Taking the long haul to open skies

Outlook

BOB AYLING must wonder whether he will be drawing his pension by the time British Airways' alliance with American Airlines is approved. On present timing the two partners will not get regulatory clearance to take to the air until this time next year - three and a half years after the link-up was first announced.

If it is any consolation, talks on the transatlantic "open skies" agreement that must accompany any BA-AA alliance have been going on even longer. They not only predate Tony Blair, they predate John Major. This week the talks have resumed in London for the first time since Mr Blair came to power in May last year.

Perhaps it will be worth the wait since the prize is large. In return for allowing BA and American to exert a monopoly on a number of key transatlantic routes, the market between Heathrow and the US will be opened up to any carrier. This largely means other US airlines.

This will require BA to give up some of its slots at Heathrow to its rivals - 267 is the figure the regulators have in mind. BA and AA appear to be coming around to the idea that these should be given away for free, rather than sold, which is an act of some magnanimity as they are valued at around pounds 500m.

That, however, will not automatically pave the way for the signing of an open skies deal. The Americans are old hands at these bilateral agreements. They have signed 31 such deals with other countries and expect the open skies agreement with Britain to follow the same formula.

The British negotiators, on the other hand, realise that access to Heathrow is worth more than a space on the apron at any other airport in the world. Certainly, it is much more valuable than access to Frankfurt, Paris or Amsterdam.

For that reason they want to cut a special deal with the US. This means that all sorts of bolt-on goodies are on the table. The UK wants to raise the issue of cabotage - the right of UK carriers to operate domestic US services - and get a commitment from the US to ease their restrictions on airline ownership. They also want to exclude the "fly America" clause from a new bilateral which requires US government personnel to fly on US airlines.

These are contentious issues which means that none of the participants expect a breakthrough when the talks conclude in London tomorrow. In fact it will probably take at least two more rounds to make progress, meaning that it could take until next spring or even longer to reach agreement on open skies.

Given what is at stake, and the bargaining chip the UK has in its grasp, it is worth playing the long game. Even if Bob Ayling has qualified for a bus pass by the time the talks reach a successful conclusion.

Microsoft

SOMETIMES THE biggest stories are those sitting there on your own front door step, but for some reason everyone chooses to ignore them. The accounting implications of Microsoft's employee stock option scheme might not immediately seem like one of these, but that's because most people do not realise the extent to which the software goliath has been paying its workers in shares.

As an example of the speculative froth that has built up on Wall Street over the past five years, the Microsoft employee share option scheme, taken together with the company's hedging activities in its own stock, takes some beating. Indeed what Microsoft has built for itself could reasonably be viewed as a financial pyramid.

A potentially vast, unrecognised liability has been accumulated. And its relevance to us here in the UK? Microsoft's share price has so far proved remarkably resilient to the correction in markets. Even a worldwide slump is not going to stop Bill Gates, is the general view. But can this really be true? Is not the rise and rise of the Microsoft share price the Wall Street bubble in microcosm?

Like most US technology companies, Microsoft has had to promise big stock options in order to attract the calibre of employee it needs to stay competitive. Its own chief financial officer has admitted that but for payment in stock yet to be exercised, the company's wage bill - its main cost - would be two to three times higher than it is. The effect has been to establish a potential liability running to some $34bn, or eight times annual net income.

Some of this liability has been hedged, either by buying Microsoft stock directly, or by selling put options in the market - that is selling investors the right to put their shares in Microsoft on the company at a predetermined price. But a large and undefined part of it appears not to have been.

According to Parish & Company Portfolio Managers, an Oregon-based consultancy, if this liability was adequately accounted for, then Microsoft and some other leading Wall Street technology companies wouldn't make any money. Already, the valuations put on these companies might seem stretched enough at upwards of 50 times earnings, but if it were generally accepted that the emperor had no clothes at all, then they would seem like pure fantasy.

What Microsoft should perhaps be doing given the importance of these options as a way of remunerating staff is accounting for them against profit as if they were an ordinary cost. Present accounting rules in the US do not require that Microsoft do this, for it would destroy the illusion of profit if they did.

And yet the only reason people want to go and work for these companies is that they are offered stock in an enterprise whose share price only seems to go up. It can readily be seen that Microsoft and others have created for themselves not only a very large potential liability, but also a serious operational problem should the stock head south, as it is now beginning to, and employees' expectations are disappointed. But that, as they say, is only the half it.

Microsoft has also been selling put options in its own stock on a grand scale. You may well ask what a serious commercial company is doing speculating in its own stock, but actually they do it all the time these days - a process we have come to know as share buybacks.

In theory, selling a put option is no different. But in practice it may very well be, since Microsoft actually books the money it earns from selling options in its own shares. Last year it earned hundreds of millions of dollars in this manner. If the stock plunges through the value of the option, as it is almost bound to in a crash, then Microsoft has to fund the difference. Again this would seem a highly dangerous and speculative activity for a company whose business is not that of investment banking but one of designing and selling computer software.

It may seem odd that a company made up of such self evidently clever people could allow itself to become as exposed as this. You could argue that if the stock collapses, then it's nobody's problem but that of the employees, since it is the value of their share options that disappears down the plug hole and Microsoft's liability with it.

But just as the illusion of profit would be shattered by proper accounting for this form of remuneration, so too would be the illusion of wealth once the fragility of the structure it is built upon is realised. Isn't that rather what's happening to financial markets as a whole right now?

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