Deal computer provided a case study in just how costly options programs can become. In 1998, Michael Deal took home 12,800,000 options - in addition to the nearly $3.5 million in salary and bonuses. That year Deal himself received 21% of all the stock options granted by the company to its employees. A year earlier, Deal had announced that it was expanding its share buyback program - even though its shares were trading at almost 40 times projected 1997 profits. The next year, the company paid $1.5 billion to buy back 149 million shares.
In business school theory, companies give out stock options in order to ensure employee loyalty and retain top talent - making them part of the family where they hold a stake in the business and thus feel more attached to it. Moreover, while receiving options, Deal was also selling his Deal stock - some 8 million shares in 1998 alone. But why was he, wearing his founder's hat, selling stock while in his managerial garb he sucks up so many options?
In fact, 1998 was a good year for Michael Deal to begin giving serious thoughts to diversification of this holding. A year earlier, Deal's shares had led the S&P 500, gaining 216%, and in '98, Deal once again ran at the head of the pack, gaining 248%. But this would be the stock's golden year. From the end of '98 through to spring of 2000, Deal shares would rise only 58% and then plummet. By the end of 2000, they had lost 70% of their value. In the summer of '03, Deal still traded below its Dec '98 high.
By Sep of '98, worldwide computer sales continued to climb, but prices were falling. It is due to saturation of the market. Nevertheless, Deal's shares were changing hands at 67 times the previous year earnings and 49 times book value.
Meanwhile, in order to try to offset the cost of buying back its shares, Deal decided to gamble on its own stock. In an effort to make buyback less expensive, the company decided to use derivatives options that gave them the right to purchase Deal shares at a preset price for a defined period of time. They began buying call options. In call options, it gives the holder of the options the right, but not an obligation, to buy a share at a preset price over a predefined period of time. If the stock continued to climb, that preset price would wind up being lower than the actual market price which they would otherwise have to pay if they are to purchase it through the normal market channel.
Deal's foray into the options market did not stop there. To pay for the call options, the company began selling "put" options - an option which gives holders the right to sell the share to the option's writer - on its stock. The "puts" gave the the buyer the right to sell the stock back to Deal at a preset price over a specific period of time. If the share price fell during that time, the investor who bought the "puts" would win the bet, but if the share continued to surge, the revenues the company raised by selling the puts would become pure profit. This profit will then be used to pay the call options at the strike price of the call options. For a while, the strategy paid off. In one quarter, Deal made more by selling options than by peddling computers.
But once Deal's share price began to plummet, the gamble backfired. In the fiscal year ending Feb 1, 2001, Deal paid an average of more than $43 for the roughly 68 million shares that it bought back that year. Meanwhile its shares were paddling on the open market at an average of $25. Deal's problem did not end there: "The company eventually must buy 51 million more share at $45 - again, well above Deal's current price - through 2004," Barron's reported in 2002. Moreover, a built-in "trigger" provision requires that if Deal drops to $8, the box maker has to settle up all the puts. Deal would have to spend $2.3 billion to cover this: it had $3.6 billion in cash at fiscal 2002's end.
Investors who bought Deal stock thought they were investing in a computer company, not a hedge fund. But unbeknownst to most shareholders, Deal had temporarily turned itself into a company that specialized in high finance - and high risk. Because Deal had gotten involved in the derivatives game, the shares it bought that year cost an extra $1.25 billion - a number that slightly exceeded Deal's net income for the entire year. Under accounting rules then, Deal was not required to show the cost in its financial statements.
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