Two interesting pieces in response to my question about expensing stock options - The first from Smet~ of Tom Hua's site and the second, with a slightly different angle, from Little Joe of Boom, Bust, Recoveries thread. I'll be looking to short at least a few of the ones mentioned if we ever get a bounce --gggg
News from The Globe and Mail
The hidden costs of stock options
00:00 GMT-04:00 Wednesday, July 10, 2002
Cognos Inc. reported a profit of $19.4-million (U.S.) in fiscal 2002, based on U.S. accounting standards. The company's chief executive officer said Cognos had a "great" fourth quarter, and its earnings handily beat analysts' expectations.
There was a catch, but one only sophisticated analysts and investors could appreciate. It was the cost of the technology company's employee stock options.
If Ottawa-based Cognos had included its options cost as a business expense on its income statement -- an accounting treatment that was not required -- its 2002 profit would have been wiped out, and Cognos would have lost $6.1-million in the year ended Feb. 28.
Canadian accounting rules have not required companies to disclose the costs of their stock options -- although that is changing this year -- but a large number have already revealed the information because they also report under U.S. accounting principles.
A Globe and Mail analysis shows that Cognos is hardly unique. A number of Canada's best-known companies have large stock option expenses, especially in relation to the size of their profits.
Hummingbird Ltd.'s $3.7-million profit in 2001 would have become a $12.3-million loss if the cost of stock options were included in the Toronto company's calculation.
ATI Technologies Inc. of Markham, Ont., would have seen its 2001 loss soar to $31.2-million from $17.1-million with option costs. Celestica Inc. of Toronto lost $51.3-million last year, which would have almost doubled to $97.1-million including option costs. Waterloo, Ont.-based Research In Motion Ltd.'s loss of $7.6-million last year would have more than doubled to $19.4-million including options.
Two companies in particular had enormously high options costs in 2001. Nortel Networks Corp. of Brampton, Ont., issued stock options valued by the company at $1.7-billion, while JDS Uniphase Corp. of San Jose, Calif., and Ottawa had option costs worth more than $440-million.
These sort of huge expense levels are changing the way shareholders think about options.
For many years, stock options were widely popular with both company executives and their shareholders. Shareholders believed executives with options had more incentive to work to increase the company's share price, thus aligning their interests with those of shareholders.
But more recently, as stock prices have fallen and scandals have swept through corporation boardrooms, conventional wisdom has been questioned. Many investors are growing skeptical that stock options have worked as intended in theory, and they are especially concerned that the cost of options is not reflected on income statements.
"I think initially it started off as a good thing," says Bill Mackenzie, president of shareholder advocate Fairvest Corp. "But it became such a huge payola. It just became too much of a good thing. Maybe as a small incentive it might have been a nice thing to have, but it just got too insane."
Dale Richmond, CEO of the Ontario Municipal Employees Retirement Board (OMERS), said he believes the tide started to turn around 1998 as stock option grants spread to more companies and in far larger amounts. They became especially popular for high-tech companies and smaller startups.
"It's grown more quickly than many people would have thought," Mr. Richmond said. "It's an issue of how you share the wealth of a company. As a shareholder, we support that all stakeholders should share. But we don't think any group should share excessively or to the detriment of others."
OMERS and other large institutional investors in Canada have begun a lobbying campaign to urge Canadian companies to record the expense of their stock options on their income statements, hoping that such disclosure will ultimately curb the tendency to grant excessive options. So far, only two major companies -- Bank of Montreal and Toronto-Dominion Bank -- have agreed to do so, and they are both companies with low option costs for the size of their profits.
"If you wanted to be cynical, it's not surprising that Microsoft was not the first company to expense options," said TD chief financial officer Dan Marinangeli.
TD estimates its earnings per share will drop by 3 to 5 cents (Canadian) when it records the expense of its options next year -- a modest cost for a company with earnings per share of $2.07 last year. Microsoft Corp. of Redmond, Wash., by comparison, would have seen its profit fall by one-third last year if it had expensed the $2.3-billion (U.S.) cost of its options.
The lack of exposure about the real cost of options is only one of many criticisms that shareholders are beginning to air. There is a growing list of concerns about the impact of large option programs, and the greatest worry is the cost to shareholders caused by the dilution of large stock option programs.
