Paul, Today's WSJ 'Heard on the Street' was written expressly for you. <gggg>...
Regards,
John
Heard on the Street
Stock Options May Take
A Hidden Toll on Profits
By ELIZABETH MACDONALD and ROBERT MCGOUGH
Staff Reporters of THE WALL STREET JOURNAL
A few brave Wall Street research analysts are venturing into
taboo territory: the hidden cost of employee stock options.
Credit Suisse First Boston analyst Michael Mayo and his team of
researchers climbed onto a chilly limb this month when they
published a report on the concealed cost to bank earnings of
employee stock options.
Accounting rules don't force companies to take an earnings hit
from employee options. But the researchers found
unaccounted-for options at 47 banks caused them to overstate
their 1998 earnings on average by about 4%. A few major banks,
including Citigroup and BankBoston, had hidden options costs of
10%.
Until now, few analysts have "ever
seriously dived into the real impact
of options on corporate earnings
power," says Daniel J. Donoghue, a
managing director and accounting
specialist at U.S. Bancorp Piper
Jaffray in Chicago. "As the use of
options becomes pervasive, no one
is taking a look at how options dilute
shareholder value. Analysis like this
is long overdue."
The stakes are high because the
use of employee stock options is
proliferating like kudzu. If Wall Street
started paying more attention to
options' implicit cost, stock prices of
some companies could come under
pressure.
Throughout corporate America, a
debate is raging over the hidden
costs of using options instead of
cash to compensate employees. If
you pay an employee cash, that cost
shows up as an expense on the
company's income statement. But if
you pay the employee by issuing an
option instead, it is "costless"
compensation.
But Wall Street, loath to upset
corporate clients, chronically ignores
the costs of employee options when valuing stocks. To
corporations, stock options are a crucial way of attracting
workers, and drawing attention to the cost of the options is simply
irritating. So Wall Street, which can boost or crush a stock for
merely beating or missing earnings estimates by a penny or two,
has been ignoring a stealth cost whose impact is many times
greater.
Perhaps it's not surprising that a groundbreaking report on
options costs comes from an analyst covering the banking
industry -- where options aren't nearly as important to
corporations as, say, at technology firms, where cash-poor
startups bloom more often. Accounting analysts estimate that
option grants issued by high-tech companies in 1997 would have
slashed net income at those companies anywhere from 10% to
100%, if they were expensed.
But employee stock options also are popular at drug,
biotechnology, pharmaceutical and financial-services firms,
including banks, says Gabrielle Napolitano, Abby Joseph
Cohen's top accounting guru at Goldman Sachs.
Mr. Mayo says he would "obviously get a more negative reaction
from tech companies if I did this kind of study for the sector." But
he adds, "I'd do it anyway," and "in the banking sector, these
adjustments are no small matter."
The Mayo report looked at the cost of options to 1998 earnings at
a select group of large-cap and mid-cap banks. The study says
that if Citigroup and BankBoston had fully accounted for their
options against their 1998 earnings, doing so would have
reduced profits by 10%. J.P. Morgan's 1998 profits would have
taken a 6% hit; Chase Manhattan and Northern Trust, 5%.
Citigroup, J.P. Morgan and Chase declined to comment. A
BankBoston spokesman says the study "does not reflect
option-grant activity in a typical year for the bank." He says last
year BankBoston awarded an unusually large number of options
in connection with its acquisition of investment bank Robertson
Stephens, among other things. Northern Trust hadn't any
immediate comment.
Some mid-cap banks fared worse. By First Boston's calculations,
Imperial Bancorp of Los Angeles would have seen its 1998
earnings sink 36% if it had to fully account for its employee stock
options. Imperial says the study didn't account for the cancellation
and repricing of options it did during the year, and that the study
should have given it a 12.5% hit to earnings. Mr. Mayo says he
stands by his numbers.
Union Planters would have seen its earnings slide 12%. Union
Planters says it had unusually heavy issuance of stock options
last year because for the first time it issued options to all full-time
employees.
Why should investors care about off-balance-sheet options
costs? Mr. Mayo says if the stock market endured a prolonged
correction (which he isn't predicting), bank executives would likely
"start demanding cash-based compensation," instead of the
now-worthless options, "thus hurting earnings," Mr. Mayo says.
In the event of a market downturn, all companies could end up
suffering some profit pains from options anyway. A new
accounting proposal now under debate would force companies
either to wait six months before repricing "underwater" options, or
else subtract from earnings the difference between an option's
new lower exercise price and any subsequent increase in the
share price. (Repricing typically involves ratcheting down the
options' exercise price, allowing employees to profit at lower
levels.)
First Boston analyzed the banks' 1998 financial-statement
footnote disclosures that showed options' pro forma effect on
earnings. First Boston took those footnote disclosures and
applied Black Scholes valuation models to calculate the total
value of these option grants. Among other things, First Boston
took into account employee turnover rates. That's because if
workers leave before their option grants vest, they must forfeit
them.
The footnotes were the result of heated battles between
options-happy technology companies and accountants. In 1995,
accounting regulators tried to force companies to expense
employee stock options against profits. Companies hollered that
it would be the end of Western civilization, in one regulator's
phrase. The regulators retreated, only requiring companies to
disclose the "pro forma" effect of options on earnings in a
footnote.
Since then, the use of options in several industries, particularly
high-tech and pharmaceutical, has flourished, buoying bottom
lines.
Some defenders of employee stock options wish people like Mr.
Mayo would just button their lips and go away. They say options
have been a main driver behind the soaring economy and stock
market, and critics like him should leave well enough alone. The
higher income-tax receipts on gains from options have even been
credited with helping close the federal budget deficit.
But Mr. Mayo points out that, more and more, options are being
used to reward mediocrity. Options set at certain strike prices
are supposed to give employees the incentive to do better on the
job, thus making their company's stock zip higher. In a rising
stock market, Mr. Mayo says, companies are setting options'
exercise prices too low. Moreover, he says, they are expanding
the time in which employees can cash in their options. The result:
Just about any slacker can join the party.
Even Warren Buffett has weighed in on the matter. The chairman
of Berkshire Hathaway argued in his most recent letter to
shareholders that employee stock options reveal an "egregious
flaw in accounting procedure." When Mr. Buffett substituted cash
compensation for employee options at General Re, which
Berkshire acquired last year, he had to report a pro forma boost
in compensation expense of $63 million.
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