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Financial Analysis Chapter 9 Page 1 of 20
Financial Analysis: A User Approach
Chapter 9
Accounting Analysis: Specific Issues 2
This chapter is a continuation of Chapter 8.
Stock Options
Note: The material in your text is substantially out of date –
please refer to these notes for the current treatment of stock
options.
The FASB issues FAS 123 which changed the treatment of stock
options. Previously when a company issued “at the money
option” (Intrinsic Value = 0) no compensation expense was
reported.
FAS 123 changed the valuation method for stock options.
Under 123 when an option is issued it is recorded at its Fair
Value (Intrinsic Value + Time Value). While the Intrinsic Value
will be in most cases still equal to zero the Time Value will be in
most cases a positive amount, resulting in a positive value for
compensation expense. The Fair Value of the option is to be
calculated using an appropriate model such as the Black Sholes
Option Pricing Model.
Financial Analysis Chapter 9 Page 2 of 20
STX Notes:
Stock-Based Compensation —Effective July 2, 2005, the Company adopted the fair value
recognition provisions of SFAS No. 123 (Revised 2004), Share-Based Payment , (SFAS No.
123(R)), using the modified-prospective-transition method. The Company has included stock-
based compensation costs in its results of operations for fiscal years 2008, 2007 and 2006 (see
Note 3). The adoption of SFAS No. 123(R) had a material impact on the Company’s results of
operations. The Company has elected to apply the with-and-without method to assess the
realization of excess tax benefits.
Stock-Based Benefit Plans
The Company’s stock-based benefit plans have been established to promote the Company’s
long-term growth and financial success by providing incentives to its employees, directors, and
consultants through grants of share-based awards. The provisions of the Company’s stock-
based benefit plans, which allow for the grant of various types of equity-based awards, are also
intended to provide greater flexibility to maintain the Company’s competitive ability to attract,
retain and motivate participants for the benefit of the Company and its shareholders.
Seagate Technology 2004 Stock Compensation Plan—On August 5, 2004, the Company’s board
of directors adopted the Seagate Technology 2004 Stock Compensation Plan (the “2004 Plan”),
and on October 28, 2004, the Company’s shareholders approved the 2004 Plan. A maximum of
63.5 million common shares is issuable under the 2004 Plan. Options granted to exempt
employees will generally vest as follows: 25% of the shares will vest on the first anniversary of
the vesting commencement date and the remaining 75% will vest proportionately each month
over the next 36 months. As of June 27, 2008, there were approximately 30 million shares
available for issuance under the 2004 Plan.
Stock Purchase Plan—The Company established an Employee Stock Purchase Plan (“ESPP”) in
December 2002. At that time, a total of 20 million common shares had been authorized for
issuance under the ESPP. On October 26, 2006, the Company’s shareholders approved an
amendment to the ESPP to increase the number of common shares available for issuance by 10
million bringing the total amount of common shares authorized to be issued under the ESPP to
30 million. In no event shall the total number of shares issued under the ESPP exceed 75 million
shares. The ESPP consists of a six-month offering period with a maximum issuance of 2.5 million
shares per offering period. The ESPP permits eligible employees who have completed twenty
days of employment prior to the commencement of any offering period to purchase common
shares through payroll deductions generally at 85% of the fair market value of the common
shares. On January 31, 2008, the Company issued approximately 1.9 million common shares
Financial Analysis Chapter 9 Page 4 of 20
Company performed a straight-line interpolation to determine the rate from the available term maturities. Estimated Forfeitures—When estimating forfeitures, the Company considers voluntary termination behavior as well as analysis of actual option forfeitures. The fair value of the Company’s stock options granted to employees, assumed from Maxtor and issued from the ESPP for fiscal years 2008, 2007 and 2006 were estimated using the following weighted-average assumptions: Fiscal Years Ended 2008 2007 2006 Options under Seagate Plans Expected term (in years) 4.0 4.0 3.5–4. Volatility 35 – 36% 37 – 39% 40 – 43% Expected dividend 1.5–2.5% 1.3–1.9% 1.2–2.3% Risk-free interest rate 2.3–4.2% 4.4–4.8% 4.1–5.0% Estimated annual forfeitures 4.5% 4.5% 4.6–4.9% Weighted-average fair value $7.31 $7.41 $7. ESPP Expected term (in years) 0.5 0.5 0.5–1. Volatility 31 – 36% 33 – 34% 37 – 41% Expected dividend 1.7–2.3% 1.4–1.5% 1.2–1.7% Risk-free interest rate 2.0–5.0% 5.0–5.2% 3.6–4.5% Weighted-average fair value $4.67 $5.80 $7. Stock Compensation Expense Stock Compensation Expense—The Company recorded $98 million, $101 million and $ million of stock-based compensation during fiscal years 2008, 2007 and 2006, respectively. Additionally, the Company recorded $15 million, $27 million and $16 million of stock-based compensation in fiscal years 2008, 2007 and 2006, respectively, in connection with the assumed options and nonvested shares exchanged in the Maxtor acquisition (see Note 10). As required by SFAS No. 123(R), management made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest. In accordance with guidance in SFAS No. 123(R), the cash flows resulting from excess tax benefits (tax benefits related to the excess of proceeds from employee’s exercises of stock options over the stock-based compensation cost recognized for those options) are classified as financing cash flows. The Company recorded approximately $6 million of excess tax benefits as a financing cash inflow during fiscal year 2008. The Company did not recognize any cash flows from excess tax benefits during fiscal year 2007. The Company recorded approximately $ million of excess tax benefits as a financing cash inflow during fiscal year 2006.
