Microsoft

Several weeks ago, we engendered the animosity of Microsoft’s hierarchy when we were quoted in a New York Times article that was mildly critical of MSFT’s manic use of put options as a means through which the company enhances its cash flow.  Our point of view was (and remains) that most investors believe they are purchasing a software (operating system) company and not a quasi hedge fund operation.  We also felt that few investors were aware of  the liabilities such activities can create or the degree to which such activities artificially inflate the company’s cash flow.

An extension of the above-noted situation is slowly but surely surfacing, courtesy of Bill Parish.  We note his excellent work on the topic that follows and commend his efforts in this respect.

Microsoft’s "Hidden" Cash Flow Bonanza.

Microsoft enjoys an excellent cash flow from royalties paid by PC manufacturers for its Windows-based operating systems.  What is not well known to the public is that the company also benefits from a remarkable, indeed arcane cash flow that emanates from its penchant for granting options to its employees.  Here is how it works.

Where other companies provide stock options to only top echelons, Microsoft grants options to most of its employees.  The granting of these options provides an initial benefit to the company in that the employee can be hired for a smaller salary than would have been required if options had not been granted.  Put another way, Microsoft’s expense line is reduced through the provision of employee stock options, which of course enhances its bottom line.

The second benefit shows up when the options are exercised by the employee.  Upon exercising his options, the employee acquires an immediate tax liability, which is the capital gains tax owing on the profits therein.  Unknown to the public, the company also reaps an immediate benefit, that being a rebate from the government of the entire sum forwarded as capital gains tax by the employee!  The preceding statement is not in error, it is accurate. The whole tax sum ends up back in the company under the heading of "compensation expense"!

When one does the numbers on the Microsoft situation, it is almost incomprehensible that such a situation can exist, but it does.  To put it into perspective, Microsoft has received $10.0 billion in "compensation expense" on exercised options since 1995.  Keep in mind that Microsoft has gross annual sales of $18.0 billion.  Also keep in mind that with close to $40.0 billion in gains to be recognized, based upon $55.0 billion in stock option commitments outstanding, the company will rake in almost $14.0 billion as these options are exercised.  If the share price increases, Microsoft benefits to the tune of $0.35 for every dollar of stock price levitation.  No wonder the share buy-back program is so important to the company.

Are there any liabilities or concerns attached to this situation?  None, unless you are a shareholder.  Those bushels of employee stock options provide massive shareholder dilution as they are exercised.  Not a problem unless somebody does the math.  Effectively it is a nifty money transfer system through which the company’s accumulated earnings are transferred to the employees.  Of course in the current tulip, few do anything as esoteric as arithmetic.  The situation also begs an additional question,…what if all companies operated in similar fashion.  The thought boggles the mind.