Stock Options

Posted by PITHOCRATES - April 29th, 2013

Economics 101

It takes a Lot of Time to Design, Develop and Bring to Market a Radical New Aircraft

The number one cost airlines have is fuel.  So anything that can reduce fuel consumption can cut an airline’s costs.  Aircraft manufacturers are aware of this.  And want to incorporate new fuel-saving technology into their aircraft.  Because that’s what airlines want.  And if you can give the airlines what they want they will buy your aircraft.  But sometimes new technology can be a little temperamental.  Everything doesn’t work as expected.  And sometimes problems that come up can take a long time to engineer through.  Like it did for the Boeing 787 Dream liner.

Boeing did everything they could think of to squeeze every last ounce of weight from the 787.  One thing they did is well known.  Thanks to a problem with it that caused the grounding of the entire 787 fleet.  The lithium-ion battery.  But that’s not the only weight-saving innovation of the 787.  They added Dual Electronic Flight Bags in the cockpit.  So pilots don’t have to bring bulky and heavy books aboard.  They went from conventional pneumatic architecture to more-electric architecture.  Eliminating the engine bleed air system and associated pneumatic system components.  Reducing weight and improving efficiency.  Which reduced fuel consumption.  They used simple trailing edge flaps.  Not slotted flaps.  Letting them use smaller flap track fairings (those canoe-shaped things underneath the trailing edge of the wings that operated the flaps).  Reducing drag.  And fuel consumption.  They used bigger engines with higher bypass ratios (the amount of air pulled into the fan disk but NOT used for combustion).  Increasing engine efficiency.  Reducing fuel consumption.  The use of composite materials decreased weight.  And the use of one-piece barrel sections eliminated additional joints, fasteners and splice plates.  Reducing weight.  And fuel consumption.

These and other innovations result in a fuel savings of 20% over similarly sized aircraft.  This is huge.  Which is why airlines are ordering this airplane.  But such a radical change in aircraft design comes with a lot of risks.  As the problem with the lithium-ion battery has shown.  And it takes a lot of time to design, develop and bring to market a new aircraft.  Especially one that is radically different from other airplanes.  So the decision to put the aircraft company on this course was a very risky decision.  And one that took a lot of guts.  Because so many things can go wrong.  Leading to cost overruns.  Which can delay promised delivery dates.  And Boeing had their share of those bringing the 787 to market.  Which they have worked through.  Will it be worth it?  As long as airlines want to save on fuel costs, yes.  And no problems arise that they can’t overcome.

Stock Options get Risk-Averse and Cautious CEOs to be Bold and Take Risks

These are big decisions.  Decisions that lead to great successes.  Or great failures.  Some so bad that they can bankrupt a company.  Someone has to be responsible for these decisions.  That one person sitting at the top of the corporation.  The CEO.  It is the CEO who has the ultimate say on the direction of the corporation.  And with this one decision all the resources of the corporation are marshaled together to take the corporation in this new direction.  Incurring great costs that will be on the books for years.  Making it hard to change course until these great investments pay off.  If they pay off.

These are the things CEOs have to deal with.  Not just at Boeing.  But throughout corporate America.  CEOs have to make these singular decisions that can have consequences for years to come.  Where it may take years to see if that one decision actually pays off.  There are few CEOs in the labor force.  So few can imagine the stress these people work under.  And in that pool of CEOs there are only a few that have the Midas touch.   Who can consistently take great risks while making all the right decisions.  Board members desperately want these CEOs.  Offering very generous compensation packages to lure them in.  And to keep them once they have them.  This crème de la crème of CEOs may make the big bucks.  But in exchange for that fat paycheck they do something few others can.  They make shareholders rich.  And they love making these owners rich.  For they love the thrill of the job.  Relishing that high-stress environment.  Where every little decision has great consequences.  Thriving under the kind of pressure that would leave most others whimpering in their beds.  Curled up in the fetal position.  In a pool of their own tears.

But not every corporation can get one of the crème de la crème.  They may have a great CEO.  But one that suffers from a major CEO character flaw.  Being averse to taking big risks.  Who instead wants to be a little more conservative.  And a little more cautious.  Shareholders don’t like overly cautious CEOs.  Because the people getting rich are doing it by breaking away from the pack.  By doing something different.  Abandoning convention.  Trying something bold.  And new.  Bringing something brand new to market that no one knows anything about.  But once they learn about it they can’t live without it.  This is what shareholders want.  Not cautious and conservative.  So to light a fire under these CEOs they came up with a new way to compensate them.  To appeal to their greed.  By letting them get rich if they can make that next great thing that sends the stock price soaring.  And the key to their greed is the stock option.

Stock Options provide a Powerful Incentive to bring Great New Things to Market

The CEO that creates the next big thing everyone will want to buy will send sales revenue soaring.  And with great sales revenue comes great profits.  Increasing the value of the company.  Which, in turn, makes the stock price soar.  This is what shareholders want.  A soaring stock price.  So to encourage the CEO to give them what they want they tie the CEO’s interest to their interests.  By giving the CEO stock options.  Making the sky the limit.  For the more the CEO increases the stock price the greater the CEO’s compensation.  Thus encouraging the CEO to try something bold and new.

A stock option is a right to buy a share of stock at a fixed price in the future.  Say the current stock price is $70/share.  The board of directors gives the CEO the option to buy, say, 500,000 shares of stock at $80/share up until some date in the future.  Creating a strong incentive for the CEO to raise the stock price.  The greater the CEO raises the price above $80 the greater his or her compensation.   Let’s say the CEO was bold and took a great risk.  And it pays off.  Sending the stock price soaring to $110/share.  When the CEO exercises those options he or she will buy 500,000 shares of stock from the company at $80/share.  The company gets $40 million in new capital to help finance further growth.  And the CEO will sell those 500,000 shares at the current market price of $110/share.  Pocketing $15 million.  And the shareholders, of course, get what they want.  A higher stock price.  Everyone wins.

Now let’s say that nothing spectacular happens.  And the stock price only rises to $75/share.  Because it’s below the ‘strike price’ the CEO will let these options expire.  The CEO profits nothing from these options.  But doesn’t lose anything either.  But what happens when the stock price falls because of that bold, new direction?  Causing the corporation to lose value.  As well as the shareholders.  But the CEO?  Again, the CEO will let those options expire.  And will lose no money.  Which is one of the benefits of stock options.  It got those risk-averse and cautious CEOs to take those big risks that got shareholders rich.  As there is no downside risk for the CEO.  Which is both good and bad.  On the one hand it encourages risk taking.  But on the other it encourages risk-taking.  Some CEOs will take excessive risks as they have nothing to lose.  Some will even cook the books to boost the stock price so they can exercise those options.  So it’s not a perfect system.  But they do provide a powerful incentive to bring great new things to market.  Which is what shareholders want.  And will take great risks themselves to get it.

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