Apple's Options Overdose
In 1997, Apple Computer was in turmoil. That year also happens to mark the beginning of a period during which the company says it found "irregularities" with the granting of stock options to executives. Since options values are so closely tied to stock movements, I thought it would be useful to look at that period to recall the events that appear to have whipsawed Apple's shares that fateful year.
Let's start with what we know. Apple (AAPL) has disclosed that it has unearthed unspecified "irregularities" with options granted starting in fiscal 1997 and ending in fiscal 2001. That corresponds to a calendar-year period beginning in late 1996 and ending in September, 2001. Apple has also said that it will have to restate earnings for somewhere in the range of fiscal years 2003 to 2005. Additionally, the company hasn't filed its quarterly financial report to the Securities & Exchange Commission for its most recent quarter. We also know, as the Los Angeles Times reported last week, that Nancy Heinen, Apple's former general counsel, has retained two defense attorneys in regard to this situation. (I tried to reach Heinen and her lawyers but haven't heard back.)
There's a lot that remains unclear. First, Apple hasn't disclosed the nature of the "irregularities" that its independent counsel is investigating. Some companies are being probed for a practice called backdating, which can occur when the grant date of the options is set in such a way that the employee receives the grant at a low strike price. That means the recipient would make a bigger profit when the options are exercised, and backdating can result in the misstatement of employee compensation costs. In the most egregious cases, criminal charges against executives can result.
TIMING IS EVERYTHING.
Ideally, stock options are supposed to be granted at a strike price that is equal to the closing market price on the day the grant is approved. And beginning this calendar year, the rules about reporting options as an expense have tightened. But before Sarbanes-Oxley and other new accounting rules went into effect, the environment for granting options was generally much looser. If a company granted options, it might be months before it was required to disclose that fact to the SEC. Now that report has to be filed within days of the grant.
Apple is refraining from making further comment on the matter until the results of its internal investigation are known. So until then, we have to go on the press releases, regulatory filings, and media reports of the time. And while little is certain yet, I can observe that in some key cases, options were granted at or very near some of the pivotal events in Apple's history.
The beginning of the period of Apple's "irregularities" coincides with the acquisition of software maker Next and the return of Steve Jobs to the firm in December, 1996. Apple was, you'll remember, in pretty deep trouble in those days. We all know the story: Steve stepped in, replacing Gilbert Amelio; Microsoft (MSFT) invested $150 million; the iMac debuted. All this occurred within a dizzying 19 months.
TEN YEARS AGO.
One interesting tidbit I found from press coverage at the time concerned a leaked Apple memo (something we never see from Apple anymore) from August 1997, about a month after Amelio's ouster. It said stock options instead of cash would be the primary method for paying employee bonuses. This gives some rare insight into what was being discussed internally at Apple at the time.
It's also interesting because several large stock-option grants were approved in the weeks before that memo emerged. For example: Several Apple executives were granted options on July 11, two days after Amelio's departure was announced. So began Jobs' term as interim CEO, the earliest phases of which were marked by substantial uncertainty, rumors of buyouts, and questions concerning Apple's long-term viability.
Granting options could have been used as a way to convince key employees to wait out the turmoil.
As it happens, July 11 marked a 10-year low in the price of Apple stock. It closed that day at $13.25 (or $3.31, when adjusted for splits). That day several executives—then-Vice-President Avie Tevanian, then-Senior Vice-President Jon Rubinstein, then-Chief Financial Officer Fred Anderson, and two others—received grants giving them the right to buy stock at $13.25. Buyout speculation kicked off a rally that quickly inflated Apple's stock price. BusinessWeek.com was unable to reach Tevanian or Rubinstein for comment. Apple declined to make Anderson, currently a board member, available.
The next major block of grants came on Aug. 5. Several executives, including Tevanian, Rubinstein, Anderson, and at least five others, received options on this date with a strike price of $19.75. The next day was Aug. 6, the day that Jobs announced during a keynote at the Macworld conference in Boston that Microsoft would invest $150 million in Apple. As you might expect, investors sent Apple stock on a rocket-ride. It surged from an Aug. 5 close of $19.75 to an Aug. 7 close of $29.19 (see BusinessWeek.com, 8/25/97, "Is This Apple's Grand Plan?").
