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Minyan Mailbag: CSCO Derivative Security

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There's no shame in my game!

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.

Hi John,

I read with interest the article in the NY Times regarding Cisco's (CSCO) attempt to create a derivative security to mimic its employee stock option plan. From what I can see this creates no value for the company. The security they are designing is so bastardized that no investor would want it except at a deeply discounted value. Of course, that is what CSCO management wants because then it can use this "market value" in determining employee stock option expense in its income statements. However, in the process management has destroyed shareholder value by wasting management time and by selling a security at below-market value. These people have no shame.

I suspect Morgan Stanley (CSCO's IB on this security) has shown this proposed security to you. I would appreciate your comments on this provided you are not prevented in doing so through some non-disclosure agreement.


Thanks,

Minyan Bruce

MB -


There are no details as of yet; there is only speculation as to what CSCO will do and why they are doing it.

First of all, by August CSCO will have to expense the value of its employee stock options. The company wants that expense to be as little as possible; the lower the option valuation, the lower the expense. The best way to illustrate to accountants and ultimately the SEC the value of these options (the security will be a note with imbedded options similar to the company's liability to its employees) is to trade them in the market.

We are speculating that the company is contemplating selling a security with imbedded options to institutional investors that will make those investors synthetically long call options that are significantly out of the money and several years in duration. They will sell this security at a price that will clear the market, that will make the valuation of those options as low as possible. This will allow the company to expense as little as possible.

It will also leave the company then double short the options: to its employees and also to investors that buy the security. The company will receive income for the sale, but have the risk that if the stock rises significantly and through the upper strike that they will incur double the dilution. Ironically, the fact that dilution will be significant if the stock price rises will in fact be a drag on the stock at higher prices.


Prof. Succo

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