Dell, Eli Lilly Join EDS
In Risky Options Game

For Dell Computer Corp., the potential liability now stands at about $501 million. For Eli Lilly & Co., the potential liability is $150 million. For McDonald's Corp., it's at least $14 million.

It turns out that Electronic Data Systems Corp. isn't alone in betting -- wrongly (for now, anyway) -- that its stock would continue to rise. Even as the stock market began its rocky descent two years ago, dozens of other big companies were striking deals with Wall Street investment bankers that, in effect, were bets their stocks would be higher in coming months. Most of these deals were designed to hedge the cost of big share-repurchase programs, and some, like those at EDS, were struck as recently as early this year.

ROLLING THE DICE See an infographic1 showing how EDS's strategy to sell put options on its stock backfired.

Some big bills already have come due for the bettors. EDS estimates it lost about $100 million in recent months after it was forced to, in effect, buy back 5.44 million shares, including a big gulp last week at prices averaging about $60 apiece while its stock was trading at $17.

On the other hand, for Dell, Eli Lilly and McDonald's, among others, any losses on their currently outstanding transactions are only potential so far. That is because the transactions don't expire for a few weeks to the end of next year, so their stocks still have a chance to rebound and eliminate the current paper losses.

Indeed, some of these companies have been doing these transactions for years and maintain that they have made money at times. "Ours was a deliberate, well-thought-out and a successful strategy. It's just not as successful as it was," says T.R. Reid, a spokesman for Dell, which made many profitable transactions during the bull market but has shelled out big bucks since early 2000, when its stock began dropping along with many other technology shares.

Then there are those companies lucky or smart enough to have quit playing this risky game. Clorox Co. and Microsoft Corp., for example, did such deals for years. They were among the handful of companies that had such agreements in place as late as 2000 and 2001 but for now they have given them up.

In general, these deals are of two sorts: One is a "forward purchase agreement," or "equity forward contract," in which a company commits to pay a set price -- above the level where the stock is trading as the pact is struck -- at some future date. Such deals help a company lock in the price at which it will later buy shares. The appeal is that the agreements provide corporate treasuries with the benefit of stability as they make plans to buy in stock in the future to fulfill obligations to employees exercising stock options.

The other deal typically involves a "put" option. In connection with share-repurchase programs, companies typically sell such options. In short, the company is providing a buyer the right to sell a specified number of shares to the company at some future date for a specified price. The main benefit to the selling company is the premium income that it earns from the sale -- anywhere from pennies to several dollars a share. This money helps a company offset its share-repurchase costs.

The options are called puts because the buyer is obtaining the right to put the contract back to the seller, forcing the deal. In a rising stock market, buyers often let such options expire, because they would get a higher price for any shares they owned by selling on a stock exchange. But in a falling market, these options become more valuable, and the buyers will come calling, as EDS learned.

"Like a lot of people who enter into options contracts, companies might not consider that possibility," says Charlie Conn, a finance professor at Miami University in Oxford, Ohio. "It certainly has the capability to backfire if they can't get out of it."

Since the stock market stalled in early 2000, Dell has spent nearly $2 billion above what open-market purchases would have cost it to repurchase the premium-priced shares required by its "put" warrants, according to a UBS Warburg LLC analysis. It has paid investment banks that bought the puts an average of $44 a share to buy shares that have traded from $16 to $33 since the start of 2000.

As of Aug. 3, Dell had put obligations covering 22 million shares at an average $47.82 strike price. At 4 p.m. Thursday in Nasdaq Stock Market trading, Dell shares were up 14 cents at $25.02.

"The thinking originally was: 'Can we minimize the expense there?' " says Dell's Mr. Reid. For more than four years, the plan worked like magic: Dell shares kept rising, and the puts expired worthless, allowing the company to benefit from the fees and lower share-repurchase prices. Dell says that, in the six years of its stock buybacks, the derivative contracts have allowed it to buy some 980 million shares back at a below-market average price of less than $15. And the remaining $500 million liability is dwarfed by its $8.6 billion in cash.

