When Stocks Rise, Look Harder

S the stock market has rallied over the last 12 months, investors have allowed themselves to become giddy again. Luckily, some companies have announced better earnings recently, lending crucial support to highflying stocks.

Still, experienced investors know that what you see is not always what you get. Because of two unrelated factors - stock option issuance and convertible bond sales - the rising shares at some companies may have the perverse effect of weighing down future values.

The potential pressure on companies' shares from stock options is not only that they dilute profits per share. Less obvious is what happens when companies spend lots of cash to buy back stock and keep a lid on shares outstanding.

Steven Milunovich and Richard Farmer, technology stock analysts at Merrill Lynch, call this an invisible cash-flow drain. That is because the cost of option-related buybacks is not tallied in companies' operating cash flows, where investors go to figure free cash flow. Rather, the cost is in tables that detail cash flows from financing.

This gives companies that buy back significant amounts of stock the appearance of higher free cash flows than would be the case if the purchases showed up in operating cash flows. Investors unaware of the cash-flow drain from options may be awarding the companies higher valuations as a result.

The Merrill analysts recently published a study of cash drains at large technology companies. During the bear market, the depletion was muted because few employees could exercise options issued at bubble prices. Now, however, rising stock prices will mean more option exercises and more dollars spent buying back stock this year and next, the analysts argue.

"It's surprising how poorly understood the drain on cash flow really is," Mr. Farmer said. In 2000, the analysts found, 11 top technology companies, including Dell Computer and Cisco Systems would have needed all their free cash flow, on average, to offset option-related new shares. This average fell to 12 percent in 2002, but the analysts say it may hit 30 percent in 2004.

"As long as these companies beat their numbers, this won't be much of an issue," Mr. Milunovich said. "But over time it could result in about a 10 percent decline in tech valuations."

THE other pressure point involves a financial instrument even more complex than options: a bond that is convertible into common stock when the issuer's shares reach a set price. Known as contingent convertible bonds - CoCo's, in Wall Street parlance - these securities are less common than plain-vanilla convertibles. But they have increased in popularity and, under accounting rules, the dilutive effect of these bonds on an issuer's share count need not be included in company filings until the contingency price is met.

David Haushalter, accounting analyst at the Susquehanna Financial Group, has analyzed the earnings impact CoCo's can represent. The effects can be substantial, he said, but may be hidden.

Among the companies whose stocks have recently exceeded the contingent conversion price or may soon do so are Lucent Technologies, the telecommunications equipment maker; the Interpublic Group of Companies, the advertising conglomerate; and Watson Pharmaceuticals.

Adding the new shares to the mix at Lucent would reduce its estimated 2004 earnings by 4 percent, Mr. Haushalter said. At Interpublic, the additional shares would cut earnings by 6.7 percent, and at Watson Pharmaceuticals, the figure would drop by 5.4 percent.

"As market conditions continue to improve, more and more of these situations arise where companies get closer to contingency prices," Mr. Haushalter said. "But it is not clear to me that investors are aware of this."

Just two more reasons to keep your pencils sharp.