Microsoft mini-case
(put options)
A number of companies engaged in stock buyback programs during the past
several years. To fund the cost of these share repurchases, many sold put options on their
stock. These companies were mainly in the high-tech sector and, when stock prices were
continually increasing, the risk of these options expiring in the money was remote. The
basic idea was that a company would sell put options on its common stock allowing the
investor to force redemption of the option at a lower stock price. These redemptions
could be either settled in cash or with additional shares depending on the contract (most
were with additional shares). If the stock kept increasing, the selling company received
the proceeds from the put and these funds defrayed the cost of share repurchase
programs. If the stock price increased, the options expired out of the money.
The basic accounting for stock warrants with a share settlement is as follows:
1. Issuance –
Cash
xxx
Paid in capital – stock warrants
xxx
(cash is increased to reflect proceeds and paid in capital – stock warrants is
increased)
2. Expire without exercise –
Paid in capital – stock warrants
xxx
Paid in capital – expired warrants
xxx
(transfer for one capital account to another)
3. Exercise with issuance of additional shares
Paid in capital – stock warrants
xxx
Common stock (#shs * par)
xxx
Paid in capital – common stock
xxx
(common stock is issued at a “purchase price” equal to the balance of the paid
in capital – stock warrants account. Note: if the settlement is in cash, Treasury
stock is debited for the difference between the cash outlay and the paid in
capital – stock warrants account)
On the balance sheet, the SEC has determined that as long as a company can satisfy any
deficiency between the exercise price and market price by issuing additional common
stock (instead of cash) the company can report the puttable stock as equity (e.g., paid in
capital – stock warrants). However, if the deficiency must be met by issuing cash or a
non-equity security, then the redemption value of the common stock must be shown as a
liability. The justification for this treatment is that the issuance of additional stock by the
company does not represent a sacrifice of assets by the firm (unlike the payment of cash),
thus the obligation is not a liability (recall the definition of liability).
An important piece of information arising from these transactions and which should
receive some treatment is the dilutive features of these puts, particularly if they can be
settled by issuing additional shares of stock ( scenario 3). This is why EPS disclosures
can be important. Note that although the put is a derivative, it does not receive derivative
accounting (mark-to-market) under FAS 133 -- that is because the standard explicitly
scopes out derivative transactions in your own stock. Thus, these are simply treasury
stock transactions.
This mini-case is designed to give you a deeper understanding of the accounting for put
options. We will use the 2000 annual report for Microsoft to illustrate the concepts,
selected pages from which follow. Please answer the following questions:
1. How much cash did Microsoft receive in FY2000 form the sale of put warrants on
its common stock? Where do you find this information?
2. In her 11/22/98 New York Times financial column, Gretchen Morgenson
discussed the Microsoft put option sales. What arguments are she making? Do
you agree with them? What do accounting standards say about recording revenue
from the sale of out warrants?
3. In general, how do you evaluate this financial technique? Do you think
accounting disclosures are adequate to fully inform investors?
Income Statement
- ------------------------------------------------------------------------------------------------------------Year Ended June 30
1998
1999
2000
- ------------------------------------------------------------------------------------------------------------Revenue
$15,262
$19,747
$22,956
Operating expenses:
Cost of revenue
2,460
2,814
3,002
Research and development
2,601
2,970
3,775
Acquired in-process technology
296
--Sales and marketing
2,828
3,231
4,141
General and administrative
433
689
1,009
Other expenses
230
115
92
- ------------------------------------------------------------------------------------------------------------Total operating expenses
8,848
9,819
12,019
- ------------------------------------------------------------------------------------------------------------Operating income
6,414
9,928
10,937
Investment income
703
1,803
3,182
Gain on sales
-160
156
- ------------------------------------------------------------------------------------------------------------Income before income taxes
7,117
11,891
14,275
Provision for income taxes
2,627
4,106
4,854
- ------------------------------------------------------------------------------------------------------------Net income
$ 4,490
$ 7,785
$ 9,421
=============================================================================================================
Balance Sheet
- ------------------------------------------------------------------------------------------------------June 30
1999
2000
- ------------------------------------------------------------------------------------------------------<S>
<C>
<C>
Assets
Current assets:
Cash and equivalents
$ 4,975
$ 4,846
Short-term investments
12,261