Financial Analysis Chapter 9 Page 5 of 20
Stock Option Activity The Company issues new common shares upon exercise of stock options. The following is a summary of option activity for the Company’s stock option plans, including options assumed from Maxtor, for the fiscal year ended June 27, 2008: Options Number of Shares Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term Aggregate Intrinsic Value (In millions) (In millions) Outstanding at June 29, 2007 56.6 $ 10. Granted 10.0 24. Exercised (10.0) 10. Forfeitures and cancellations (1.6) 22. Outstanding at June 27, 2008 55.0 $ 10.38 4.7 $ 255 Vested and expected to vest at June 27, 2008 51.8 $ 16.74 4.6 $ 254 Exercisable at June 27, 2008 29.5 $ 12.34 4.1 $ 235 The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common shares for the 28.0 million options that were in-the-money at June 27, 2008. During fiscal years 2008, 2007 and 2006 the aggregate intrinsic value of options exercised under the Company’s stock option plans was $ million, $280 million and $228 million, respectively, determined as of the date of option exercise. The aggregate fair value of options vested during fiscal year 2008 was approximately $84 million. At June 27, 2008 the total compensation cost related to options granted to employees under the Company’s stock option plans (excluding options assumed in the Maxtor acquisition) but not yet recognized was approximately $122 million, net of estimated forfeitures of approximately $17 million. This cost is being amortized on a straight-line basis over a weighted- average remaining term of approximately 2.3 years and will be adjusted for subsequent changes in estimated forfeitures. In addition to the stock-based compensation cost not yet recognized under the Company’s stock option plans, the Company has additional stock-based compensation costs related to options assumed in the Maxtor acquisition of approximately $ million, which will be amortized over a weighted-average period of approximately 0.9 years. Performance Shares
Financial Analysis Chapter 9 Page 7 of 20
From STX
6. Business Segment and Geographic Information
In accordance with SFAS No. 131, Disclosure about Segments of an Enterprise and Related
Information, the Company has concluded that its manufacture and distribution of disc drives
constitutes one segment. The Company’s manufacturing operations are based on technology
platforms that are used to produce various disc drive products that serve multiple disc drive
applications and markets. The Company’s main technology platforms are primarily focused
around areal density of media and read/write head technologies. In addition, the Company also
invests in certain other technology platforms including motors, servo formatting read/write
channels, solid state technologies and sealed drive technologies. The Company has determined
that its Chief Executive Officer is the Company’s chief operating decision maker (CODM) as he is
responsible for reviewing and approving investments in the Company’s technology platforms
and manufacturing infrastructure.
In fiscal years 2008, 2007 and 2006, Hewlett-Packard Company (“HP”) accounted for 16%, 16%
and 17% of consolidated revenue, respectively, while Dell, Inc. (“Dell”) accounted for 11%, 9%
and 11% of consolidated revenue in fiscal years 2008, 2007 and 2006, respectively. No other
customer accounted for more than 10% of consolidated revenue in any year presented.
Long-lived assets consist of property, equipment and leasehold improvements, capital leases,
equity investments and other non-current assets as recorded by the Company’s operations in
each area.