Stock options give employees the right to buy shares from the company in the future at a fixed price. When they exercise their options, employees pay their employer cash in exchange for shares. That means many companies issue new shares from treasury to honour the options, which can greatly increase the number of shares outstanding for some companies. Over time, existing shareholders have an increasingly diluted ownership stake in the company, and, therefore, a lower stake in the company's profit.
If stock option programs are small, dilution is minor. As they've grown, however, dilution has become far more significant. Cisco Systems Inc. of San Jose, Calif., issued options valued at $2.6-billion last year alone, while New York-based AOL Time Warner Inc. issued $1.4-billion of options.
In Canada, most companies currently do not provide estimates of their option costs unless they choose to report under U.S. accounting standards. But a look at available data shows a number of significant option programs among Canadian companies. Last year, for example, Toronto-based Four Seasons Hotels Inc. issued options worth $31-million (Canadian), which would have cut its profit by more than 50 per cent if the cost had been recorded as an expense. Barrick Gold Corp. of Toronto issued options valued at $31-million (U.S.) last year, which would have reduced its profit by 32 per cent if the expense had been recorded. Vancouver-based QLT Inc. issued options worth $40-million (Canadian) last year, for a potential 35-per-cent drop in profit if expensed.
James Gillies, a corporate director and founding dean of the Schulich School of Business at York University, says shareholders should see the risks of this dilution measured as a cost on companies' income statements.
"With the experience we've had with Enron and the meltdown of the technology bubble, surely we should be looking for ways to make fair and complete and proper statements on the earnings capacity of companies," he says.
Mr. Richmond said OMERS is voting against any employee stock option programs that lead to excessive dilution for shareholders. OMERS rejects options programs that would increase the number of shares outstanding by more than 10 per cent, and might reject even 5-per-cent dilution for large or mature companies. In a single month this spring, OMERS voted 97 times on various option changes, and voted against 48 of them.
Of course, companies don't have to issue new shares from treasury to honour their employee options. Many companies buy shares in the open market to avoid dilution. But that means there's often a huge cash drain, which doesn't show up on the earnings statement either.
If an option is exercisable at $10, and the employee waits until the market price is $100 to cash it in, the company receives a $10 payment from the employee and hands over a share it had purchased in the marketplace for $100. Some investors believe this is not a highly profitable way for a company to spend its cash.
Even new shares issued from treasury in this scenario are expensive, since they could have been sold in the market for $100, rather than handed over to employees for $10.
As well, Canadian companies cannot write off the expense of stock options as a business cost similar to salary costs, so companies forgo a potential tax benefit by issuing options as an alternative to other methods of compensation.
"There's no cash cost, that's clear," says Paul Cherry, chairman of Canada's Accounting Standards Board. "But you lose a tax deduction. From my point of view, the better approach is to put all the [compensation choices] on the table and let people understand what the pros and cons are. There are all sorts of motivational issues that people can judge for themselves."
Shareholders are also increasingly concerned about the psychological impact on executives when there are extremely large stock option programs. The fear is that a CEO who is sitting on, say, $100-million of stock options has every reason to think short term, knowing that he will soon be enormously wealthy.
This can create an enormous incentive to ensure the share price does not dip, reducing the value of options before they can be exercised. Some shareholders believe this has enhanced the pressure on executives to cut corners to ensure they meet or exceed profit targets.
"You slowly shift your focus from a corporate manager to a stock promoter," says Tom Caldwell, chairman of Caldwell Securities Inc. in Toronto. "Now, beating quarterly earnings becomes very important to you, because you have $50-million or $100-million of value tied up in these things."
The fact that some executives own options, but don't own much stock, also means that they don't have the same downside risks, some shareholders argue. When a stock price drops, investors who paid money for shares face an immediate loss on their investment. An executive holding options has put no money on the table, and faces no cash loss. Even if options become worthless, an executive loses the potential gain, but doesn't lose a personal cash investment.
"He doesn't have to worry about downside, he only has to worry about upside," Mr. Caldwell said.
