Legato's Recent Insider Option Buys Aren't Just for Show

But, there's still danger in assigning undue significance to insider buys that are required or subsidized.
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It's the old Trilogy of Terror: First, momentum mysteriously wilts beneath persistent rumblings that a Street favorite might have trouble meeting estimates. Next, reported revenue falls short. Finally, in keeping with the more conservative outlook, management guides future estimates downward. Want to see something really scary? Take a look at the chart.

For

Legato Systems

(LGTO)

, the evil progression was set in motion back in January. Having swaggered into the millennium at more than 70 a share, the enterprise software company's stock hit a wall; at first, it seemed in sympathy with the general market. For Legato, however, which announced its much-worse-than-expected fourth-quarter earnings Jan. 20, things only got worse. The remainder of the month staged a race to the bottom -- or at least to 25, which the stock tested and momentarily peeked through on Jan. 31.

So, now Legato insiders are acquiring stock -- a trap, right? Maybe not. First, unlike situations in which insiders jump in with token open-market purchases to show support after a meltdown, these particular insiders are exercising options. This could be good news for two reasons. First, because options exercises receive much less play in the press than open-market buys, it is less likely that these acquisitions were motivated by a desire to promote the stock.

Second, the 192,000 options exercised by Director David Strohm were nonqualified options. Remember, with nonqualified options, the spread between the option exercise price and the stock's market price is taxed as ordinary income on the day of the exercise. For this reason, it pays to exercise these options with the stock trading at the lowest possible price. I also like that Strohm exercised options from five separate options series, none of which were set to expire in the near future.

In all, from late December through the end of January, three Legato insiders exercised options to acquire a combined 203,710 shares. True, one insider exercised his options in December, before the stock's fall from grace, but these were incentive stock options, which, depending on individual circumstances (for example, the insider's exposure to the alternative minimum tax), are not taxed until the insider sells the shares. More important, for both Kent Smith, chief operating officer, and Nora Denzel, senior vice president of product operations, the exercise-and-hold strategy implies a clear shift in sentiment: Both had sold Legato shares as recently as November 1999.

As expected, Wall Street has taken a cautious stance toward Legato. It's no surprise, either, that the company has been besieged by shareholder lawsuits. Nor, certainly, is there any guarantee that earnings will jump back on track. After all, the stock meltdown has dimmed the prospects for near-term acquisitions; in fact, an announced deal to acquire

Ontrack Data

(ONDI)

has even been canceled.

On the other hand, the stock does appear to have turned a corner. More important, it has never been the habit of Legato insiders to accumulate stock, either on the open market or through the exercise of options. Granted, there is always the risk that they will turn around and sell after all. Until they do, however, it seems reasonable to suspect that the downside is limited.

On another front, readers continue to voice their views on the danger of assigning undue significance to insider buys at companies that either require executives to own shares or loan these individuals funds to buy shares, or both. Indy native

Stu Sandberg

, for example, writes of his experience trying to decipher the situation at

Conseco

(CNC) - Get Report

. We're glad he did. For those who aren't aware, Conseco sponsors one of the most massive executive loan programs you're likely to encounter. And its executives have taken advantage of it. As a result, when people (even those who should know better) talk about insider buys, Conseco's name nearly always floats to the top.

By no means am I attacking the concept of aligning management and shareholder interests, nor even (at least, in theory) proactive corporate approaches to this goal. The problem, however, is that where a company-sponsored loan program or ownership mandates or guidelines exist, it becomes exceedingly difficult to get a good read on insider sentiment. This is especially true within the first few years of a program's initiation, especially in the case of ownership guidelines, as insiders move toward satisfying these requirements.

Does this mean that such stocks are not good values? Of course not. For that matter, it doesn't even mean that the insiders aren't buying for all the right reasons. What it does mean is that you just can't tell. And as more and more outlets publish raw insider buy/sell numbers, this will become more and more important to know and remember. After all, like Conseco, companies with executive stock ownership guidelines and/or loan programs will inevitably preside atop all such rankings of insider accumulation.

Bob Gabele has been tracking and analyzing insider trading since 1978, most recently for First Call/Thomson Financial. This column is not meant as investment advice; it is instead meant to provide insight into the methods of insider trading. At time of publication, Gabele held no position in any of the companies discussed in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gabele appreciates your feedback at

rgabele@thestreet.com.