Taking Stock / Creative High-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 when the odds against you are 1 to 6 billion? You do it by first turning the wheel and waiting for the ball to stop. Then you place your chips.

Amnon Landan, the CEO of another giant Israeli high-tech company, was forced to quit half a year ago after it turned out that he had been indulging in retroactive roulette: Specifically, he retroactively amended the dates of stock option grants 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 and loss statement.

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

But his achievements, great 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 cannot disprove the suspicions, he will have to quit the company he founded and rules.

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

But the truth is that many high-tech managers on the Street, mainly at the bigger companies, have become master financial engineers.

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

Last week, The New York Times quoted analysts on an interesting development involving the three biggest giants of high-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. Over the last year, Dell bought back $7.2 billion worth of stock, which was greater than its earnings. Intel repurchased $10.6 billion worth of shares and Texas Instruments bought back $4.15 billion worth of 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 that the companies are earning is streaming straight into management's pockets. Even better from the managers' perspective is that the tremendous perk they are getting does not get booked in the company's report, as long as the options were granted at the market price.

This 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 was the first one to get caught, and now Comverse is in the spotlight, too. It may not be the last. American high-tech managers may be good at financial engineering, but Israeli managers are especially creative.

Over the last decade, the Israeli high-tech sector proved its mettle in global markets 0and on Wall Street. Now it has to prove that the wealth generated in boom years was legitimate.