down.

How much more can firms cut costs than they already have during the last recession? In a market with too much production capacity and heavy competition, how much can a firm raise prices?

For some firms, it will simply mean that profits are going to drop to a new level. It certainly means earnings are going to be under severe pressure for firms that have been liberal with stock options, unless they stop the practice.

2. Much of the misery in the above numbers is past history, and these companies are returning to profitability. But in the era of new accounting and a Muddle Through Economy, profit growth is going to be much slower. That means that investors will assign these former market darlings much lower earnings multiples, and that means lower share prices.

3. These are large companies. Large companies cannot compound earnings at 15%-20% for any length of time. It is just not possible. At 15%, that means a company would have to double every five years. It is difficult to keep creating billion dollar revenue streams. Growth in large companies follows a natural evolution and simply slows down. Slower growth means lower multiples.

4. At the end of the day, why is a large high tech company valued more than a company which makes TVs or refrigerators? They both have lots of competition. They both make boxes, and they both will experience normal growth. As industries mature, profit margins fall. Ultimately, the market will lose patience and begin to assign the NASDAQ tech companies an earnings multiple similar to the Old Economy companies. It will be based upon actual earnings and potential for growth.

If you want to find a growth stock, look for smaller companies in immature industries. That is not Cisco, Intel, Qualcomm or Maxim, just to name a few.

How Far Away Is the Bottom?

One of my consistent themes for the past few years is that NASDAQ stocks are greatly over-valued compared to Old Economy stocks. The above back of the napkin study illustrates this point.

Let's say that high-tech CEO's wake up and smell the coffee. They dramatically cut back options. They get their ships in order. They make an honest $25 billion, instead of merely pro forma. That would put their stock prices today at a P/E of about 30. Is that possible? Yes, but in a slowly growing economy, it is not likely.

The NASDAQ is vulnerable as no other index is. This group of 15 stocks is subject to at least a 50% drop from today's levels, if historical standards are applied. You do not even want to know the number if you apply bear market standards. I won't print it, as it is all conjecture anyway. Besides, if you won't sell now because I think there is potential for another 50% drop, then telling you it could be worse won't make any difference.

NASDAQ Prediction

There were 5,556 companies listed on the NASDAQ in December of 1996. Today there are 3,883 and dropping. The index is a list of survivors. When a company is de-listed, it no longer is able to drag the index down. This tends to make the index appear better than what investors actually experienced. It is called survivor bias.

$4.25 trillion dollars of market value has disappeared from the NASDAQ alone since March of 2000.

Investors are going to start asking about dividends and dependability. That is going to make a lot of boring old companies look good again. A lot of those companies are in the S&P 500. Even though that index will suffer as we progress into this secular bear market, it will not drop as much as the NASDAQ.

I think the day could come when the NASDAQ Index is lower than the S&P 500.

The Economy Muddles Through - Maybe

Growth, we are told, was a mere 1.1% in the second quarter, down sharply from the downwardly revised 5.0% in the first quarter. (They said it was 6.1% just a few months ago.) My prediction that growth would be in the Muddle Through 2% range for the year doesn't look as foolhardy as it did in April. In fact, it may prove to be optimistic.

(One interesting thing about the GDP announcement was the revision to last year's number. It now seems that rather than growing in the first two quarters of 2001, we were in recession. So, we did have an official recession of a full three quarters in 2001 after all. I do find it strange that there was such a dramatic difference in the first quarter of 2001 from plus 1.2% to down 0.6%. That is a large change from over 15 months ago.)

Frankly, the poor performance of the economy worries me. If the economy is only growing at 1%, there is no room for the economy to absorb what Steve Roach calls a "shock," like an increase in unemployment or a drop in consumer demand. I can think of others like a slowdown in housing or another terrorist attack.

Historically, the norm has been for a recession to have two dips. Only in 1969 and 1990 was there only one dip per recession. It is now clear that the growth in the first quarter was from inventory rebuilding, and that the underlying economy was not that strong, as I wrote at the time.

