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The Hidden Cost of Dilution

Within the world of CEO’s, the issue of dilution generally splits the group into two camps - those who are concerned with dilution and those who don’t care about it. As an investor you should be pleased that among the party that worries stands Warren Buffet.

Just what is dilution? Here is a perfect example - the chip company Intel (INTC). The basic share count declined by 234 million shares during 2001 to 2003, a result of $12 billion in stock repurchases. During those three years, Intel bought back 492 million shares at an average price of $24.46, while 237 million options were exercised for an average price of $14.05, including the company's tax benefit. The company also issued 21 million new shares from acquisitions.

This is how the bottom line reads: 234 million shares were repurchased for the benefit of stockholders and 237 million shares were handed over to employees with an average loss of $10.41 per share. Put another way, $2.5 billion in shareholder wealth was transferred to employees. $2.5 Billion. That is quite an incentive plan. I thought plush paper in the washroom was nice enough.

You might think that this rather large and substantial expense would appear as a compensation expense in Intel's financial statements. It’s not, because it is considered neither cash nor an expense. Instead, it's buried deep in the footnotes of the 10-K. Were it to appear on the income statement, reported net income for last year would have been 16% lower. Furthermore, the stock's trailing P/E ratio would be worse as well.

This is where the CEO camps are split. Warren Buffett has stated that the costs associated with stock options should be treated as a cash expense on the books. And to his credit, when he moves into a company, the options plan is usually one of the first things to go. The other camp likes things they way they are. And by an 88-9 vote, U.S. senators made these CEO’s, some of their largest campaign contributors, ecstatic by affirming that stock options would remain expense-free. Mr. Buffet declared this to be “survival of the fattest.”

Back to Intel and the CEO Craig Barrett…In addition to his salary of $610,000 with a bonus of $1.5 million received 1.35 million options in 2003 (131% more than the previous year), worth an estimated $14.4 million. It doesn’t take a rocket scientist to figure out in which camp Mr. Barrett pops his tent.

I don’t want you to think that I’m singling out Intel. And don't think for a moment that it's the only company that does this. In 2003 alone, Oracle (ORCL) transferred $170 million to employees, Cisco (CSCO) $182 million, and Harley-Davidson (HDI) zapped a cool $20 million. Don’t think about what these amounts would have added to your dividend, it’ll make you mad.

Put this idea into the back of your mind and remember that when a company issues a large amount of stock options to employees, there is a real cost. You can’t find the cost of these programs on the books, not in earnings or cash flow. It comes out of shareholder funds—our funds.

If you take anything away, remember... Stock buybacks are not always an effective tool for enhancing shareholder value. Normally, they reduce outstanding shares and increase the ownership percentage of existing stockholders. But, buybacks are often used to mask the dilutive effects of stock option grants and quietly, subtly, transfer shareholder wealth to employees. So, the next time a company speaks about the benefits of a buyback to shareholders, look to see which camp songs they’re singing.