The following table summarizes the Company’s operations by geographic area:
Fiscal Years Ended June 27, 2008 June 29, 2007 June 30, (In millions)^2006 Revenue from external customers(1): United States $ 3,880 $ 3,260 $ 2, The Netherlands 3,696 2,666 2, Singapore 4,915 4,346 3, Other 217 1,088 740 Consolidated $ 12,708 $ 11,360 $ 9, Long-lived assets: Singapore $ 1,020 $ 1,038 $ 915 United States 774 792 701 Thailand 303 368 432 China 210 288 251 Other 463 205 97 Consolidated $ 2,770 $ 2,691 $ 2,
Financial Analysis Chapter 9 Page 8 of 20
MSFT - SEGMENT INFORMATION
Segment revenue and operating income (loss) was as follows: (In millions) Year Ended June 30, 2008 2007 2006 Revenue: Client $ 16,472 $ 14,844 $ 13, Server and Tools 13,189 11,184 9, Online Services Business 3,214 2,441 2, Microsoft Business Division 18,937^ 16,404 14, Entertainment and Devices Division 8,139 6,066 4, Unallocated and other 469 183 10 Consolidated $ 60,420 $ 51,122 $ 44, (In millions) Year Ended June 30, 2008 2007 2006 Operating Income (Loss): Client $ 12,537 $ 11,338 $ 10, Server and Tools 4,261 3,593 2, Online Services Business (1,309) (630) 194 Microsoft Business Division 12,182 10,696 9, Entertainment and Devices Division 267 (2,016) (1,329) Reconciling amounts (5,446) (4,457) (5,116) Consolidated $ 22,492 $ 18,524 $ 16,
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , establishes
standards for reporting information about operating segments. This standard requires segmentation
based on our internal organization and reporting of revenue and operating income based upon internal
accounting methods. Our financial reporting systems present various data for management to operate
the business, including internal profit and loss statements prepared on a basis not consistent with U.S.
GAAP. The segments are designed to allocate resources internally and provide a framework to
determine management responsibility. Amounts for prior periods have been recast to conform to the
current management view. Operating segments are defined as components of an enterprise about
which separate financial information is available that is evaluated regularly by the chief operating
decision maker, or decision making group, in deciding how to allocate resources and in assessing
performance. Our chief operating decision maker is our Chief Executive Officer. Our five segments are
Client; Server and Tools; Online Services Business; Microsoft Business Division; and Entertainment and
Devices Division.
The types of products and services provided by each segment are summarized below:
Financial Analysis Chapter 9 Page 10 of 20
accelerated amortization for depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity including certain legal settlements and accruals for legal contingencies. Significant reconciling items were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Summary of reconciling amounts: Corporate-level activity(1)^ $ (6,704) $ (4,777) $ (4,804) Stock-based compensation expense 844 123 (173) Revenue reconciling amounts^368 120 (7) Other 46 77 (132) Total $ (5,446) $ (4,457) $ (5,116) (1) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. No sales to an individual customer accounted for more than 10% of fiscal year 2008 or fiscal year 2007 revenue. Sales to Dell and its subsidiaries accounted for approximately 11% of fiscal year 2006 revenue. These sales were made primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2008 2007 2006 United States(1)^ $ 35,928 $ 31,346 $ 27, Other countries 24,492 19,776 16, Total $ 60,420 $ 51,122 $ 44, (1) Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations. Long-lived assets, classified by the geographic location of the controlling statutory company in which that company operates, were as follows: (In millions) Year Ended June 30, 2008 2007 United States $ 19,129 $ 9, Other countries 1,194^ 856 Total $ 20,323 $ 9,
Financial Analysis Chapter 9 Page 11 of 20
Foreign Operations
When a company establishes operation and/or trading
partners in a foreign country it will begin to transact in
foreign currencies. This will, in turn, create foreign currency
risks and associated gains and losses.
FAS 52 established the proper method of translating financial
transaction and financial statements from a foreign currency
to a domestic currency.
