Dell's Share-Price Bet Cost It $1.25 Billion
By FLOYD NORRIS
The New York Times
May 3, 2002
GAMBLING on their own stock prices is not something companies often advertise they are doing. But for some companies, particularly technology companies, it was a popular strategy in the 1990's. Now it is coming back to haunt them. The costs are not showing up in financial statements, but they are huge.
In Dell Computer's last fiscal year, which ended Feb. 1, it bought back 69 million shares for $3 billion. That means it paid an average price of more than $43 a share. When you consider that Dell's average share price during the year was about $25, you begin to wonder whether Dell had a truly incompetent trader.
The problem was not with Dell's trader, however. The company was locked into paying high prices because it had gambled on its share price. Had it not done so, the shares it bought last year could have been bought for $1.25 billion less. That number is just a bit larger than Dell's net income for the year.
That cost is not in the financial statements. Under accounting rules, the money a company makes, or loses, in trading its own stock does not affect reported profits. So there is nothing improper in Dell's not recording an expense. But that is still a lot of cash.
Here's how Dell's strategy worked: It entered into complicated options transactions that assured it a lot of money if the stock rose and that would cost it dearly if shares fell. To get a bit more specific, it bought call options, giving it the right to buy Dell shares at a preset price. It got the money to buy those options by selling put options, which gave the buyer the right to sell stock back to Dell at preset prices. The strategy worked well when Dell's price was rising, but now it is costing Dell a lot.
More important, Dell has a lot of risk in the 51 million put options that are still outstanding, with an average exercise price of $45 a share, far above Dell's current $25.42 price.
Dell does not have to put the value of that obligation on its balance sheet because it has the right to pay it off by issuing enough shares to settle its obligation. But in fact it intends to pay the cash, and as such the obligation is as real as any debt.
If Dell's stock price stays just where it is, those options would cost Dell $1 billion. Their current fair value is more than that because of the time value of options.
Just how much more they are worth is something that Dell could compute and disclose, but does not. As it happens, it will soon have to do so. In March, the Emerging Issues Task Force, a part of the Financial Accounting Standards Board, ruled that such fair values must be disclosed. Sam Lynn, a standards board expert on this rule, said that the interpretation took effect immediately, meaning Dell's next quarterly report must tally up the bad news.
Dell made those options transactions to help in its repurchase of shares to offset the dilutive effect of the shares it issues to executives and employees when they exercise stock options. Figures provided by Dell show that from 1997 through the summer of 2000, while Dell's stock was strong, the strategy worked well, enabling Dell to pay well below market prices when it bought back stock.
But then the gamble started getting costly, and it appears that someone at Dell realized what the risks really were. It stopped placing new bets on its stock price in the fall of 2000, but the ones still on the books will be around until mid-2003.
A footnote: Dell's disclosures are a bit sloppy. The figures Dell provided me showed that it repurchased 69,054,919 shares last year. But the annual report says the number was 68 million. Dell says it rounded each quarter's repurchases to the nearest million, and then added up the rounded numbers. Someone should buy Dell a computer with a good spreadsheet program.
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