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Why Will I Sell Microsoft Stock Award Shares?

Contributed by mm | August 27, 2004 2:42 PM PST

Sometime next week, I will sell my first batch of vested Stock Award shares of Microsoft, immediately after it becomes vested on August 29th. I briefly discussed this choice back in early July but I feel it's worthwhile to put together a holistic view of why I choose to do so.

In case you are not familiar with Stock Award, here is a one-minute introduction: Stock Award is the most current stock-based incentive for Microsoft employees that replaced the original Stock Option system since July 2003. After each annual review in summer, most Microsoft employees are awarded a number of Stock Award shares, which will vest over a five-year period. Unlike stock option, once vested, Stock Award shares are actual Microsoft shares in each employee's brokerage account. Stock Award shares are immediately subject to income tax when vested, and therefore Stock Award is different from restricted stock in terms of tax consequences.

Now let me give out a few reasons why I will sell these vested shares immediately:

Employee View vs Shareholder View

Let me start by saying as an employee, I love the company and it is very likely that I will work for Microsoft for another three to five years, if not more. As a matter of fact, in a recent internal poll as many as 76% employees think the company is heading in the right direction, and I am among them.

However, a good company does not necessarily make a good investment; the key difference is whether the stock is trading at a sensible price. From my value investor's mind, the employee view can be very different from the shareholder view. A healthy and consistently growing company can still be a bad investment if you pay too dear a price. Microsoft CEO Steve Ballmer shares the same view: when asked whether stock repurchase will add to shareholder value, he said if MSFT is trading at $10, it definitely will, but if MSFT is changing hands at $100 a piece, definitely not.

The Shareholder View

So the next question is: whether Microsoft is a good investment. Many arguments have been made that MSFT is trading well below the NASDAQ average in terms of P/E ratio, and therefore represents much better value compared to eBay, Amazon, or the stock market new comer Google.

However, a more rationale way is to set an expected rate of return in absolute terms (say 10%), and see if the investment at question can realistically deliver that. To me, the answer for MSFT is no. No matter how you cut it, at $27 and with the EPS guidance of $1.05-$1.08 (after $0.16 stock based compensation) for FY05, MSFT is trading at more than 20 times earnings. The growingly more difficult top line growth makes it an unlikely choice to deliver more than 10% return per annum.

(In fact, I'm pretty convinced that the entire market is overvalued now and we might not see green pastures for a while. If you track my portfolio (yes, it is performing pretty bad this year), I've loaded a lot of PUTs and am bracing for a bear market.)

Don't Put All Eggs In One Basket

Even if you disagree with me on the assessment of Microsoft as an investment opportunity, think this: for people working for Microsoft for more than two years, many have accumulated a much larger number of stock options with the striking price between $23 and $42. (For me, the range is $23 - $29 -- I already sold my higher-priced options thanks to last year's Stock Option Transfer Program.)

When we transitioned from Stock Options to Stock Awards last year, it is estimated that the number of Stock Award shares granted is only 20% to 25% of the number of Stock Options granted. Adding the fact that previous Stock Option grants have been vested for a longer time, it should be pretty common that many employees have accumulated at least five times more vested Stock Options than Stock Award shares. (In my example, the ratio is more than 10 to 1.)

In other words, if MSFT rises, these vested Stock Options will win an employee ten times more than vested Stock Awards. But if MSFT dives, Stock Options will be protected by the striking price, but there is no floor as of how much one may lose if Stock Award shares are holded on. The old saying of "don't put all eggs in one basket" cannot be more appropriately applied.

Is The $3 Special Dividend A Reason To Hold?

Now, some of my colleagues argue that we should wait till the $3 special dividend, payable on December 2 pending shareholder approval. People think it can be a big bonus.

It is not. If you believe in free market, you will believe the next day after the special dividend, MSFT will drop by more or less $3. A not-so-distant example is MGM: its stock price dropped almost exactly $8 on May 18, just after a $8 special dividend.

(In theory, there is a small arbitrage opportunity, but for the 1% arbitrage gain, I will not bet my shirt that MSFT will not decline more than 1% for three months -- three months is the amount of time you need to hold your Stock Award shares to take advantage of this arbitrage.)

Even If You Still Want to Hold...

Still not convinced? One more issue to consider: Stock Award income will be subject to income tax the moment it is vested. In fact, Microsoft will withhold a portion of the shares upfront to "cover the minimum statutory withholding required." In other words, after Microsoft making its withholding, your Stock Award shares are no different from those you can purchase from the open market on the same vesting day.

If you really, really love the stock, and are truly convinced you will not lose any money in this horse, your best choice is still to sell your Stock Award shares, but only to load the same number of shares in your 401(k) accounts or IRA accounts. Either way, if MSFT jumps, you can shield your capital gains from tax.

Anybody still wants to hold Stock Award shares?

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