From Options Backdaters to M&A Targets

Both M-Systems and Mercury Interactive were enmeshed in the options scandal and have agreed to be acquired. Who's likely to be next?

On July 31, computer-memory maker SanDisk (SNDK) announced that it would acquire smaller rival M-Systems (FLSH) of Israel for $1.35 billion in stock. From a strategic standpoint, it's a logical merger between two players in complementary businesses. Both companies make flash memory that stores digital images, music, and more. But SanDisk is known for removable cards, while M-Systems concentrates more on the memory that's embedded in wireless phones, MP3 players, and other devices (see, 8/01/06, "Flash Free-for-All?").

The deal stands out in another important respect, however. M-Systems is one of more than 60 companies that have been caught up in the ever-widening scandal over the backdating of options. In most cases, the companies awarded stock options to executives at advantageous prices, and they are now investigating whether the disclosure and accounting for those awards was proper.

Now, it looks like some of the companies involved in backdating may become takeover targets. M-Systems is the second company touched by the scandal in as many weeks that has agreed to be acquired. On July 25, computer giant Hewlett-Packard (HPQ) announced that it would buy software maker Mercury Interactive (MERQ) for $4.5 billion in cash (see, 7/29/06, "Mercury's Star Rises"). Before the deal, Mercury's shares had been in a prolonged slump, after the company had disclosed its own backdating issues and the departure of its chief executive.


  In the case of M-Systems, merger negotiations had begun before the accounting issues had come to light. But the controversy may have played a role in the price at which the deal was struck. M-Systems shares slid after the company disclosed on June 1 that it had opened an internal investigation into its stock options practices. Its stock fell from $33.45 on May 31 to $25.13 on July 13, just above its 52-week low of $24.27 set last Aug. 22.

SanDisk agreed to pay what it termed a 26% premium to the average price over the past 30 trading days. "Ultimately, price is some multiple of the spot price or a 30- or 60-day average. M-Systems's price has been somewhat impacted by the options situation. It was a factor, but one of many factors in arriving at a deal," SanDisk Chief Financial Officer and Executive Vice-President Judy Bruner said in an interview.

HP declined to comment on its acquisition for this article. But HP Chief Executive Mark Hurd said on a conference call that HP is "comfortable" with the options issue. "We went through a lot of that in due diligence, and we believe the issues are limited to what has been disclosed and we are comfortable the issues will be resolved," Hurd said.


  As it has become clear that many companies have been using backdated options, federal regulators have launched investigations. An option is a contract that allows someone to buy a stock at a specified price known as the "strike" price. If the market moves higher, the option amounts to the right to buy the stock at a discount to the current price. If the market price moves lower, the option is worthless. By backdating an option to a point in time when the stock was below its current price, a company can increase the value of its options. That can create a bigger profit for executives who receive backdated options.

The backdating of options isn't necessary a problem unto itself. The issue is how backdated options are accounted for, says Christopher Aguilar, chief compliance officer and general counsel for Merriman, Curhan Ford & Co., an investment bank. "We are really talking about selectively assigning a strike price to an option. There's no proscription against giving someone a strike price below fair market value on the day the agreement is signed. But when you do that, you need to account for it correctly," Aguilar said. The expenses and taxes related to the higher value of the option must be taken into account.

The scores of companies caught up in the backdating controversy include many that are well-known. Among them are Microsoft (MSFT) and Apple Computer (AAPL), as well as book dealer Barnes & Noble (BKS) and home-improvement giant Home Depot (HD). Those accounting issues could have major strategic implications for some of those companies, if the controversy depresses stock prices and gives cash-rich buyers an opportunity to acquire otherwise-healthy businesses at a bargain price. "From a buy-side perspective, there's an opportunity for price negotiation," Aguilar said. Of course, the other side of that coin is that an options-accounting issue may be so large that it's more difficult for a company to be acquired.


  Here are half a dozen examples of companies that could turn into takeovers as a result of option accounting issues. This is not to say that these companies are in merger talks, let alone that a deal is likely. But they have several things in common, including a weak stock price and a recent history of accounting issues. And in this market, where the volume of M&A activity is at a record high (see, 6/30/06, "Investment Banks Jockey for Position") and shareholders are placing huge demands on management to boost stock prices, an accounting issue can have unforeseen consequences.

Barnes & Noble

The bookseller has been hit with a shareholder lawsuit that alleges the company improperly backdated stock options. The Securities & Exchange Commission is looking into the matter in an informal inquiry. Those issues, which came to light in July, have done nothing to help end the six-month-long slide in the company's stock. The shares traded July 31 at $33.52, down from a 52-week high of $48.41. That could make Barnes & Noble a target for a takeover. It's just the sort of powerful brand that private-equity investors like (see, 6/13/06, "Fresh Barbarians at the Gates").

Home Depot

The SEC also has opened an informal inquiry into options activity at Home Depot. The company issued a press release on June 16, stating that on five occasions prior to 2000, "the date of the meeting or resolution approving the grant was later than that used to determine the stock option exercise price." In three instances, the company said, the market price of the stock on the award date was higher than that on the date the exercise price was determined. The company estimates that unrecorded expenses are no more than $10 million, and that it does not expect to restate any prior financial results. It's just one of several challenges facing Home Depot, which is fighting off competition. Its stock price of $34.71 is well below the 52-week high of $43.95. And it is down from $36.91 on June 16.

United HealthGroup

Health insurer United HealthGroup (UNH) faces an SEC inquiry, too. CEO William McGuire told investors during a conference call in July that he didn't know how long the investigation, which began last spring, would last. The issue has undoubtedly led to a cloud of uncertainty over the company's stock. The shares are trading at $47.83, down from a 52-week high of $64.61.


The semiconductor maker Broadcom (BRCM) said on July 16 that it could face more than $750 million in additional noncash expenses related to its use of stock-based compensation. While its earnings are under pressure amid fierce competition, it nonetheless has a solid position in the quickly growing market for wireless and broadband communications. Its shares are currently trading at $23.96, down from a 52-week high of $50.

The Cheesecake Factory

The number of retail deals has been soaring of late, and restaurants are one of the sectors favored by private-equity buyers (see, 7/5/06, "Private Equity Takes a Shine to Retail"). The Cheesecake Factory (CAKE) announced on July 19 that its board was looking into corporate stock option practices. The announcement accompanied first-quarter results. The report for the second quarter will be delayed because of the probe, the company said. The shares, which have been sliding all year long amid competition, have dropped to $22.85. That's down from a 52-week high of $39.28.


Activision (ATVI) has a solid position in the quickly growing video-game market, thanks to titles such as Doom and X-Men. That could make the company an attractive takeover target. But the uncertainty from an informal SEC inquiry into its options accounting has helped drive shares down to $11.95. That's down from a 52-week high of $18.03.

Shareholders across the globe are putting pressure on companies and their managements for better results. Investors such as Carl Icahn have pushed for the breakup of giant companies like Time Warner (TWX) (see, 5/17/06, "Private Equity's Media Targets"). In such an environment, companies with weak stock prices, and, in some cases, tainted top executives, are vulnerable to takeovers. To the extent that options accounting is a cloud hanging over the stock market, companies may end up being put under even more pressure to sell.

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