Beware of the Practices of This Company

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Stocks options are a wonderful instrument. The underlying rationale behind stock option grants is to align the interests of employees with the interests of shareholders, thereby turning employees into "mini owners." But this wonderful instrument, although born good, can very quickly turn into a weapon for mass dilution of current shareholders, disguised in the form of option grants. 

The wild west of the Dot-Com bubble

In the jolly years before the bubble burst, many companies were in love with stock options. And that's mainly because stock options weren't regarded as a cash expense, so a company could just hand out millions in the form of stock options and not be on the hook for the same millions on its books. One extreme example of this abuse was orchestrated by Juniper Networks (NYSE: JNPR). In 2000, Juniper reported profits of $147.9 million. It also granted options worth $318.6 million to its employees and executives. Or, in other words, adjusted for all compensation, the company's net income wasn't positive $147 million, it was negative $170.7 million. And that's not all. From 1997 through 2001, Juniper granted options costing shareholders $522 million. That's roughly 21 times the value of all the profits the company had ever reported, according to GAAP. Later on, the company was forced to take a $900 million charge when it restated its earnings.

And Juniper wasn't alone. Broadcom (NASDAQ: BRCM), for example, added a $2.2 billion charge against its earnings when it finally restated its results for 1998-2005. That left investors with a cumulative GAAP net loss of $6 billion, according to the restated earnings. In other words, during its entire period as a public company, Broadcom didn't actually generate a penny in profits. It only racked up huge losses. Even so, at one point, both of its founders were worth more than $10 billion in stock – thanks to options.

Those days are gone. Nowadays, it's illegal not to expense options. But a company can still elect to dilute shareholders on an unprecedented scale by issuing a staggering amount of stock options to employees. And that's what I believe Salesforce.com (NYSE: CRM) is engaged in. 

How to abuse stock options, the modern way

Salesforce.com is a $22 billion developer of customer management software. Over the last three and a half years, Salesforce.com has made 46 acquisitions and spent a total of $4.6 billion in stock and cash. To date, despite these acquisitions and the large revenue growth it facilitated, Salesforce.com has ceased to be profitable. Its loss per share has widened, moving from $0.02 per share in 2010 to more than $0.56 per share in 2012. There's a simple explanation for why Salesforce.com isn't actually making any money, and that's because it's spending far too much on stock option grants to employees.

Over the last three years, the company has spent $728 million issuing stock options, according to GAAP accounting rules. Since these expenses are non-cash expenses, the company's executives simply pretend they don't exist. But they will cause a painful dilution to the existing shareholders unless a huge amount of cash is spent to buy back these newly issued shares. If not, then a huge percentage of the company will end up being owned by the employees, not the current investors. In total, the grants over just the last three years ($728 million) make up nearly 20% of the company's combined three-year gross profit. These expenses explain why, despite the company's impressive sales growth, its losses are growing.

When you think of the amount of stock options in relation to the company's earnings, things are starting to seem horrifying. Over the last three years, gross profits have grown from a little more than $1 billion to $1.7 billion, growth of 70%. That sounds pretty good. But options expenses have soared from $120 million per year to almost $380 million per year – growth of 215%. This can't end well for the company's shareholders. Eventually, Wall Street will pick up on that and dump shares. 

My Foolish conclusion

Stock options are a legitimate way to incentivize employees. But abusing stock options, by issuing them on a massive scale, will ultimately dilute shareholders. If you are a Saleforce.com shareholder, chances are that the company's employees will receive a growing part of your future earnings per share. Invest accordingly.  

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Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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