In the same vein, there are concerns that options have not actually led to employee share ownership, but only to employees owning highly leveraged options for a limited period of time. That's because most employees exercise their options and immediately sell their shares to lock in their profits. Only a small number of companies require employees to keep some of the shares they receive from option programs, giving them a direct ownership interest for the longer term.
Bill Dimma, a corporate director and author of the new corporate governance book Excellence in the Boardroom, says executives and corporate directors should be required to retain some shares when they exercise options. He argues directors in particular should not sell shares from exercising options, except to cover their costs, until they retire from the board.
"I just cringe at the insider trading reports that show directors selling their shares. What kind of a signal is that to the market? It's a terrible signal."
Mr. Dimma also advocates options programs that include performance hurdles before the options vest. That means a company has to outperform its peer group or meet internal targets for returns before the options are handed over to executives.
"Rewarding people with excessive grants that pay off simply because the whole market went up in the 1990s just doesn't make any sense," he says.
Perhaps the impact of options that has been most difficult to analyze is their effect on management decisions about how a company should spend its cash.
Some investors now believe, for example, that options are a factor in the long trend toward fewer companies paying dividends. The concern is that executives have a bias against dividends because the cash goes to shareholders, but not to option holders. Mr. Mackenzie says dividends also tend to make a company's shares far less volatile, and thus less likely to soar.
"[As an option holder,] you want volatility because it doesn't necessarily hurt you, and it might give you an opportunity to exercise at a higher price than if there was no volatility," he says.
Similarly, some investors fear that options have increased the popularity of share buyback programs, in which companies purchase their own shares in the open market to boost their stock price. In the past, buybacks were common when companies believed their shares were undervalued. But in the boom market of the late 1990s and 2000, there was a large business in buybacks even when markets were at their peak and shares were considered expensive.
The accusation is that some executives with options have used buybacks to boost the share price in the short term, even when they are not a cost-effective investment choice for long-term growth.
Mr. Richmond at OMERS notes that these sorts of items on the long and growing list of concerns about stock options only become relevant when options programs are large.
"If they aren't excessive, many of those things don't kick in," he says. "But if it's excessive and if it's a very great part of the compensation . . . then those things can result."
Shareholders concerned about option costs have focused most of their attention on urging companies to voluntarily record the expense of their options on their income statements. They believe disclosure would discourage companies from thinking of options as "free" compensation that carries no cost.
Accounting regulators, however, have been cautious in their response.
Canadian regulators have taken their lead from the United States. The U.S. Financial Accounting Standards Board (FASB) considered mandatory expensing of options, but dropped the idea years ago after companies -- and particularly the technology industry -- mounted a furious lobbying campaign. Instead, FASB only requires that companies disclose the value of their options in a note to their financial statements, and it is usually buried deep in the fine print.
In Canada, the Accounting Standards Board (ASB) had a similar debate, and concluded that this country could not adopt mandatory expensing of options after the United States had rejected it, Mr. Cherry said. Instead, the ASB adopted the U.S. rule.
Starting with 2002 financial statements, Canadian companies will also have to either explain the value of their annual option grants in a note to financial statements, or include them as an expense on the income statement. As in the United States, almost all companies are choosing the former.
Cognos, for example, is not going to expense the cost of its stock options, spokesman Sean Reid said, but will comply with disclosure requirements under generally accepted accounting principles. He said Cognos has no comment on the broader debate about mandatory expensing of options.
Mr. Cherry says he believes mandatory expensing of options is coming soon. Nine months ago, he said the change was impossible given widespread opposition. But with accounting scandals mounting, there is greater willingness to make major changes. The International Accounting Standards Board is expected to issue a report later this year endorsing the mandatory expensing of stock options, and Mr. Cherry believes U.S. regulators may now be willing to adopt a new international standard.
"I think we will eliminate this one last loophole. The mood has changed dramatically," he says.
Mr. Gillies from York University says investors need a mandatory rule requiring companies to expense their options. Otherwise, he believes few companies will voluntarily accept the added expense.
"There are certain things that need to be regulated," he said. "I sit on an awful lot of boards, and the reality is that change to deal with external diseconomies never takes place without regulation. It never does."
Mr. Dimma, meanwhile, says shareholders pressing for change have to acknowledge the impact of expensing stock options. Corporate profits will fall, especially in industries that use options most, such as the technology sector.
