Citigroup analyst Mark Mahaney lowered his price target for Monster Worldwide (MNST) from $61 to $46 due to expected uncertainty resulting from its options granting practices. The backdating issue is detailed below:
Yesterday, MNST issued a statement that a committee of independent directors has been conducting an internal review of all stock options grants issued by the Company. The committee has retained independent outside legal counsel to assist in this matter.
We detail below MNST’s stock option grants from 1997 to 2004 and highlight those grants that may potentially indicate backdating. We analyzed the available DEF 14A proxy filings for MNST. For each proxy, we extracted the dates and exercise prices for that year’s options grants to high-level executives. We then calculated the mean, high, low, and standard deviation for the stock price in the 40 trading days surrounding each grant date.
In the exhibit below, bolded stock prices in the “Stock Price on Day of Grant” column indicate that the price on the grant date was the low for the surrounding 40-trading day period (i.e., 20 days before and after). Bolded standard deviations in the column entitled “Grant Price +/- Std Dev” indicate that the standard deviation was below -1.65, indicating that there was less than a 5% chance that the grant price would be that much lower than the mean stock price over the surrounding 40-trading day period.
(Quick statistics refresher: The cut-off thresholds for 90%, 95%, and 99% confidence intervals are +/- 1.645, +/-1.96, and +/-2.575 standard deviations, respectively. Since we’re only interested in those caseswhere the stock price on the grant date was significantly below the mean price over the 40- trading day period, we are only focused on the negative standard deviations or just one tail in a normal distribution. So the likelihood of a result that is more negative than -1.645 is half of the remaining 10%, or 5%; more negative than -1.96 equates to a probability of less than 2.5%, etc., for the 40-trading day period.)
MNST Option Grants Vs. 40 Day Trading Range
For insight into MNST's possible stock movement, we also detail the recent stock movements of companies that have been identified as possibly involved in the backdating of stock options. Specifically, we look at the stock action of the 17 companies highlighted on May 16th by CFRA (The Center for Financial Research and Analysis) as having the “highest risk of having backdated options.” On average, this group of stocks has declined 7.5% since that date vs. a 3.1% decline for the S&P 500 and a 4.2% decline for NASDAQ. And some stocks have declined by as much as 19% and 20%.
Stock Price Changes for 17 Companies Highlighted by CFRA
The following commentary has been provided by Tobias Levkovich (CIR U.S. Equity Strategist) and Phil Gainey (CIR Accounting Specialist):
Over the past few weeks, equity markets have struggled through a quick and painful correction, with tech stocks participating, in some cases pretty violently. Part of the pullback has been beta-related and part due to a new issue that questions earnings figures and accounting credibility. In particular, the SEC is now scrutinizing companies that allegedly have backdated option grants. Although backdating is not illegal per se, it can easily be considered poor corporate governance in an intolerant era for such factors. A growing list of stocks in various sectors are getting hit for fear that these allegations are true and will lead to large restatements, management resignations, and the realization that more corporate governance mandates may pop up.
Up until this year, most companies followed option accounting rules found in APB 25. These rules required companies to expense the intrinsic value of options based on grant date. It didn’t take long for companies to realize that options priced at- or slightly out-of-themoney would mean that option expense would be zero.
The backdating issue relates to the grant date “chosen.” Backdating means that a grant date is “chosen” that precedes the actual measurement date. Usually the “chosen” grant date corresponds with or is near the lowest market price for the stock in that period. The actual measurement date should be the date that both the number of shares and the option purchase price are known (usually the date that the Board approves the grant).
Since the market value of the stock on actual measurement date in some of these cases is higher than the “chosen” strike price, the options in actuality were issued in-the-money. The result is that those who received these backdated options were actually given compensation rather than incentive compensation. Here’s the impact on the financial statements of the company:
1. Compensation (option) expense was understated since the intrinsic value was positive. Thus, net income was overstated in those periods.
2. Shareholders equity was overstated (due to higher reported net income). When restatements are made, it is possible that lower equity levels could trigger company debt covenants.
3. Cash is not affected, although had the company reported the compensation appropriately, they would have been able to utilize tax benefits at the time. So, some tax benefits may be forgone.
The real economic impact of backdating may just be an inappropriate transfer of wealth from investors to management. In some instances, the management teams could be accused of securities fraud and the headline event of subpoenas already has caused a number of stock prices to fall sharply in response. The concerns range from possible management team changeover (with commensurate loss of business momentum) to shareholder lawsuits and accounting restatements. While it is extraordinarily difficult to assess the actual vs. feared impact, our technology analysts have come together to create an analysis for investors to consider when assessing the potential threat from the backdating issue. In addition to quantitative triggers which help determine companies with “red flags”, we have gone a step further by considering the dates of the stock options, risks perhaps baked into share price activity, historical transparency, the significance of stock based compensation to the company, and any management changes over the past few years.
While we do not believe that the issue is as devastating as the accounting scandals back in 2002, the issue is likely to cast a pall over the IT sector for the time being and further news flow will determine the extent of the investigations and the outcomes. Not surprisingly, companies that have made the newspapers are clamming up (most likely due to legal advice) and the situations are fluid. Hence, the stock options analysis could be invaluable to investors is assessing the risk quotient.