18,952
- ------------------------------------------------------------------------------------------------------Total cash and short-term investments
17,236
23,798
Accounts receivable
2,245
3,250
Deferred income taxes
1,469
1,708
Other
752
1,552
- ------------------------------------------------------------------------------------------------------Total current assets
21,702
30,308
Property and equipment, net
1,611
1,903
Equity and other investments
14,372
17,726
Other assets
940
2,213
- ------------------------------------------------------------------------------------------------------Total assets
$38,625
$52,150
=======================================================================================================
Liabilities and stockholders' equity
Current liabilities:
Accounts payable
$
874
$ 1,083
Accrued compensation
396
557
Income taxes
1,691
585
Unearned revenue
4,239
4,816
Other
1,602
2,714
- ------------------------------------------------------------------------------------------------------Total current liabilities
8,802
9,755
- ------------------------------------------------------------------------------------------------------Deferred income taxes
1,385
1,027
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock--shares authorized 100;
shares issued and outstanding 13 and 0
980
-Common stock and paid-in capital--shares authorized 12,000;
shares issued and outstanding 5,109 and 5,283
13,844
23,195
Retained earnings, including other comprehensive income
of $1,787 and $1,527
13,614
18,173
- ------------------------------------------------------------------------------------------------------Total stockholders' equity
28,438
41,368
- ------------------------------------------------------------------------------------------------------Total liabilities and stockholders' equity
$38,625
$52,150
=======================================================================================================
Statement of Cash FLows
- --------------------------------------------------------------------------------------------------------Year Ended June 30
1998
1999
2000
- --------------------------------------------------------------------------------------------------------<S>
<C>
<C>
<C>
Operations
Net income
$ 4,490
$ 7,785
$ 9,421
Depreciation, amortization, and other noncash items
1,024
926
748
Write-off of acquired in-process technology
296
--Gain on sales
-(160)
(156)
Stock option income tax benefits
1,553
3,107
5,535
Unearned revenue
3,268
5,877
6,177
Recognition of unearned revenue from prior periods
(1,798)
(4,526)
(5,600)
Other current liabilities
208
1,050
(445)
Accounts receivable
(520)
(687)
(944)
Other current assets
(88)
(235)
(775)
- --------------------------------------------------------------------------------------------------------Net cash from operations
8,433
13,137
13,961
- --------------------------------------------------------------------------------------------------------Financing
Common stock issued
959
1,350
2,245
Common stock repurchased
(2,468)
(2,950)
(4,896)
Put warrant proceeds
538
766
472
Preferred stock dividends
(28)
(28)
(13)
- --------------------------------------------------------------------------------------------------------Net cash used for financing
(999)
(862)
(2,192)
- --------------------------------------------------------------------------------------------------------Investing
Additions to property and equipment
(656)
(583)
(879)
Cash portion of WebTV purchase price
(190)
--Cash proceeds from sale of Softimage, Inc.
-79
-Purchases of investments
(19,114)
(36,441)
(43,158)
Maturities of investments
1,890
4,674
4,025
Sales of investments
10,798
21,080
28,085
- --------------------------------------------------------------------------------------------------------Net cash used for investing
(7,272)
(11,191)
(11,927)
- --------------------------------------------------------------------------------------------------------Net change in cash and equivalents
162
1,084
(158)
Effect of exchange rates on cash and equivalents
(29)
52
29
Cash and equivalents, beginning of year
3,706
3,839
4,975
- --------------------------------------------------------------------------------------------------------Cash and equivalents, end of year
$ 3,839
$ 4,975
$ 4,846
=========================================================================================================
Statement of Stockholders’ Equity
- -----------------------------------------------------------------------------------------------------Year Ended June 30
1998
1999
2000
- -----------------------------------------------------------------------------------------------------<S>
<C>
<C>
<C>
Convertible preferred stock
Balance, beginning of year
$
980
$
980
$
980
Conversion of preferred to common stock
--(980)
- -----------------------------------------------------------------------------------------------------Balance, end of year
980
980
-- -----------------------------------------------------------------------------------------------------Common stock and paid-in capital
Balance, beginning of year
4,509
8,025
13,844
Common stock issued
1,262
2,338
3,554
Common stock repurchased
(165)
(64)
(210)
Structured repurchases price differential
328
(328)
-Proceeds from sale of put warrants
538
766
472
Stock option income tax benefits
1,553
3,107
5,535
