Creativity in Hi-tech Financing

The probability is 1 in 6 billion.

That is the Wall Street Journal's answer to the question: What is the chance that the dates on which Kobi Alexander granted stock options to himself, and to other Comverse executives, were random?

How can you win a roulette game with odds against you of 1 to 6 billion? You do it by first turning the wheel and waiting for the ball to stop. Then you place your jetons in the right place.

Amnon Landan, the CEO of another giant Israeli hi-tech company, was forced to quit half a year ago after it turned out he'd been indulging in retroactive roulette. Meaning, the date of stock option grants was retroactively amended to dates on which the share price tanked, in order to maximize the profit to the beneficiaries, and spare the company the need to book the costs in its profit & loss statement.

Alexander built Comverse from scratch into an Israeli hi-tech empire with thousands of employees. He is held in high esteem in local hi-tech circles and has not yet commented on the suspicions that his company also played retroactive stock option roulette.

But his achievements, estimable as they may be, will not be a factor if it turns out that he erred. The rules on Wall Street are clear and if Alexander can't disprove the suspicions, he'll have to quit the company he founded and rules.

Mastermind engineers

For scandal to touch hi-tech may surprise some. Hi-tech was perceived as a glittering, squeaky-clean sector where the leading companies were terrific at creating new inventions with the help of their mastermind engineers, genius physicists and absent-minded mathematicians.

But the truth is that many of the hi-tech managers on the Street, mainly at the bigger companies, have become masters of financial engineering.

TheMarker readers in general, and readers of this column, know our skepticism about bookkeeping in hi-tech circles, and about its reputation as the biggest generator of value on the stock exchange. The American press and cm also seem to be entertaining doubts about the accounting acrobatics of the glittering sector.

Last week the New York Times quoted Street analysts on an interesting development involving the three biggest giants of hi-tech: Intel, Dell and Texas Instruments. Their shares have been dropping in the last year even though the companies have been reporting steeply climbing profits, well beyond analysts' expectations.

The analysts pointed at an interesting item in said companies' financial statements, an item that tends to get overlooked in analytical reports and in articles in the press. Namely, the companies' book equity. While Dell, Intel and Texas report profits in the billions of dollars each year, their shareholders equity (the difference between assets and liabilities) keeps shrinking, even though they hardly pay any dividends to shareholders.

Where is the money going?

Why is that? Because the companies are using the cash they generate to buy back their own shares on the market. In the last year Dell bought back $7.2 billion worth of stock, which was greater than its earnings. Intel repurchased $10.6 billion worth and Texas Instruments bought back $4.15 billion worth of its shares.

Why are the companies buying back their stock so aggressively? Naturally - because they want to reduce their float and increase profit per share, which is the main parameter by which analysts measure their performance.

So if they are buying back so many shares on the market, why is their number of floating shares not dropping?

Naturally - because they keep handing out stock options to managers and employees. The options get converted into shares, which increases the number of floating shares, the company buys back the shares on the market using its cash, and around and around it goes.

What is the bottom line? Simple. Much of the cash the companies are earning is streaming straight to the pockets of the management. Even better from the managers' perspective is that the tremendous perk they're getting doesn't get booked in the company's report, if the options were granted at the market price.

The gambit is nothing new. What has changed is that Wall Street analysts are paying closer attention to it. They are asking whether these companies really are generating value for shareholders, or mainly for their own people.

Now it appears that one, two or maybe more of the Israeli companies on Wall Street took the gambit one step further, by back-dating stock option grants to convenient dates.

Mercury Interactive was the first one to get caught and now Comverse is in the spotlight of the Street investment community, and perhaps of the SEC too.  It may not be the last. American hi-tech managers may be good at financial engineering, but Israeli managers are especially creative.

In the last decade, the Israeli hi-tech sector proved its mettle in global markets and on Wall Street. Now it has to prove that the wealth generated in the boom years was legit.