Putting Fat Cats on a Capital Starvation Diet

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Starve them of capital. That's the simplest solution to what I've called "Corporate America's Dirty Little Secret" -- namely, the enormous transfer of wealth from shareholders to corporate employees in the form of stock options.

Starving them of capital means avoiding owning their stock. More than anything else, the issues of capital and stock value resonate in corporate boardrooms. If and when the big guns such as Fidelity, Vanguard and other large institutional shareholders draw a line in the sand and say "enough," the grab for shareholder property will be over.

Spa Diet

Consider Elizabeth Arden ( RDEN), a leading fragrance maker that sells products such as Elizabeth Taylor's Passion and that recently secured Catherine Zeta-Jones as its spokeswoman. It's an interesting turnaround stock with a lot of potential pop. It's a $200 million company that could be worth $600 million or more with a successful turnaround.

However, two significant problems make it a nonstarter. First, long-term debt is too high at $317 million on a revenue run rate of about $750 million. This ups the stakes considerably for the owners of Elizabeth Arden equity. With such a weak balance sheet, the company doesn't have a lot of time to get it right with consumers.

Second, this company appears to be run for the benefit of management. Management's grab for shareholder property is excessive by any measure. In fiscal 2001, the company granted options representing 16.4% of shares outstanding, with one-quarter of that going to the CEO.

When the stock rallied in fiscal 2002, the number of options granted dropped considerably to about 1.3% of shares. But in fiscal 2003, the stock slid back to fiscal 2001 levels, and there was another big grant -- this time representing slightly less than 6% of shares.

The grab for shareholder property at Elizabeth Arden -- of roughly 25% of shares outstanding over the past three years (including some restricted stock grants) -- can be summarized easily enough: It's all about what management thinks it can get away with.

FASB Will Carry the Day

The Financial Accounting Standards Board's move to expense stock options is a fait accompli. As I stated in a prior column, "what gets measured gets controlled." Because companies recognize that option expense will soon be "measured" (reported in the income statement, not in an obscure footnote), the issuance of options is already being "controlled."

Microsoft ( MSFT), Apple ( AAPL), Yahoo! ( YHOO), Dell ( DELL) and Amazon ( AMZN), among many others, have all made moves to significantly curtail option issuance. Still, some companies continue to fight for the status quo. For example, Intel ( INTC) lobbied hard against a shareholder proposal to expense options (a nonbinding proposal) before barely winning the vote.

Intel remains steadfast against FASB's plan. CFO Andy Bryant said about options: "Cash doesn't change, revenue doesn't change, the ability to invest doesn't change. What changes is future profits are spread more broadly." However, his statement doesn't hold up to scrutiny:

  • 'Cash doesn't change': This is misleading. Either (1) cash is depleted because the company purchases stock on the open market to cover dilution due to options, or (2) if the company doesn't buy back stock, shareholders' pro rata claim on cash is diminished because there are more shares outstanding.

  • '... revenue doesn't change': Again, either the company must use shareholder property (cash) to purchase shares on the open market to prevent dilution, or a shareholder's ratable share of revenue declines with more share issuance.

A cornerstone of accounting is comparability. Income statements in Andy Bryant's world aren't worth much, because he doesn't want to include option expense on the income statement. Because many companies now expense options or don't issue them at all, comparability of earnings is difficult, if not impossible, for many users of financial statements.

It's Chat Time!

I'm looking forward to chatting with you live on Wednesday at 1 p.m. EDT. If you're looking for more tips on finding the good and bad in a company balance sheet, please be sure to mark your calendars! I'll be talking turnarounds and turndowns in a live chat with readers. Please click here to sign up.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, neither Alsin nor ACM held a position in any securities mentioned 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. Alsin appreciates your feedback and invites you to send it to arne@alsincapital.com. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.

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