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Microsoft Changes ESPP Terms, Analysis Part II

Contributed by mm | June 7, 2004 11:59 AM PST

Last month, I analyzed the revised Microsoft Employee Stock Purchase Plan terms and concluded it is bad news for most "savers," but may help a small group of people who couldn't contribute to the maximum in the past due to liquidity issues.

Since then, a number of media have reported this benefit change. Washington Post offers one of the most complete coverage in Microsoft Masters the Art of the Cutback, which also points to analysis from some other news sources.

Lots of employee feedback mentioned the alleged saving of $80 million is minuscule compared to Microsoft's $59 billion war chest (number from the last quarterly earning release). FOr example, the Washington Post article quoted an employee saying:

"I am all for running a lean mean business but we are talking about an organization with >$50 billion in the bank and 10.7 billion shares outstanding. I know every dollar counts but from informally what I've heard around the office I think that changing our ESPP will have a negative net effect. $80 million/10.7 billion shares = not enough savings to spur our stagnant share price into positive movement. Sure employees who are shareholders might see this $80 million cost savings as a net gain but only if they own MILLIONS of shares. Average employees will not benefit from these cost savings."

In this analysis, let's put this into perspective and calculate how many shares an employee needs to own to break even after this benefit cut:

1. Starting from $80 million annual cost reduction and 10.7 billion shares, the benefit changes will lead to Earnings-Per-Share (EPS) increase of 0.747 cents per share.

2. MSFT's EPS consensus estimate is $1.34 for FY05 and its forward-looking P/E ratio based on June 4 closing price is $25.95 / $1.34 = 19.36 (times)

3. Therefore, the $80 million worth of benefit cut should theoretically bring MSFT stock price up by 19.36 * 0.0075 = $0.1447. Remember this is before tax capital gain, so the after-tax effect, at 25% tax bracket, is $0.1086, or a dime a share.

4. As I discussed in my last analysis, the ESPP term change will take away around 1% of the annual salary (after tax effects) for people who contribute to the maximum of what ESPP program allows (15%). So for an employee with $100,000 in base pay and bonus, the $1,000 loss can only be recovered if he also owns $1,000/0.1086 = 9,211 shares (worth $239,036). As ESPP contribution is not capped at certain dollar amount, this ratio should work for most people at 25% tax bracket.

5. For people at different tax brackets, the benefit loss from every $100,000 base pay and bonus can be recovered by owning the following amount of shares:

At 10%: 7,678 shares/$100,000 pay
At 15%: 8,130 shares/$100,000 pay
At 25%: 9,211 shares/$100,000 pay
At 28%: 9,598 shares/$100,000 pay
At 33%: 10,314 shares/$100,000 pay
At 35%: 10,632 shares/$100,000 pay

6. However, the magnified stock price appreciation (due to the P/E ratio) is one-time while the ESPP benefit reduction is an annual event, so the above numbers only represents how many shares an employee needs to own to break even in this game in the first year.

7. If we want to include the impact for Year 2 and forward, we need to consider the expected return rate for each individual. Let's say one expects to earn 10% on each dollar that is free to invest, this means for $10,000 stock appreciation (after tax effect), he is willing to give up $10,000 * 10% = $1,000 compensation every year. Therefore, for employees to really come ahead of the game in the long run, one needs to own the following number of shares (based on different tax brackets):

At 10%: 76,780 shares/$100,000 pay
At 15%: 81,300 shares/$100,000 pay
At 25%: 92,110 shares/$100,000 pay
At 28%: 95,980 shares/$100,000 pay
At 33%: 103,140 shares/$100,000 pay
At 35%: 106,320 shares/$100,000 pay

To be fair, for employees who also have an inventory of stock options and stock awards, they may need less than the tabulated number of shares to winthe game. Therefore, the break-even point is closer to MILLIONS of dollars instead of "MILLIONS of shares." However, I suspect only a very small group of employees will have more than two million dollars invested in Microsoft to claim success in this deal (and for those who have that many shares, it may not be wise to tie that much money in employer's stock in the first place -- diversification is an important investing discipline). Thus, this calculation again shows that the ESPP term change is almost a net-negative to majority of Microsoft employees.

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