FAS 52 identifies three currencies
o Local Currency – the currency that the books and
records are maintained in
o Functional Currency – the currency that the foreign
business creates/destroys value in
o Reporting Currency – the currency used by the parent
company to report its financial results
If the local currency is the functional currency, then the
current rate method (translation) is used and all translation
gains/losses are reported as a component of Other
Comprehensive Income
If the local currency is not the functional currency then the
temporal rate method (remeasurement) is used and
translation gains/losses are reported in current earnings
Financial Analysis Chapter 9 Page 13 of 20
recognized in earnings in the same period as the gains and losses from the remeasurement of the assets and liabilities. These foreign currency forward contracts are not designated as hedging instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. We evaluate hedging effectiveness prospectively and retrospectively and record any ineffective portion of the hedging instruments in Other income (expense) on the Statement of Operations. We did not have any net gains (losses) recognized in Other income (expense) for cash flow hedges due to hedge ineffectiveness in fiscal years 2008, 2007 and 2006. Nor did we discontinue any cash flow hedges for a probable forecasted transaction that would not occur in fiscal years 2008, 2007, and 2006. As of June 27, 2008, our notional fair values of foreign currency forward contracts totaled $ million. We do not believe that these derivatives present significant credit risks, because the counterparties to the derivatives consist of highly rated financial institutions, we manage the notional amount of contracts entered into with any one counterparty, and we maintain limits on maximum tenor of contracts based on the credit rating of the financial institutions. The table below provides information as of June 27, 2008, about our derivative financial instruments, comprised of foreign currency forward contracts. The table is provided in U.S. dollar equivalent amounts and presents the notional amounts (at the contract exchange rates) and the weighted average contractual foreign currency exchange rates. (In millions, except average contract rate) Notional Amount Average Contract Rate Estimated Fair Foreign currency forward contracts: Value (1) British Pound $ 25 1.94 $ — Euro 27 1.55 — Singapore Dollar 115 1.36 — Thai Baht 510 32.18 (23) Chinese Yuan 20 6.75 — Malaysian Ringgit 2 3.26 — Japanese Yen 15 103.45 (1) Czech Koruna 15 15.94 — Total $ 729 $ (24)
Financial Analysis Chapter 9 Page 14 of 20
Pension and Other Post Employment Benefits
Many companies offer some sort of retirement benefits to
their employees.
The two most common types of retirement plans are:
o Defined Contribution (401-K)
o Defined Benefit (Pension plan)
Defined contribution plans are more common among newer
companies, whereas defined benefit is more common among
older and more mature companies
Material in the book is out of date, please refer to these
notes.
For STX:
Tax-Deferred Savings Plan - The Company has a tax-deferred savings plan, the Seagate 401(k)
Plan (“the 401(k) plan”), for the benefit of qualified employees. The 401(k) plan is designed to
provide employees with an accumulation of funds at retirement. Qualified employees may elect
to make contributions to the 401(k) plan on a monthly basis. Pursuant to the 401(k) plan, the
Company matches 50% of employee contributions, up to 6% of compensation, subject to
maximum annual contributions of $2,500 per participating employee. During fiscal years 2008,
2007 and 2006, the Company made matching contributions of $15 million, $15 million and $
million, respectively.
Financial Analysis Chapter 9 Page 16 of 20
before December 31, 2008 will continue to participate and accrue pension benefits after satisfying the eligibility requirements of these plans. In connection with these closures, the Avery Dennison Corporation Employee Savings Plan (“Savings Plan” — a 401(k) savings plan covering its U.S. employees) has increased the Company’s maximum matching contribution. This enhancement is only available to employees who are not eligible to participate in the Company’s defined benefit pension plans and early retiree medical plan. Plan Assets Assets of the Company’s U.S. defined benefit pension plans are invested in a diversified portfolio that consists primarily of equity and fixed income securities. Furthermore, equity investments are diversified across U.S. and non-U.S. stocks, including growth, value, and both small and large capitalization stocks. The Company’s target plan asset investment allocation in the U.S. is 75% in equity securities and 25% in fixed income securities, subject to periodic fluctuations in the respective asset classes above. As of December 31, 2007, the Plan assets included investments in the Company’s stock, which totaled approximately 630,000 shares. This amount, however, does not include any shares that may be held in index or other equity funds. Assets of the Company’s international plans are invested in accordance with local accepted practice, with asset allocations and investments varying by country and plan. Investments utilized by the various plans include equity securities, fixed income securities, real estate and insurance contracts. The weighted-average asset allocations for the Company’s defined benefit pension plans at year end 2008 and 2007, by asset category are as follows: 2008 2007 U.S. Int’l U.S. Int’l Equity securities 60 % 43 % 74 % 55 % Fixed income securities 40 49 26 35 Real estate and insurance contracts – 8 – 10 Total 100 % 100 % 100 % 100 % Postretirement Health Benefits The Company provides postretirement health benefits to certain U.S. retired employees up to the age of 65 under a cost-sharing arrangement, and provides supplemental Medicare benefits to certain U.S. retirees over the age of 65. The Company’s policy is to fund the cost of the postretirement benefits on a cash basis. The Company uses a fiscal year end measurement date for its postretirement health benefit plan. While the Company has not expressed any intent to terminate postretirement health benefits, the Company may do so at any time.
