Amazon's Valentine options could be a heartbreaker later

According to a filing with the Securities and Exchange Commission on Wednesday, Amazon employees, including top executives, will have the opportunity to exchange current stock options with a strike price of at least $23 a share for new options, in some cases for fewer options, at a lower exercise price.

For example, an employee holding an option to buy 750 common shares that vest over a five-year period could trade those shares in for a new option that would allow him or her to buy 400 shares at the new exercise price. These new shares would vest over the next two years.

The new strike price will be whatever Amazon's lowest closing price is between Jan. 1 and Feb. 14, but no less than 85 percent of the closing price on Valentine's Day. The offer expires Feb. 28.

Employees holding options that vest within this two-year window can exchange their current options under the new plan at a 4-to-3 ratio, meaning an employee who held options for 300 shares that will vest in the next two years will receive 400 shares at the new strike price.

Amazon, like many Internet companies, is wrestling with options plans that can't keep up with market conditions. In the fourth quarter of 1999, Amazon shares hit a high of $113. A year later, the best Amazon shares could do was $40.38. Investors would gladly take that $40 target today; it's more than double Wednesday's closing price of $17.31.

Amazon is recommending that its employees take the deal. "The Compensation Committee of our Board of Directors has approved this offer and recommends that employees accept it," said Amazon in a letter to employees. "All of our eligible executive officers intend to accept the offer. The Compensation Committee believes that, in general, the offer creates a better chance for employees to obtain value from their options in the short term. We still intend to provide long-term incentives through our regular annual option grant program in September 2001."

Potential charges ahead
This all sounds like a sweetheart of a deal to employees who have watched Amazon shares collapse in the past year, leaving new hires with a bunch of worthless options and little incentive to stay with the company.

But shareholders, particularly large fund managers, certainly aren't going to like the compensation charges and dilution these additional shares will bring if and when Amazon finally turns a profit.

Amazon CFO Warren Jenson mentioned the "options exchange" on the company's earnings conference call Tuesday, but details were sketchy. The company's regulatory filings filled in the details.

Amazon will have to record the noncash accounting impact of these new options in its compensation expenses. Should the stock appreciate and the company reaches profitability, the company would have to treat the new options as variable rewards.

At this point, it's tough to gauge how much these rewards and the additional shares would dilute earnings in future quarters, especially since both the strike price and the number of shares that would be added or removed from the pool are still unknown.

That's why it's called variable accounting.

There's also this nagging issue of profitability, a position Amazon executives feel they can reach on an operating basis by the fourth quarter.

"Purely on an operating cash flow basis, the benefits of retaining employees outweigh the possible dilution down the road," said Shawn Milne, an analyst at Wit SoundView. "Fund managers who trade the stock based on earnings, might make a big issue out of this, but we haven't reached that point yet"

Assuming that all employees holding options with a strike price of $23 a share decide to take the offer, and the stock appreciates above the new exercise price, Amazon will be eating the difference, albeit in noncash charges, for years to come.

"There's a significant economic cost to granting new options, regardless of the accounting method used," said Kevin Murphy, a finance professor at the University of Southern California. "You have to take the value of the shares under this new plan and subtract the value of the forfeited shares. If the stock goes up considerably, it will be a big cost to shareholders."

That's not what long-time Amazon shareholders want to hear in the wake of the company's tepid fourth-quarter earnings report and announcement that it will axe 15 percent of its work force.

While the company did post a slightly smaller-than-expected loss in the quarter, dropping $90.4 million, or 25 cents a share, total sales of $972 million fell about $20 million below most analysts' estimates.

Add another $2.5 million worth of stock the company is essentially giving away in its trust fund for recently laid-off employees, and you can see why some investors aren't thrilled by this latest development.

"A lot of economists and shareholders will fixate on what these accounting charges will mean," Murphy said. "But we'd be fooling ourselves to think that earnings and GAAP (generally accepted accounting principles) have been driving this stock. So far, no one has reasonably made the argument for this stock based on its earnings."

Boosting morale
Jeffrey Fieler, an analyst at Bear Stearns, said Amazon's options exchange plan makes more sense than simply issuing more options.

"It helps morale because the exercise price will be closer to the stock's current trading price," he said. "It's probably a good move to keep employees there. The only other option, no pun intended, would be to issue more options which also would be dilutive."

Considering the meltdown in Amazon shares in the past year, it's a safe bet that most, if not all, of the eligible employees will accept the new plan.

"Employees will pounce on it," Murphy said. "The stock price would have to get very high before people would start kicking themselves for doing it."

In the scenario outlined earlier, the Amazon employee holding 750 shares that would have vested over the next five years will forego the other 350 shares for a lower strike price and accelerated vesting period.

The employee would also have to forfeit any special options that were granted on July 27, 2000 and on Aug. 8, 2000 at exercise prices of $30.88 and $35.83 a share, respectively.

If the employee was hired in February when Amazon shares were trading at $80 a share, those 750 shares at an exercise price of $80 a share are worthless today. If the employee were to accept the new plan, the stock would have to go to around $150 a share, assuming a new strike price around $20 a share, before he or she would start feeling pangs of regret.

"All things being equal, most employees will choose to take a better probability of a smaller return than a smaller chance at a huge return," Murphy said.

Unlike the $2.5 million trust fund for departing employees, the new repricing plan presents an opportunity to salvage quality employees and boost spirits when Amazon workers are saying good-bye to many of their colleagues.

"Kudos to Amazon for that offer," said Deborah Thobe, president of Thobe Group, a leading human resources management consulting firm. "It sends a good message to the employees that the company cares while maintaining the 'at risk' attribute of equity."

Thobe points out that Amazon employees will have a say in the amount of risk they want to take, a choice that long-suffering shareholders had when they bought the stock at $200 or $300 a share.

"It's not like the market right now is so hot that (employees) could go somewhere else and get back that same perceived upside level," Thobe said. "This is a remarkable bit of public relations for the firm."

But one can only wonder how long it will take Amazon shareholders to start whining about the dilution of earnings from this morale-boosting decision.

"The top-line growth has been steady to this point and now is over $1 billion," Murphy said. "But profitability is another issue. Once it does start making money, and the stock improves, shareholders are going to begin seeing the impact of this repricing plan."

Amazon shares closed off $1.63, or 9 percent, to $17.44 Wednesday, off 80 percent from its 52-week high of $85.94 set last January.