eBay ( EBAY) has become known as a cash machine. But much of the cash the company has generated in recent years has come not from its thriving auction business, but from the brisk sales of stock options by its employees.

Nearly one-fifth of eBay's operating cash flow last year came from the tax benefit related to stock options. Meanwhile, the money generated from that tax benefit plus the actual cash it saw from employees selling their options was equivalent to eBay's free cash flow last year and helped swell the company's cash-on-hand position.

This options-related cash forms a large fraction of the company's overall cash flows, which are touted by analysts as an indicator of value. And the sheer amount of options being exercised at eBay raises questions about fairness to shareholders.

"The way (the company's) financial statements are presented makes it look like eBay earned four times as much as they really did (last year) and it also obscures the fact that the company's been funding operations by offering half-off bargains on sales of stock to its employees," said Gary Lutin, an investment banker and corporate-governance critic.

"It's astonishing that people can still be doing this."

eBay representatives did not return calls seeking comment about the company's options practices or the money it raised from their sale. However, company officials have said in the past that they view options as a way to attract and retain employees.

The use of options in general has drawn criticism from investors because they dilute shareholder value and their use has been linked to the scandals at Enron, Tyco and WorldCom. But little has been made of the enormous cash benefit that some companies have seen from options.

When an employee at a company exercises and sells options, the company benefits in two ways.

First, while the money made on the sale of an exercised option is counted as income for the employee, it also counts as a compensation expense for the company and is tax deductible for the company.

eBay and many other companies don't include options expenses on their income statements they file with the Securities and Exchange Commission, so they don't include the corresponding tax benefit from them on those statements. But they do include the tax benefit in their statements of cash flows, because the benefit does have a real effect on the amount of cash going into and out of the company.

The other way a company benefits from an option exercise is that it receives all of the money for the option up to the exercise price. Thus, if an employee sells an option that has a strike price of $50 for $75, the employee gains $25 of income and the company raises $50 from the stock sale.

Turning Options Into Cash

At eBay, these two benefits have turned into huge cash generators.

In 2002, for instance, the company had operating cash flow of $479.9 million. Operating cash flow is supposed to represent the money a company generates from its operations and is essentially calculated by removing noncash gains and charges from the company's net income.

But more than $91 million of eBay's operating cash flow came from the tax benefit related to options.

Meanwhile, eBay last year generated an impressive $341.2 million in free cash flow, which is operating cash flow minus capital expenditures. But if the tax benefit the company saw from options is combined with the cash it received from options sales -- $255.6 million -- the company saw more money from options-related benefits than it posted in free cash flow.

Those trends continued in the first quarter of this year. Of the $190 million eBay generated in operating cash flow in the quarter, nearly 22% came from the tax benefit related to options. With the company seeing $208.4 million from the exercise of stock options, eBay's total options benefit in the quarter was 171% of the $146.1 million it posted in free cash flow.

Head of Its Class

As a proportion of operating and free cash flows, eBay's options benefits outdistanced those of some of its high-tech and Internet brethren.

Amazon ( AMZN) and Siebel ( SEBL), both known for their past profligacy with options, saw no tax benefit from the exercise of stock options last year, because neither company paid income taxes last year, having both lost money. At Intel ( INTC) and Cisco ( CSCO), the tax benefit related to options exercises in their 2002 fiscal years was 3% and less than 1%, respectively, as a portion of operating cash flow.

Yahoo!'s ( YHOO) tax benefit last year slightly topped eBay's for the same period as a portion of operating income, coming in at 20% compared to 19% for eBay. But Yahoo!'s total option benefit -- the tax benefit plus the cash it received from employees' exercises -- represented about 51% of free cash flow in 2002, compared to more than 100% at eBay.

At Siebel, Cisco and Intel, the total option benefit as a proportion of free cash flow was less than 18% in their 2002 fiscal years. As a fraction of free cash flow, Amazon's total option benefit was the closest to eBay's, at 90% of free cash flow last year.

How Investors Lose Out

To be sure, the use of stock options does benefit companies. The money companies raise through options can offer a source of working or investment capital.

Conversely, using options allows companies to pay lower cash salaries or bonuses to employees. But while companies and sometimes employees can benefit from options, investors often have a lot to lose.

Already a prolific dispenser of options, eBay is asking shareholders at its annual meeting next month to increase its number of shares available for options grants by 50%. Shareholders have approved similar sizeable increases in eBay's pool of available options in each of the last two years.

Investors feel part of the brunt of options through dilution. Options exercises at eBay last year, for instance, amounted to 3.5% of the shares outstanding at the beginning of 2002. As the company granted options equivalent to 4.2% and 5.8% of outstanding shares in 2002 and 2001, respectively, more dilution will be coming down the pipeline.

But beyond dilution, options can have a perverse effect on valuations.

eBay's stock price, which closed at $101.65 on Friday, has grown nearly 50% in value this year. Part of its appreciation can be attributed to its growth in earnings and its ability to generate cash.

In a research note issued after the company posted its first-quarter earnings last month, Smith Barney analyst Lanny Baker, for instance, touted eBay's cash generation in the quarter.

"Free cash flow provides the best illustration of eBay's financial might: Up 80% year-over-year to $146 million in the quarter, representing an impressive 31% of revenue," Baker wrote. "eBay's cash balance continues to swell, now to over $2 billion."

In setting a price target for eBay, Baker again pointed to the company's cash generation, putting a valuation on the company equal to 55 to 60 times its estimated 2003 free cash flow.

But Baker did not mention in his report how much of eBay's free cash flow or its overall cash is coming from options. (Smith Barney does not have any investment banking business with eBay.)

Trying to determine a fair valuation for eBay -- or many other technology companies -- is difficult because of the aberrations caused by options, said one hedge fund manager, who asked not to be named. Free cash flow is distorted by the tax benefit from options. And the bottom-line earnings number is often distorted because companies don't expense options.

"How do you make sense of that? The entire industry needs to face that," said the fund manager, who does not have a stake in eBay. "Someone's got to take Silicon Valley to task on this. From a shareholder's perspective, they are stealing from us."

Last year, the average exercised option at eBay had a strike price of $26.16. In contrast, the average closing price of the company's shares last year was $58.97. While that difference between market price and exercise price represents a windfall for employees, it also represents an opportunity lost for the company. That difference means the company likely saw less than one-half of the market value of its stock for each option that was exercised.

It also points to a fairness issue and other red flags, said Lutin. The sheer amount of stock being exercised at eBay is tantamount to a public offering. But at such an offering, the market would get to determine the price of the excess shares.

Instead of a public offering of shares, though, the company is restricting to insiders the opportunity to buy stock at deeply discounted prices, while forcing outsiders to pay what is essentially an inflated market price for it, Lutin said.

"It raises real questions of fairness."

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