Market Place: Future May Be More Uncertain for Technology
June 20, 2001
By GRETCHEN MORGENSON
With the Nasdaq composite index up 23 percent from its April lows, investors are clearly betting that the worst is over for technology stocks. But according to an extensive new report from Merrill Lynch that examines the financial results of 37 technology favorites, those bets may be premature.
The study shows that even at their current depressed levels, technology shares remain expensive. That is because long before the economy turned south and even as their reported earnings soared, technology stocks' true earnings had begun deteriorating.
"On average, real tech earnings are less than they appear," said Steve Milunovich, technology strategist at Merrill Lynch. "As a result, valuations are higher than investors think."
The earnings slide among technology companies started three years ago, but the deterioration was hidden from many investors' views by accounting gimmickry and a roaring stock market.
Everybody knows that a rising stock market lifts all boats. But as Mr. Milunovich's study shows, the market's big surge that began three years ago lifted the largest technology stocks far higher than it did other sectors. Now, with the overall market in the doldrums, technology companies' earnings in future quarters will lack a lot of the juice that made them seem so superpowered in the recent past.
Perhaps the single biggest contributor to technology stock earnings during the mania was the use of stock options, which these companies bestowed on employees in lieu of higher salaries. Technology companies benefited two ways from options. First, because the cost of stock option grants are not considered a wage expense, the earnings at companies giving out large option grants looked better than the results at companies that paid cash to workers.
In addition, companies receive sizable tax deductions from stock options when they are exercised. That is because employees who exercise their options must pay income tax on the difference between the option's strike price and the current market price, and companies receive a tax deduction in that amount. These tax benefits show up in a company's operating cash flow.
Mr. Milunovich and Gary Schieneman, an accounting analyst at Merrill Lynch, computed what these two benefits contributed to earnings at the technology companies they studied, including America Online, now AOL Time Warner; Applied Materials; Microsoft; Sun Microsystems; Juniper Networks; and Qualcomm.
Had the companies considered their options a wage cost, their 2000 earnings would have been reduced an average of 60 percent. More specifically, earnings would have been 49 percent lower at America Online, 40 percent lower at Nortel Networks and 63 percent less at Lucent Technologies if options had been accounted for as an expense.
The tax deductions associated with employee option grants also gave these companies a big boost, on average accounting for 48 percent of their operating cash flows. That is double the contribution made by option grants in 1999.
For instance, stock option tax benefits made up 67 percent of operating cash flow at Sun Microsystems, 41 percent at Cisco Systems, 34 percent at Yahoo and 30 percent at Juniper Networks.
Mr. Milunovich said that these tax benefits helped mask a severe deterioration in technology companies' cash flows that began three years ago. When he compared cash flows to earnings, he found the ratio fell from 2.2 to 1 in 1998 to 1.2 to 1 last year. But when he excluded the tax benefits owing to option exercise, cash flows declined to roughly equal the level of earnings. When a company's cash flow falls below its earnings, it indicates the inclusion of significant noncash items in a company's income.
Thanks to the desultory stock market, both stock option benefits are now becoming banes. Falling share prices have made many employees' options worthless; as of late March, Mr. Milunovich estimated that 41 percent of the options handed out by the companies he studied were underwater.
Mr. Milunovich suspects that the companies with large numbers of underwater options will reprice them in coming months to reflect depressed stock levels. As a result, he says he thinks some managements may have an incentive to keep their stocks' prices depressed until the period — six months and one day — passes that repricings can occur without a company taking a hit to its earnings under accounting rules.
According to Mr. Milunovich, it is more important than ever for investors in technology stocks to look closely at these companies to assess their earnings. "Cash is king," he said. "Tech investors who haven't focused on cash flow have to start looking at it." And for now, anyway, they may not like what they see.
nytimes.com |