"And the effect on the stock market, which loops back on the economy, could be significant," he adds. "So it's got to be done carefully. But subject to doing it right, and maybe introducing it fairly gradually, I think the principle does make sense."
For their part, investors say they are willing to accept lower earnings if the numbers are accurate. They argue shareholders are already bearing the cost of options, but it is simply hidden from them by keeping it off the books.
"If they're not expensed, earnings are artificially high," says Mr. Richmond at OMERS. "We want to know what the commitments of these companies are, so that we can make our own risk assessments of the extent to which we want to invest in them."
Copyright © 2002 The Globe and Mail
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Company Focus
11 stocks the accountants left hanging
Wave goodbye to EBITDA, the artificial measure of corporate health at the heart of current scandals. Now that investors and analysts want to follow cash instead, some big names could suffer.
By Michael Brush
To the scrap heap of market-bubble casualties like busted pension plans and downsized portfolios, investors may soon add a lesser-known accounting tool that’s still used to prop up many stocks. Car? Home? Home equity?
One application.
Up to 4 loan offers.
Though bookkeeping doesn’t make for gripping reading, this change is worth figuring out because you may be holding some potential victims in your portfolio -- especially if you own stocks in the wireless, cable and media sectors. We’ll get to vulnerable stocks in a moment. But first, some background.
In the crosshairs is a fairly arcane accounting measure some financial experts have used over the years to value companies known as EBITDA. That stands for earnings before interest, taxes, depreciation and amortization.
Though it is now in disrepute, EBITDA is a sensible valuation tool when reported net income gives a distorted view of a company’s potential. This happens when companies that made big, one-time investments long ago end up “paying for them” for years because accounting rules force them to spread those costs out over, say, decades.
If so, those costs get chalked up each quarter in the form of ongoing interest, depreciation and amortization charges. Depreciation and amortization are simply the cost of buying or building real assets and intangible assets, such as a trademark or license, spread out over time.
For accountants, it makes sense to spread out these costs, because you are supposed to match expenses to revenue over time. But you can also make a case that for many companies, those costs will go away sooner or later. So why not put your hand over them now -- and look at EBITDA -- to get a sense of what those companies are really worth?
You can, in industries where big, up-front investments truly are one-time costs. Think hotels and casinos, or real estate investment trusts, says Sean Reidy, a manager at Olstein Financial Alert Fund. The initial investment in land was a must, for example, but it probably does not have to be repeated.
Real results distort "reality"
From these humble origins years ago, however, EBITDA branched out as a valuation tool into many industries such as cable and wireless where a lot of debt is needed to make large investments in expensive plants and equipment. These investments, of course, lead to big interest and depreciation costs, which bring down reported income each quarter. Cover ‘em up and you have a healthier-looking company.
The logic managers might use to employ EBITDA was this: "We have a business whose results are distorted for now by the interest and investment charges required to get us going. If we strip those issues away, you get a better picture of how our business works and what the profit potential is."
This kind of thinking always confounded accounting purists like Doug Carmichael, the director of the Center for Integrity in Financial Reporting at Baruch College in New York. “When EBITDA moved out into other industries, it made a whole lot less sense because, in most industries, the capital base needs to be maintained,” says Carmichael. “While deprecation is not a perfect representation of what needs to be spent to maintain capital, it is one way to measure a very necessary cost of doing business. EBITDA does not account for all ongoing expenses.”
Criticism like this, however, went pretty much ignored throughout the bubble years of the late 1990s as EBITDA came to be used to justify otherwise questionable valuations. “The reason EBITDA became more widespread is because many companies did not look particularly great by more conventional measures,” says Donn Vickrey, with Camelback Research Alliance in Arizona, which provides financial statement analysis for money managers. “A great example would be some of the Internet companies who invented all sorts of creative reporting to mask the fact that they were not fundamentally sound.”
But EBITDA as a valuation tool also took hold in the wireless, telecom, cable and media sectors, all industries where high debt and capital expenses lead to huge ongoing interest and depreciation charges that knock down -- or wipe out -- reported income.
“Many of these companies had various warts like high interest charges, and they wanted to make things look better,” says Carr Conway, a former Securities and Exchange Commission official who now works as a forensic accountant with Dickerson Financial Investigation Group in Denver. “So companies said, ‘Let’s present EBITDA and disregard these terrific interest charges.’”
