Dilution Threatens Tech's Revival

Broad's policy has been to steer clear of companies that are notoriously generous with employee options, including eBay, Adobe Systems (ADBE), and Siebel Systems(SEBL).

Citigroup's Berquist and Verbeck also flagged Siebel, noting that the company's disappointing first-quarter guidance was in large part due to increased employee option exercises. (The analysts rate Siebel a buy; Citigroup hasn't done banking with the firm.)

Siebel has taken steps to cut back its options, bringing them down from a whopping 53% of total shares outstanding in 2001 to about 31% on Sept. 30.

Despite that drop, Siebel's so-called options overhang still is higher than most tech peers -- high enough to prevent some from owning shares.

"When you think about the idea they gave away a third of the company and didn't tell anybody about it, it just doesn't inspire a lot of confidence, at least from my end, that these guys are going to look out for your best interest as a shareholder," said one buy-side analyst, who asked not to be named. (Options a company is authorized to grant are disclosed and sometimes approved by shareholders. But the actual number granted is not disclosed until 10-K filings are made after the end of the fiscal year.)

Meanwhile, offsetting dilution from options by buying back stock drains a company's cash. In a recent analysis of 11 tech companies, Merrill Lynch found on average that a full 100% of free cash flow would have been required to fully offset dilution from options exercises in 2000, 43% of free cash flow would have been required in 2001, and 12% would have been required in 2002.

But Merrill analysts Richard Farmer and Steve Milunovich predicted that this improving trend is likely to reverse in the coming year, especially if stock prices continue climbing. Most tech firms will divert "a rising double-digit percentage of free cash flow to employees through circular share repurchases now that stock prices are exceeding strike prices of options granted in the bear markets of 2000-2002," they estimated.

Investors may be overlooking this potential drain because accounting rules allow companies to exclude stock repurchases in their calculations of cash flow from operations, Farmer added. By not including stock repurchases in that calculation, investors are overestimating free cash flow and in some cases the value of a stock, he said, offering yet one more reason why the dilution dilemma could put a damper on some of the excitement about rising stock prices.

>To order reprints of this article, click here: Reprints