- -----------------------------------------------------------------------------------------------------Balance, end of year
8,025
13,844
23,195
- -----------------------------------------------------------------------------------------------------Retained earnings
Balance, beginning of year
5,288
7,622
13,614
- -----------------------------------------------------------------------------------------------------Net income
4,490
7,785
9,421
Other comprehensive income:
Net unrealized investment gains/(losses)
627
1,052
(283)
Translation adjustments and other
(124)
69
23
- -----------------------------------------------------------------------------------------------------Comprehensive income
4,993
8,906
9,161
Preferred stock dividends
(28)
(28)
(13)
Immaterial pooling of interests
--97
Common stock repurchased
(2,631)
(2,886)
(4,686)
- -----------------------------------------------------------------------------------------------------Balance, end of year
7,622
13,614
18,173
- -----------------------------------------------------------------------------------------------------Total stockholders' equity
$16,627
$28,438
$41,368
======================================================================================================
Put Warrants
Prior to the termination of the stock buyback program, Microsoft enhanced the
program by selling put warrants to independent third parties. These put
warrants entitle the holders to sell shares of Microsoft common stock to the
Company on certain dates at specified prices. On June 30, 2000, warrants to put
157 million shares were outstanding with strike prices ranging from $70 to $78
per share. The put warrants expire between September 2000 and December 2002.
The outstanding put warrants permit a net-share settlement at the Company's
option and do not result in a put warrant liability on the balance sheet.
MARKET WATCH; Financial Engineering 1.0
By GRETCHEN MORGENSON
The wondrous innovations of America's technology companies make them the envy of the
world. But for some of the biggest names in technology, one of the most profitable
inventions is not about computer hardware, software or microchips. It's about finance, and it
is generating hundreds of millions of dollars -- tax-free -- a year.
Intel, Microsoft and, to a lesser degree, Dell Computer sell put warrants on their own stock to
outside investors. The warrants give buyers the right, for a limited period, to sell shares of
stock back to the company at a set ''strike'' price below the market at the time they buy. In the
quarter ended Sept. 30 alone, Microsoft took in $225 million from the sale of puts -- a sum
equal to 13.4 percent of its net income in the period.
The transactions are ingenious, because tax law makes any dealings that a company has in its
own shares tax-free. And tax-free income is always nice. But it is a godsend for many
capital-intensive technology concerns, whose operating costs are often so close to operating
income that few generate positive cash flows. Even companies as mighty as Intel operate
close to the bone.
But because the money received in these deals is not detailed on the income statement, it is
unclear whether investors understand how much the sales can contribute to a company's
financial position. The proceeds show up on statements of cash flows, on which fewer
investors focus.
Furthermore, when companies are forced to buy back shares, they often have to use hardearned money that could otherwise be reinvested in their business.
''This is part and parcel of the remarkable degeneration in the quality of earnings reporting
that we have seen in the last two or three years,'' said Larry Woods, editor of The Technology
Review, an investment newsletter in Stony Creek, Ontario. ''They provide companies with an
inflated bottom line, and they dilute shareholders' equity.''
Companies that sell puts are betting that their shares won't fall to the options' so-called strike
price during the transaction's time frame. If they're right, the put expires, and the company
keeps the money paid for it. The buyers of the warrants are betting that the stock could fall.
But because the company is obligated to buy back its shares from the outside investors if its
stock drops below the strike price, the warrants are a potential liability.
While Intel reports the potential liability for its warrants -- currently $588 million -- on its
balance sheet, Microsoft does not, so some math is in order.
In notes to its financial statements, Microsoft said it had 75 million put warrants outstanding
on Sept. 30. They expire between March 1999 and September 2001 and have strike prices of
$76 to $88 a share.
Taking the average of the two prices, if the company had to buy back all the stock covered by
these warrants, it would spend more than $6 billion. That's about one-third of Microsoft's net
worth (or shareholders' equity) of $19 billion.
It is unlikely, of course, that Microsoft's stock will drop from its current $113.625 to below
$76, requiring all the warrants to be exercised. But it's not out of the question. In January,
Microsoft stock traded at $63.50.
Companies using these programs say they offset some of the costs associated with aggressive
buyback programs that benefit shareholders. But investors wowed by big jumps in income at
technology concerns would do well to dig beneath the surface to see if the good news was the
result of operations -- or of financial engineering.