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Falling Money. (iStockphoto)
Falling Money. (iStockphoto)


Warning: Free cash flow may be anything but free Add to ...

The idea that stock options are an expense, and that a proper look at earnings includes their cost, is a well-known notion. Outside of a few tech companies that encourage investors to look beyond their employee-stock expenses at earnings time, we’ve come to accept that these outlays belong in an accounting of the bottom line.

Here, however, is a little-known but no less important question: Should we be adjusting a company’s cash flow numbers to reflect its employee stock programs?

That was the subject of a recent exercise by A.M. (Toni ) Sacconaghi Jr., a tech analyst at Bernstein Research. Mr. Sacconaghi asked, “How much of free cash flow is really free?”

While “free cash flow” has no explicit definition in the accounting literature, it’s generally taken to mean the company’s operating cash flow, minus the capital expenditures it needs to make to reinvest in the business.

The implication is that the company is “free” to use that amount of cash in any number of ways, including giving it back to shareholders in the form of dividends and stock buybacks. Investors often use some sort of price-to-free-cash-flow measure to value stocks.

What Mr. Sacconaghi found, however, was that many companies in the tech space were using their free cash flow for acquisitions (some of dubious value) or share buybacks that had a limited effect, as a result of the offsetting impact of employee compensation programs. Among the top 25 tech companies, Mr. Sacconaghi figured, only about half of free cash flow was truly available to shareholders.

While the use of cash for ill-fated deals is a fascinating topic, let’s focus today on how free cash flow relates to stock compensation.

Mr. Sacconaghi observed that while many of the companies in the tech sector spent hundreds of millions of dollars buying back their shares on the open market, their overall share count declined marginally – or not at all – from 2008 to 2012.

That’s because many of the companies were obligated to issue new shares as their employees exercised long-held stock options, or as they granted stock as part of current compensation programs. “If repurchases are just to keep the share count flat, or from rising, [the cash] is not actually available to shareholders,” he notes.

More specifically, he says, free cash that’s used for buybacks that support employee stock plans should perhaps be viewed more like cash compensation – and not part of free cash flow at all.

Mr. Sacconaghi points to storage and networking company EMC Corp., which told analysts in March that it had used nearly half of its free cash flow over the past five years on stock buybacks. However, its share count actually increased 6 per cent over that time. “We found this striking: Effectively all of EMC’s cash flow was ‘spoken for’ – either to buy other companies, or effectively to pay employees.”

Mr. Sacconaghi acknowledges that any company that has both share buybacks and stock compensation plans is engaged, to some degree, in this practice. His research, he says, is “a blunt tool” to illustrate the phenomenon, and “a much deeper dive into each company” is required to obtain more particulars.

I am happy to oblige. VMware, which is nearly 80 per cent owned by EMC, is another company that engaged in stock buybacks, but saw its share count increase.

Here is what happened in the past three years, per VMware’s most recent annual report. From 2010 to 2012, the company spent more than $1.3-billion (U.S.) buying 11 million shares on the open market. (Nearly $1-billion of those were at an average price around $90, versus the current share price of $66.)

During the same period, VMware employees exercised nearly 32 million stock options at an average price of about $27 apiece.

All of this was perfectly legal and fully disclosed. But note the impact: In practical terms, the company was minimizing the effect of all those stock options by buying shares on the open market, then selling them back to their employees, often at less than one-third the open-market price.

The cash used to buy those shares? Technically it’s free cash flow. But it more closely resembled a free lunch for employees, and money that shareholders will never see again.

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  • VMware Inc
  • Updated October 24 4:02 PM EDT. Delayed by at least 15 minutes.

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