We are vulnerable to another dip. I have previously thought that if we did slide into recession again, it would not be this year. Now, if we are truly only growing at 1%, then we could be there this year if we get that "shock." This is an economy that is on the edge. It will not take much to push it over.

Frankly, we need to see the market at least stabilize, if not go back up somewhat. If the market gets uglier this fall, that could be enough to further depress consumer confidence and spending, which would send us into a second round of this recession.

However, if it is not this year, then it is likely to be sooner rather than later that we dip back into recession. The next recession will take another large bite out of the stock market. Those market cheerleaders who are calling the bottom are simply assuming the economy will resume its normal growth pattern of 3%+ for the rest of the decade. I think you can count on at least one more recession within a few years, at the outside.

The Bouncing Dollar Bill

I wrote this spring that the dollar was getting ready to weaken, and suggested investors could open euro based bank accounts at Everbank (www.everbank.com). In addition to the interest, you also have a nice gain. I also thought that the euro would go to parity at the end of the year, but it moved quite rapidly

Frankly, an encouraging sign is the recent strength in the dollar. It was going down too fast, and if it continued on that path, that could be the "shock" that pushes us back into recession. I have written in past weeks about the rapid drop giving me deep concern.

The euro was worth $1.17 at its high shortly after its birth in 2000 and $.82 at its low last year. Parity is where the euro is equal to the dollar. The dollar broke through parity with the euro this month, and seemed poised to move on down. But the dollar has strengthened.

I still think it will once again reach parity, and eventually go to $1.10 or lower. That is by many estimates closer to true value. But it would not be good for the dollar to get there too rapidly, just as it would not be good for the stock market to reach its ultimate bear market bottom too rapidly.

It would make me feel a lot better to see the dollar gain strength for the next while before it drops again. Slow is better than fast.

While we are on the subject of the dollar, let me address those who see a 50%+ decline in the dollar. Mostly, these dire predictions come from those who want to see gold go to $1,000 plus. I agree that if the dollar were to drop by 50%, gold would soar.

But drop against what? The European economy shows little sign of getting stronger, as unemployment rises and confidence falls, as well as many indicators in outright retreat. The Bank of Japan is perhaps signaling they are serious about moving the yen lower.

Dennis Gartman pointed this out to me. It too complicated to explain in detail, but the US Fed sends signals to the banks and financial institutions about its policies by the technique in which it increases the money supply. Gartman explained it to me that it is somewhat like my wife politely asking me to take out the garbage, or yelling at me to get off the couch and do it NOW! The results are the same as the garbage gets taken out, but the tone in her voice conveys completely different meanings.

Japan is currently using the shouting technique to monetize Japanese government debt. They may be telling the markets that they intend to drive the yen down, and attempt to bring back inflation. Central banks have the ability to devalue a currency by printing too much of it. We will see if Japan is serious this time.

The rest of Asia is not that strong, and Latin America is a mess. Uruguay has declared a bank holiday, the Brazilian currency has dropped 60% in just a few months, Columbia is reeling and Argentina is down for the count. While the United States economy may not be that strong, much of the rest of the world is not looking all that well either. That is not an environment for a 50% drop in the value of the dollar.

Living on Maine Time

With all this good news, I really need a vacation. Tomorrow my bride and I leave for New England, where we will eat pizza in Mystic, Connecticut and then head north for Maine. Since I have been working a little more than normal, I have promised to not even take my laptop. This will be my first cold turkey vacation in a long time.

Greg Weldon will be filling in for me next week. He is doing a Special Report for you that you will not want to miss. Lots of people pay $5,000 a year to get his investment insights, and next week, you get him free, courtesy of this letter. He has really been on a roll lately. Enjoy it as I rest up and come back with enough juices to finally get that book finished.

Your hoping it will be cool in Maine analyst,

John Mauldin

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