Financial Analysis Chapter 9 Page 17 of 20
Measurement Date The Company uses a calendar year end measurement date for both its U.S. and international plans. Plan Assumptions Discount Rate - The Company, in consultation with its actuaries, annually reviews and determines the discount rates to be used in connection with its postretirement obligations. The assumed discount rate for each pension plan reflects market rates for high quality corporate bonds currently available. In the U.S., the Company’s discount rate was determined by evaluating several yield curves consisting of large populations of high quality corporate bonds. The projected pension benefit payment streams were then matched with the bond portfolios to determine a rate that reflected the liability duration unique to the Company’s plans. Long-term Return on Assets - The Company determines the long-term rate of return assumption for plan assets by reviewing the historical and expected returns of both the equity and fixed income markets, taking into consideration that assets with higher volatility typically generate a greater return over the long run. Additionally, current market conditions, such as interest rates, are evaluated and peer data is reviewed to check for reasonability and appropriateness. Healthcare Cost Trend Rate - For measurement purposes, a 7% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2009. This rate is expected to decrease to approximately 5% by 2011. A one-percentage-point change in assumed health care cost trend rates would have the following effects: One- One- percentage- percentage- point point (In millions) increase decrease Effect on total of service and interest cost components $ .01 $ (.01) Effect on postretirement benefit obligation 1.05 (1.24) Plan Balance Sheet Reconciliations The following provides a reconciliation of benefit obligations, plan assets, funded status of the plans and accumulated other comprehensive income:
Financial Analysis Chapter 9 Page 19 of 20
U.S. Postretirement Pension Benefits Health Benefits 2008 2007 2006 2008 2007 2006 U.S. Int’l U.S. Int’l U.S. Int’l Weighted-average assumptions used for determining year end obligations: Discount rate^ 6.60%^ 5.74%^ 6.55%^ 5.53%^ 5.90%^ 4.67%^ 6.60%^ 6.30%^ 5.75% Rate of increase in future compensation levels 3.59 2.59 3.59 2.66 3.59 2.90 – – – The projected benefit obligation and fair value of plan assets for pension plans with projected benefit obligations in excess of plan assets for both the U.S. and international plans were $1,057.9 million and $706.9 million, respectively, at year end 2008 and $634.3 million and $485.8 million, respectively, at year end 2007. The accumulated benefit obligation and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets for the U.S. and international plans were $797.4 million and $498.9 million, respectively, at year end 2008 and $597.6 million and $467.7 million, respectively, at year end 2007. The amount in non-current pension assets represents the net assets of the Company’s overfunded plans, which consist of a few international plans. The amounts in current and non- current pension liabilities represent the net obligation of the Company’s underfunded plans, which consist of all U.S. and several international plans. U.S. Postretirement Pension Benefits Health Benefits 2008 2007 2006 2008 2007 2006 U.S. Int’l U.S. Int’l U.S. Int’l Weighted-average assumptions used for determining net periodic cost: Discount rate Expected long^ - term rate 6.55%^ 5.53%^ 5.90%^ 4.67%^ 5.75%^ 4.49%^ 6.30%^ 5.75%^ 5.50% of return on plan assets 8.75 6.6 6 8.75 6.30 8.75 5.77 – – – Rate of increase in future compensation levels 3.59 2.66 3.59 2.90 3.59 2.79 – – – Plan Contributions In 2009, the Company expects to contribute approximately $33 million to its U.S. pension plans and a minimum of $14.2 million to its international pension plans, respectively, and approximately $2.8 million to its postretirement benefit plan.
Financial Analysis Chapter 9 Page 20 of 20
Derivatives
A derivative is a financial instrument whose value is
derived from another financial instrument, index, rate or
commodity price
Examples:
o Options (puts/calls)
o Forwards
o Futures
o Swaps (Interest Rate Swaps/Currency Swaps)
General purposes
o To hedge risk
Fair value changes
Cash flow changes
o To speculate
All derivatives are recorded on the balance sheet at Fair
Value
o Fair Value changes flow through current earnings for
Fair Value hedges
o Fair Value changes flow through Other
Comprehensive Income for Cash Flow hedges (and
are recycled out when hedged cash flow impacts net
income)
o Fair Value changes for speculative investments in
derivatives are reported in current earnings