Lots of investors gladly went along until WorldCom (WCOME, news, msgs) blew up because of alleged accounting fraud last month. The telecom company was a natural for the use of EBITDA as a valuation tool because it had no free cash flow or positive earnings. But the WorldCom disaster now has many analysts rethinking EBITDA because it showed how easily this tool can be fudged through the use of accounting shenanigans.
Cash flow is king again
Instead, investors are focused more than ever on free cash flow, or the amount of real cash on hand after all the bookkeeping. The reason is simple. Cash levels are harder to distort. To calculate free cash flow, go to the company’s “consolidated statement of cash flows” in the financials and subtract the changes (cash additions and subtractions) that take place in all three sections -- cash from operations, investing and financing.
WorldCom discredited the idea that you can use EBITDA as a cornerstone measure for investing, says Thomas Lee, a wireless-telecommunications analyst at J.P. Morgan. “Investors don’t want to take the risk of investing with EBITDA stories because they don’t want to trust the accounting. Equity investors want to understand how much cash a company is burning or throwing off. So metrics move to cash flow. This is going to affect a lot of industries.”
“No one in his right mind would ever use EBITDA, unless you were a sell-side analyst trying to create a story that values a business in an exorbitant way,” adds Juan Colina of REL Consultancy Group, a Boston firm that advises companies on how to manage cash and capital more efficiently. “EBITDA is used by investment bankers and sell-side analysts because they want to sell a story. But the story is a bad story. EBITDA should never be used as a metric for any serious thinking.”
Who's vulnerable to a shift away from EBITDA?
If EBITDA really does get tossed out in favor of free cash flow, which companies might be affected the most? To come up with a short list of candidates, we asked Camelback Research Alliance to screen for companies whose EBITDA exceeded free cash flow by the most. Among the biggest offenders in sectors traditionally valued by EBITDA, we looked for the companies with high valuations compared to their peers, on a price-to-sales basis.
According to Olstein’s Reidy, some of the most vulnerable stocks lie in the cable and broadcasting sector. Many of these companies have a lot of debt, light or negative free cash flow, and a need to keep spending. Four with relatively rich valuations and a fairly big gap between EBITDA and free cash flow are: Cox Communications (COX, news, msgs); Comcast (CMCSK, news, msgs); Beasley Broadcast Group (BBGI, news, msgs) and Salem Communications (SALM, news, msgs).
In the movie and entertainment business, 4Kids Entertainment (KDE, news, msgs) and Pixar Animation Studios (PIXR, news, msgs) have relatively rich valuations and fairly large differences between EBITDA and free cash flow.
Companies such as AT&T Wireless Services (AWE, news, msgs) and Nextel (NXTL, news, msgs) in wireless and telecom look pretty safe because they have a decent amount of free cash flow backing EBITDA. But Rogers Wireless Communications (RCN, news, msgs), United States Cellular (USM, news, msgs) and Price Communications (PR, news, msgs) look more vulnerable because they don’t come up as strong on this front -- and they still have relatively high valuations.
Telecom companies with above-industry values and a fairly large spread between EBITDA and free cash flow are BellSouth (BLS, news, msgs), SBC Communications (SBC, news, msgs) and PanAmSat (SPOT, news, msgs).
If you go hunting in these areas for suspects that look pricey because they are light on free cash flow, keep in mind there’s a chance that a solid economic recovery could mask many of the remaining accounting problems and make investors forget all about the issue. If so, EBITDA valuations for companies that otherwise don’t cut it might come back in style.
And because of the way Wall Street works, some analysts question if EBITDA will ever really go away. “EBITDA will not be thrown out because the investment bankers love it,” says Colina of REL Consultancy Group. “It makes their products look better than they are.” Baruch’s Carmichael agrees, because there will always be investors who need to find the latest “hot stock,” and likewise investment bankers and analysts eager to sell it to them.
“Will EBITDA go away? Will everyone go to cash valuation? Probably not,” says Carmichael. “Cash valuation doesn’t capture the next big thing.”
As of the date of publication, Michael Brush owned or controlled no shares mentioned in this article.
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