Consider Eli Lilly. The drug maker has used equity forward contracts, put options and other financial instruments since 1998. Since 2000, it has posted a $24 million net gain on these pacts, due in part to a stock price that rocketed to more than $100 in 2000.

But Lilly, which has seen its stock tumble to about $55, acknowledges it now faces $150 million in potential exposure from these kinds of contracts. The stock traded in the $70 range in March 2000 when the biggest of the outstanding deals was struck, obligating it to buy 4.5 million shares at $86 to $100 each by the end of 2003. Another requires the company to purchase 900,000 shares at $83; this obligation lasts through November.

Lilly spokesman Rob Smith says the exposure "is not anything that would impact the liquidity of the company at all," noting the company has cash of about $3 billion. The company is optimistic its share price will rise significantly before the end of 2003.

The Indianapolis company, which is considered to have one of the richest new-drug pipelines in the pharmaceuticals industry, traded as high as $109 in 2000, but as the market tumbled early this year it fell from $80 and faced regulatory scrutiny of its manufacturing facilities. After the 4.5-million-share pact was struck in 2000, Lilly lost its patent protection on the leading antidepressant Prozac.

At 4 p.m. in New York Stock Exchange composite trading Thursday, Eli Lilly was up $1.02 at $59.99.

McDonald's, which began using put options in 1992, now has 2.3 million put options outstanding, exercisable at $26.37 to $29.49 a share. If the options were exercised today, it would cost the company about $14 million, based on today's stock price, says McDonald's spokeswoman Anna Rozenich. That assumes a net price of $24, which is the price it would be paid upon the exercise of puts, less the premium received for selling it. The Oak Brook, Ill., burger company says it sold no new put options this year and is still studying what it will do in 2003.

McDonald's shares were up 35 cents to $18.45 at 4 p.m. Thursday on the Big Board.

Dow Jones & Co., publisher of The Wall Street Journal and the Online Journal, also has entered into put options agreements, with 667,000 shares outstanding as of Dec. 31. Since then, Dow Jones had to buy some of the shares, because the strike price was above the market price. Christopher Vieth, the company's chief financial officer, said the company doesn't publicly disclose the details of such transactions, but that the cost of the transactions to the company was minimal. The last put options expired in April, and Dow Jones doesn't have any more put options contracts outstanding.

Clorox began hedging its stock purchases in 1995, initially using puts and "calls," which give a company the right to buy shares at a future date. It switched to forward purchase contracts. All totaled, Clorox has recorded a net gain of nearly $70 million, says Chief Financial Officer Karen Rose. In June, it settled its remaining contracts for "approximately a wash," she says. "In the '90s, stock prices, including our own, were on an upward, upward trend. As a consequence, these things made a lot of money."

That is the case, too, at software giant Microsoft, which last year quit selling put warrants to investment banks after making several hundred million dollars on the effort over the course of about six years, according to the company. With its stock price no longer rising dependably, Microsoft last year decided that the put warrants were a potential liability. By June 30, 2001, cash-rich Microsoft had exercised or retired all of its put warrants, recording a cost of $1.367 billion for its 2001 fiscal year.

Other companies that previously sold put options, but aren't currently, include Caterpillar Inc., RadioShack Corp., Target Corp. and Xerox Corp. Intel Corp. sold put warrants from 1991 through 1999, netting about $348 million over the final three years. Its board discontinued the practice as the stock market began to look overheated. "We were in a bubble-sort-of environment," says Tom Beerman, an Intel spokesman. "Continuing with the program presented too much risk."

-- David Bank and Shirley Leung contributed to this article.

Write to Robin Sidel at robin.sidel@wsj.com², Gary McWilliams at gary.mcwilliams@wsj.com³ and Thomas M. Burton at tom.burton@wsj.com⁴

Updated September 27, 2002