It's important to note that none of these executives would have been able to immediately cash in on such a sudden growth in the value of their options. As a rule, the options are vested over the course of three years: If you got options on 300,000 shares, as Rubinstein did that day, you'd have to wait a year before exercising the first 100,000, and another year to sell the next 100,000, and so on.
During that period you run the risk of seeing the stock price fall below your strike price, just as you could also sell the stock at a profit. One could argue that granting options when the stock is trading at or near a historical low lessens such risk—so would knowing that major positive news is only a day or two away.
Options were sometimes granted upon reporting bad news. On Jan. 17, 2001, Anderson, Heinen, and others received options grants at a strike price of $16.81 on the same day Apple reported a $247 million loss that was bigger than it had warned about. For the better part of the next year, the stock would trade within a range of $17 to $27. September 11 and the economic wipeout that followed didn't help.
It's also worth noting that options were often granted at times when there's no evidence of any great news events. Take Mar. 2, 1999. Several executives including Heinen, Rubinstein, and Tevanian received grants when Apple stock was trading at $34.63. I don't see any major news preceding or following. But the stock was trading at $11.87 below its 52-week high, and it did go for a stunning run over the course of the following year, topping $130.13 on Mar. 1, 2000, a day short of the anniversary of the grant.
WHAT ABOUT JOBS?
And none of these instances take into account the options grants given to Jobs. One huge batch—options on 10 million shares—was granted to him on Jan. 12, 2000, when the stock was at $87.19. The very next day, an upgrade by a Morgan Stanley analyst boosted the stock to $96.75 and $106.60 by Jan. 19, giving Jobs a paper profit of $194 million over the course of a week.
Within a year, the story was very different. The stock had split on June 21, 2000, and Jobs' 10 million options became 20 million, and by Jan. 12, 2001, the stock was trading at $17.19, leaving his options substantially under water. What happened? The PowerMac G4 Cube, for one thing. Fondly remembered by Mac collectors now, the Cube qualifies as one of the few honest-to-goodness commercial failures under Jobs. Even as complaints about cracks in its otherwise gorgeous casing were getting press coverage, the stock closed at $53.50 on Sept. 28, 2000. After the close of the market, Apple announced it would miss sales and profit forecasts. Cube sales were slow, as were sales to education and business customers. The stock went into free fall. Analysts sliced their ratings, and investors bailed out in droves.
By the time the smoke cleared, Apple's stock was at $25.75 and it was mostly downhill from there. Jobs' options never really recovered. Ultimately, three years later, Jobs canceled 27.5 million shares as part of a companywide effort to reduce the number of outstanding options. The canceled options resulted in "no financial gain to the CEO," Apple said in June, at the time it disclosed the "irregularities."
So far, investors and analysts aren't having fits over Apple's disclosure. And apart from some earnings restatements, it's not clear there will be a major long-term impact from the review. Merrill Lynch analyst Richard Farmer tried to craft a back-of-the-envelope estimate of how much Apple might have to report as expenses by assuming that Apple should have granted all of its reported options grants at a higher price. He came up with a number of $442 million, or about $74 million on an annualized basis, which amounts to 2% of the $3 billion in profits he's forecasting at Apple in fiscal 2008.
And what about Jobs? What if this options kerfuffle somehow results in his departure? Farmer suggests that Apple's fundamental strength doesn't depend on "any single executive." While the stock would likely drop in the unlikely event that this situation somehow results in Jobs stepping down, he says that consumers will continue to purchase iPods and Macs at roughly the same rate "regardless of who is in the executive suite." Such a sudden drop, he said, would just be a buying opportunity.
But until the conclusion of Apple's investigation and any other probes that may ensue, we won't know for sure. Until then, we'll be keeping an ear to the ground and our eyes on the filings.