Will Tech Companies Get Called on Options?
By Bill Alpert
Barrons Online
February 18th, 2002
Reform is on a roll, after Enron. Accounting reformers have renewed calls for companies to count the costs of stock options. Few issues affect tech-industry profits as broadly as option accounting. Without the padding of reported profits that current rules allow, tech-stock valuations would look very pricey. Wednesday, Democratic Sen. Carl Levin of Michigan, Republican Sen. John McCain of Arizona and several other senators introduced a bill that would force companies either to recognize the cost of stock options on the income statement, or to give up option-related tax deductions.
The option-accounting war has another active front. The International Accounting Standards Board, in London, is considering an option-expensing rule as one of its first initiatives to teach the world to ka'ching in perfect harmony.
Eight years ago, when accounting rulemakers first suggested the expensing of options, they were bullied into retreat by New Economy executives, financiers and their political allies, who included such erstwhile do-gooders as Democratic Sen. Joe Lieberman of Connecticut and former Sen. Bill Bradley. A compromise rule, grudgingly issued in 1995 by the Financial Accounting Standards Board, has allowed firms to expense options if they choose, or merely to disclose in a footnote how option costs would have nicked the income statement. Guess which presentation they choose.
When a company pays employees with stock options, instead of just cash, the firm still incurs a cost, because options represent dilutive slices of the business. By leaving that cost out of earnings reports, firms overstate their profits. A Bear Stearns study says that if companies in the Standard & Poor's 500 had expensed their options in the year 2000, reported earnings would have been 9% lower. And Merrill Lynch figures that tech company earnings in 2000 would have been 60% lower because of their hefty option programs. If tech firms are forced to report option expenses, Merrill Lynch tech strategist Steven Milunovich thinks tech-stock valuations will suffer. Tech stocks already look expensive, he told clients Thursday, and option expenses would make them look dearer still.
The Nasdaq slipped 1%, to 1805. Dell and Brocade reported good quarters, but were cautious about the current period. Only Applied Materials said business was picking up.
Investors like Warren Buffett long have urged firms to recognize options as an expense. A worldwide survey of more than 1,900 analysts, reported in November by the Association for Investment Management and Research, showed that 83% wished that options were expensed on income statements. Perhaps that's because only two-thirds said they bothered to look for option information in an obscure footnote.
For the benefit of the other third, I studied the footnotes of some celebrity firms. Counting options as an expense would have trimmed Microsoft's reported earnings for its June 2001 fiscal year to $5.1 billion, or 91 cents, from $7.3 billion, or $1.32 a share. At the time it reported, Microsoft shares would've been valued at 77 times its option-accountable earnings, instead of 53 times. Cisco Systems, instead of reporting a loss of $1 billion, or 14 cents, for its July 2001 fiscal year, would have shown a loss of $2.7 billion, or 38 cents.
Not counting option expenses, Hewlett-Packard reported October 2001 year earnings of $624 million on continuing operations, or 32 cents. Counting options, H-P had a loss of $65 million, or 3 cents. Sans options expense, Applied Materials reported $508 million, or 60 cents. Counting options, Applied earned $291 million, or 24 cents, and the semiconductor equipment firm would've been valued at 163 times earnings, instead of 65 times.
Brocade Communications Systems, the leading- edge networking vendor, reported October year earnings of $2.8 million, or one cent. But if Brocade counted the cost of stock options, it would've shown a huge loss of $592 million, or $2.68 a share, and the trailing earnings multiple on Brocade's $30 shares would go from astronomical to incalculable. Tony Canova, Brocade's chief financial officer, says his firm's October 2001 year option awards were exceptionally large, with half issued to replace higher-priced options awarded when Brocade enjoyed a bubble market share price above 100. Brocade hired most of its employees before the stock market peaked, and Canova says Brocade issued new options in its October 2001 year to retain those workers.
Before Enron gave ammo to accounting reformers, Big Business was massing for an assault against the option expensing proposal of the International Accounting Standards Board. In December, IASB chairman David Tweedie got a critical note from the trade association of U.S. venture capitalists, co-signed by tech firms from Broadcom to Xilinx, and groups from the Biotechnology Industry Association to the U.S. Chamber of Commerce. Expensing options would hurt workers, high-tech firms and the world economy, said the letter. Besides that, added the critics with a genteel threat to the IASB's life, "the debate on this one issue could endanger the current consensus supporting the IASB."
Members of the IASB know the options score. One of them, Stanford accounting professor Mary E. Barth, looked at the relation between share price and the option costs disclosed in the footnotes of nearly 900 firms. A yet-to-be-published study by Barth, Stanford colleague Ron Kasznik and UCLA professor David Aboody suggests that investors indeed consider options to be an expense, because firms disclosing higher option costs suffered lower stock valuations.
The Sun Also Rises
At a recent 9 bucks, Sun Microsystems shares have fallen hard from the $65 levels of Sun's dot.com glory. A week ago Thursday, the Santa Clara firm tried to shake things up by announcing midyear plans to ship computers with the Linux operating system and Intel-compatible microprocessors. On the announcement, Merrill's Milunovich upgraded his long-term view of Sun. Merrill surveys report that a quarter of big companies have started to use Linux, the "open source" operating system that costs nothing and whose instructions are open to inspection. Milunovich's colleague, Peter von Schilling -- who hopes the Sun announcement will enhance prospects for Linux software supplier Red Hat -- says that the last 12 months have seen Linux embraced by leading computer makers. The next 12 months will see strong Linux offerings from software leaders like Oracle, SAP and Veritas Software.
Milunovich thinks Sun is facing up to the competitive threat from Microsoft Windows and Intel hardware vendors like Dell Computer. But he says that investors aren't yet convinced that Sun can maintain profits amid the upmarket moves of Linux and Windows. To succeed, says Milunovich, Sun needs to offer higher level software that's comparable with offerings from BEA Systems, IBM and WebLogic.
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