Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Strategies & Market Trends : Value Investing -- Ignore unavailable to you. Want to Upgrade?

To: Don Earl who wrote (14047)	2/28/2002 1:01:52 PM
From: Bob Rudd	Read Replies (3) \| Respond to of 78671

<<I guess I still don't follow the reasoning that options should be treated as basically what amounts to a cash charge against EPS. Options already affect EPS in the form of dilution and taking a second hit on some theoretical pricing model doesn't make sense to me.>>Because earnings are distorted without reflecting that compensation expense. Here's a NYT article from last year that indicates the substantial impact that had on the tech bubble [I uppercased some stuff to highlight it for my text file notes, not reflective of author's intent]: FUTURE MAY BE MORE UNCERTAIN FOR TECHNOLOGY June 20, 2001 By GRETCHEN MORGENSON NYT 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. <<Personally I think we have enough real problems with accounting issues without opening a whole new can of worms.>>The can is already open. There's been heated debate over recognizing options on the income statement for quite awhile. And yes, there will be some impact on tech companies that have relied heavily on the practice once their real earnings are revealed. We are going to go towards the point where GAAP reported earnings are meaningfull. Enron is the catalyst. It's going to happen, IMO. So as a value investor, if you have holdings in something that's not going to have such great earnings if options are reflected as compensation, you may wish take a hard look at it.

To: Don Earl who wrote (14047)	3/1/2002 12:08:53 AM
From: James Clarke	Read Replies (3) \| Respond to of 78671

<<I guess I still don't follow the reasoning that options should be treated as basically what amounts to a cash charge against EPS. Options already affect EPS in the form of dilution and taking a second hit on some theoretical pricing model doesn't make sense to me.> You are correct later in your post that the biggest problem is what value to use, what is an option worth not knowing the future and any smart value investor will tell you a Black Scholes theoretical valuation is garbage. But the reason this is THE MOST IMPORTANT accounting distortion is twofold: 1) the scale - EVERY company does this. Its rare now to find a company with less than 5% of its shares outstanding diluted by options and issuing less than 1% more a year. Most I look at its 10 and 2. 2% a year dilution given that long term returns from capital appreciation are in the order of 6% is a HUGE number. 2) Income statement accounting is based on expenses being matched with revenues. Saying options show up in dilution doesn't cut it, because that shows up years later. Take a very clear example. I got paid last year. That showed up on my public company employer's income statement. I also got bonuses. That showed up on its income statement. (Don't worry, I'm not even a rounding error!). But they also gave me options. That was something of value paid to me for work I did last year, but it shows up nowhere on the company's financial statements. Whats the difference bewteen that and cash compensation IF THE INCOME STATEMENT IS SUPPOSED TO REFLECT WHAT IT COSTS TO COMPENSATE EMPLOYEES FOR THEIR SERVICES. Thats the problem.