Bullish stock bets come back to haunt tech sector

By Siobhan Kennedy and Dan Wilchins

NEW YORK: In the high-tech go-go days, companies that took bets on their stock prices raked in millions from investors. Now, those wagers are coming back to haunt them. During the boom market of the 1990s, businesses, the majority of them in the exploding tech sector, sold millions of "put options" to investors, giving those investors the right to sell shares back to the company at a future date and a set price.

The prices were set when stocks were soaring and few believed they would come back to earth. So as stocks rose, the puts expired worthless and the companies pocketed easy money. Intel Corp., for example, made $347 million in the three years up to 1999 on these types of contracts.

"It was free money as long as the stock kept going up," said Abe Mastbaum, managing director at American Securities, a New York money management firm. "But once it turns round it becomes significantly less pleasant." And turn it did.

The ugly flip side for the companies playing that game is that if their stocks dive -- as they did when the Internet bubble burst -- they have to buy back millions of shares far above the market price. Imagine being forced to pay $20,000 today for a 1982 Chevette. That was exactly the scenario that caught up with Electronic Data Systems Corp. this week.

On Tuesday, investors learned that EDS had issued $225 million in commercial paper to buy back 3.7 million of its own shares at prices well above the current market value. Some of that outlay came from forward purchase agreements, and some came from put sales. Either way, EDS had to buy back its stock for around $62 a share, when the stock had fallen to about $17.

Merrill Lynch analysts noted the big cash outlay would effectively wipe out the company's free cash flow for 2002, and downgraded the stock to a rare "sell" rating. EDS shares tumbled 29 percent on the New York Stock Exchange on the news, sinking to a 14-year low.

That fall added insult to injury: shares of EDS had already plunged 53 percent last Thursday after the company slashed its third-quarter earnings estimate by four-fifths and said it would generate far less cash than expected. The shares are down 83 percent this year.

A no-lose proposition becomes a loser

A number of companies have faced or may face huge costs from the kind of strategy EDS used. Intel was a lucky winner, but even that company ultimately ended its put option program because "the board decided that the exposure risk was too high," said Chuck Mulloy, a company spokesman.

Dell Computer Corp., on the other hand, still has outstanding put obligations covering 22 million shares at an average price of $47.82 per share, for a total of about $1 billion in cash. Dell's current stock value is about $25.

Microsoft is another technology company that got burned. It started to issue put options in August 1994, but as the markets sagged, the software giant realized it stood to get caught out and began buying back the outstanding puts. By June 2001, it had forked out nearly $1.4 billion in cash to settle the outstanding contracts. Unlike with EDS, the $1.4 billion was a drop in the ocean to Microsoft, which has more than $39 billion cash on hand.

So why did companies get themselves into this pickle in the first place?

Selling put options on a company's own shares was seen as a way to offset costs associated with employee stock option programs. Employees were given options by the truckload during the Internet boom. As shares were rising, companies faced an increasing risk that employees would exercise their options, forcing the company to issue new shares or buy back their own stock in the open market to avoid dilution.

Companies cautious

Companies are more cautious now, partly because the market is declining, but also because the accounting climate for buying forwards or selling puts on their own shares is becoming much less friendly.

The Financial Accounting Standards Board is likely to enact accounting changes that would require companies to recognize increases or falls in the fair value of most puts and forwards in their income statements, said Brooke Richards, project research associate at the accounting rule-making body in Norwalk, Connecticut.

Currently, those transactions are recorded as equity on a company's balance sheet, and changes in their value have no impact on its income statement. The proposed changes would make these types of transactions much less palatable to corporations, said Stephen Haratunian, managing director in corporate equity derivatives marketing at Credit Suisse First Boston in New York.

Haratunian said companies are still buying back their shares to take advantage of low prices, but by and large they're not doing it via puts and forwards. The board has not issued its final rules, but it decided that the rules would be effective for new transactions as early as this year, and for existing contracts for most companies in the second quarter of next year.

© Reuters