Old Options Produce New Hangover

TECHNOLOGY stocks are supposed to be the vehicle of choice for investors interested in high-powered gains. So why have many of the biggest names been such laggards lately?

It's not that these companies — Intel, Dell, Texas Instruments and the like — haven't been making money. In fact, revenues and earnings at these and other bellwether technology companies have been rising nicely. Dell's earnings grew 17.4 percent last year, Intel's rose 15.3 percent, and Texas Instruments' jumped 25 percent.

Their stocks, however, are going in the opposite direction. So far this year, Intel has lost 22 percent of its value, Dell has fallen 3 percent and Texas Instruments is down 5.9 percent.

To some degree, these companies are in the doldrums because the long-anticipated rebound in technology spending by corporations remains frustratingly elusive. In addition, a glut of technology gear — like computers, disk drives and storage equipment — is putting pressure on prices.

The Department of Labor said last week that computer prices were down almost 15 percent from a year earlier. That means that even as other companies can increase their profits by raising prices on their products, technology companies cannot.

"There is a tremendous undertow of price pressure that is undermining unit growth in what has been a recovery period," said Fred Hickey, a technology stock expert and editor of The High-Tech Strategist in Nashua, N.H. "What will happen if we have an economic downturn? Price pressure will be even more intense in this business."

But Mr. Hickey points to something else that is weighing on the shares of some technology companies — the fact that even as these companies have generated billions of dollars in revenues and earnings growth in recent years, the value of what their shareholders actually own has been declining.

Typically, a portion of a company's profits winds up on the retained earnings line of its balance sheet, adding to its net worth. But years of excessive stock option grants to executives and employees are now catching up with these companies, Mr. Hickey said. The result is a decline in their true values.

"You're seeing a destruction of book values at some of these companies," Mr. Hickey said, referring to the difference between a company's assets and its liabilities. "There's been a lot of earnings shown, and yet it hasn't gone out in dividends and doesn't show up in the balance sheet. Their shareholders are growing poorer."

Stock options are the biggest force behind this trend, Mr. Hickey said. First, they dilute per-share earnings at the companies that dispense them, hurting existing shareholders. Then, to try to reduce the burgeoning growth in stock outstanding that results from option grants, companies spend their owners' cash to buy back shares in the open market. This cuts into the amount of earnings that can be retained by the company and that contribute to shareholder equity.

HERE are some data points. In the last two fiscal years, Dell has earned a total of nearly $6.6 billion. During that same period, Dell's shareholder equity has gone from $6.3 billion in 2004 to $4.1 billion this year, a decrease of 35 percent. While Dell has shown earnings growth, the value of what Dell's shareholders own at the end of the day has declined.

In the most recent two quarters, Mr. Hickey said, Dell's book value has declined by 48 cents a share. If this pace continues, Dell's book value will vanish in two years, he said.

One reason for this is Dell's aggressive purchases of its own shares. In its last fiscal year, which ended on Feb. 3, it spent $7.2 billion to buy back 205 million shares.

Jess Blackburn, a Dell spokesman, said the company's buybacks were a shrewd investment that would pay off. "When the price of Dell stock goes back up, as we have faith that it will, we could sell that stock and have a very positive impact," he said.

But Dell is not alone in this trend. Intel's shareholder equity, which stood at $38.6 billion in 2004, fell 6.2 percent last year. It spent $10.6 billion buying back shares in 2005.

Texas Instruments' stockholder equity dropped from $13.1 billion in 2004 to $11.9 billion in 2005, a decrease of 9.2 percent. The company spent $4.15 billion buying its own shares last year.

Tom Beermann, an Intel spokesman, said: "We've had a fairly significant cash position and very strong balance sheet with very little debt. Intel has been on a track to reduce its overall cash balance intentionally through buybacks and stock dividends." He said that "shareholder equity would have been reduced" as a result.

Gail Chandler, at Texas Instruments, said: "We intend to continue to deliver great results. We plan to continue to keep costs in line, gain market share and turn in the kind of performance that investors are looking for."

Cisco, whose shares have bucked the trend and risen 26 percent this year, saw its shareholder equity decline by 10.5 percent from 2004 to 2005. Cisco's net worth peaked at $28.6 billion in 2002; it is now $23.2 billion, almost 20 percent less.

During the six months ended Jan. 28, the most recent figures available, Cisco spent $4.24 billion repurchasing its shares.

Heather Dickinson, a spokeswoman for Cisco, said the company's stock buyback program, which began in 2001, had reduced its share count by 16.5 percent. "Cisco believes that for now, our share repurchase program, combined with ongoing strategic investments in our business and maintaining a strong cash balance, are in the best interest of our shareholders."

The book values of technology companies have also been hurt by the expensive acquisitions they made to keep their earnings growth going, Mr. Hickey said. Costly write-downs often follow these optimistic purchases, reducing the company's overall values. "We know the history of acquisitions have not been good in the tech world," he said. "NCR and AT&T. Compaq and Digital Equipment and Tandem. Intel poured all sorts of money into smaller acquisitions."

(Mr. Hickey has made no bets on the companies mentioned here except for Intel; he owns put options on the company's shares, but his position amounts to less than 0.5 percent of his portfolio.)

In better times, technology companies could use their high-flying shares to buy other concerns. Now that the shares are closer to earth, they are borrowing to make acquisitions. Last month, for example, Cisco raised $6.5 billion in bonds, its first debt offering, to help finance its $6.9 billion purchase of Scientific-Atlanta. Borrowing costs will also make a dent in shareholder equity.

"Intel's stock price is the same as it was in 1997; Dell is the same price as 1998," Mr. Hickey said. "These big-name companies are not driving any kind of real value for their shareholders and not issuing much in the way of dividends. Instead there has been a wealth transfer from shareholders to company management."

After the wild and crazy stock option party of the 1990's, it should surprise no one that one heck of a hangover might result. But it is unfortunate that while managers and employees were the ones overserved, it is the shareholders who feel the most pain.