Brocade Swaps Swamped Options

Brocade Communications Systems Inc. (Nasdaq: BRCD) is planning to grant approximately 28.5 million new stock options to employees after the close of the market today, in program to replace "underwater" options that are worthless at Brocade's current stock price.

In its most recent 10-Q quarterly filing, Brocade says the new stock options "could have a dilutive effect on the company's future earnings per share to the extent that the future market price of the company's common stock exceeds the exercise price of the new stock options." The 28.5 million new stock options represent about 11 percent of its total shares of common stock outstanding as of April 26, 2003.

However, Wall Street analysts believe the option exchange will have a negligible effect on the company's stock price. Brocade originally announced the program on December 9, 2002 (see Brocade OKs Employee Option Swap).

"My impression is that this is pretty well known out there," says Harry Blount, senior analyst at Lehman Brothers. "There will probably be no effect, to the extent that people have already built their models accounting for the incremental share count."

But Brocade is sidestepping a broader hot-button issue that public companies have been facing lately: Whether to account for stock options as an expense. This week, Microsoft Corp. (Nasdaq: MSFT) announced that it will treat stock-options compensation as an expense on its income statements, and that it will voluntarily restate past years' financial results to reflect that change -- making it the first major technology company to do so.Currently, as with most public companies, Brocade does not account for stock-based compensation as an expense, but under SEC rules it's required to disclose the value of stock options as if it had. For the quarter that ended April 26, 2003, Brocade said it would have had $34.4 million in stock-based compensation expenses under the fair-value method of accounting.

Steve Berg, senior analyst at Punk Ziegel & Co., says Brocade has long been recognized as a company that has relatively high options exposure.

"Certainly, options are a valuable tool for hiring and retaining creative and valuable people," Berg says. "However, because of the focus on pro forma results rather than GAAP [Generally Accepted Accounting Principles] for technology companies, investors have not punished those companies that have issued an excessive amount of options."

Under Brocade's stock option exchange program, the exercise price per share of the new stock options will be equal to the share price at the close of trading today. In morning trading, Brocade's stock was at $6.57, down 3.7 percent. Employees that held options with exercise prices equal to or greater than $12.00 per share were given the opportunity to receive new stock options in exchange for their eligible outstanding stock options at an exchange ratio of either 1 for 1, 1 for 2, or 1 for 3, depending on the grant date of the original stock option.

Meanwhile, Brocade CEO Greg Reyes is receiving new stock options in exchange for his eligible outstanding stock options at an exchange ratio of 1 for 10 -- a self-imposed penalty, analysts say, designed to show investors that Reyes will not unduly benefit from the program. "It would not be good form to improve your personal lot in this situation," says RBC Capital Markets analyst Robert Montague. "It's mostly to make it more palatable to the shareholders."In late February, Reyes purchased 2.5 million additional shares, worth about $10 million at the time, a move intended in part to boost investor confidence in the company, analysts say.

Todd Spangler, US Editor, Byte and Switch