When Honesty Is the Most Expensive Policy

They call it the honesty bandwagon. And now that some heavyweight companies have jumped on, pledging to include employee stock options as a cost of doing business, the practice actually stands a chance of becoming the norm.

But it's way too early to say the battle has been won, especially if technology companies have their say.

Amazingly, two technology giants have joined the options-disclosure vanguard. Amazon AMZN recently announced that it will begin expensing options. Also on board is software giant Computer AssociatesCA.

Some of the biggest companies pledging to expense their stock options are General ElectricGE, which joined the corporate-reform chorus last week, and Coca-Cola KO, which announced its new policy earlier this month.

But Computer Associates and Amazon are more like traitors than bellwethers for the technology sectors. Indeed, this sector led the fight in 1994 to keep stock options off the books.

It's easy to see why. For most of the companies that have agreed to reflect the cost of options, it wasn't a terribly expensive decision, a few pennies a share each year in most cases. But for many technology companies, it could mean the difference between posting a profit or a loss. Software maker Siebel Systems SEBL, biotech behemoth Genetech DNA and even IntelINTC, on a bad year, could see their profits erased by the costs of employee stock options.

Ambivalence in Redmond

MicrosoftMSFT, the world's largest software maker, is uncharacteristically divided on the thorny issue of expensing stock options.

The Redmond, Wash., behemoth addressed both the pros and cons of the issue for investors last week at its annual analyst day. But even if Microsoft is eventually mandated to expense stock options along with other publicly traded companies, investors don't have a lot to fear, analysts say.

"Clearly it's going to have an impact on their earnings," said Erik Gustafson, a senior portfolio manager at Stein Roe, which owns Microsoft shares. But Gustafson said he's more impressed with Microsoft's dominance in the desktop operating system market, innovations, cash position and the fact that it is "run by one of the smartest guys in the world. The option calculus doesn't really impact our decision there," he added.

Plus, Gustafson points out, Microsoft already fully discloses the value of its options in its filings with the Securities and Exchange Commission. "Investors who aren't aware of this are simply not doing their homework," he said.

Those filings show that during the past four fiscal years, expensing options would have reduced earnings per share between 12 cents and 45 cents, or between 8.5% and 31.9%.

Microsoft's Options Expensing options would take a bite out of Microsoft earnings
Year	Revenue(billions)	Option Expense	Exposure	Net Income w/o Options	Net Income With Options	EPS Excluding Options	EPS Including Options	Decline in EPS
2002	28.4	2.5	8.8%	7.8	5.4	1.41	0.96	-31.9%
2001	25.3	2.3	9.1	7.3	5.1	1.32	0.91	-31.1
2000	23	1.2	5.2	9.4	8.2	1.70	1.48	-12.9
1999	19.7	0.7	3.6	7.8	7.1	1.42	1.30	-8.5
Note: Numbers may not add up due to rounding. Source: Microsoft 10-K, Microsoft fiscal year 2002 results

But that's not a huge amount compared to other software companies. Among 38 software companies, Merrill Lynch found that earnings per share would fall an average 59% in 1999, 98% in 2000 and 79% in 2001 if stock options were expensed.

In addition, Microsoft's overall exposure -- the percentage of revenue affected by the option expense -- of nearly 9% in fiscal year 2001 is relatively low compared to other software makers, an analysis of 14 software stocks by Friedman, Billings, Ramsey found.

Siebel Systems, by contrast, has an exposure of 35%, meaning Siebel's options were valued at more than one-third of revenue in the last fiscal year. If options were expensed, Siebel's fiscal year 2001 pro forma results would plummet to a loss of $1.02 per share from earnings of 49 cents a share without expensing options, according to Friedman.

If options are expensed, particularly using the commonly used Black-Scholes model, Microsoft retains a strong position in the software sector on a couple of fronts. First, because volatility is one variable in the Black-Scholes model, Microsoft options will be valued lower than other software companies because its stock is less volatile, Friedman, Billings, Ramsey pointed out in an Aug. 1 note on stock options.

Second, with nearly $39 billion in cash on its balance sheet, Microsoft can replace options with salary raises far more easily than other companies. "In this market, cash is king, and Microsoft has a lot of cash," Friedman software analyst Daniel Ives said. "When you look at some of its competitors, they're in a much more precarious cash position, where options are one of the only ways they're going to incentivize employees and bring them in." Friedman does not cover Microsoft.

Indeed, Microsoft CEO Steve Ballmer said last week that over the past three years the company has increased its cash compensation "quite dramatically."

But Microsoft execs seem to have a difference of opinion over options. During lunch last week, Chairman Bill Gates indicated he's in the Warren Buffett camp, supporting expensing stock options, said David Readerman, equity growth strategist for Thomas Weisel Partners, who has covered Microsoft for 16 years.

But Ballmer told analysts that Microsoft intends to stand with the rest of the tech industry, which has lobbied heavily against expensing options. "The health of the technology ecosystem not only to us as a leader for the industry but to our customers is very important," Ballmer said.

Ballmer added that a broad set of companies have predicted that expensing options could have "very, very gloomy" consequences. Some companies fear that expensing options could hinder technology innovation and also lead to more stock price declines as earnings fall.

Readerman, who has a buy rating on Microsoft, suggested that one of those consequences already is being felt.

"I think that the invisible hand of the market will price and value technology and telecom at the stock-option expense number, and I think as a result, multiples and valuations are adjusting as we speak," said Readerman, who owns Microsoft shares. His firm hasn't done any banking with Microsoft.

Keeping it on the Down Low

But Standard & Poor's software analyst Jonathan Rudy said he believes that Microsoft is being more than just a team player with its relatively low profile on the stock options issue. The company also is watching out for itself.

"At this point, they don't need any more enemies, especially with trying to get the settlement through with the nine remaining states," said Rudy, referring to the nine states who are fighting for tougher penalties in the antitrust case against Microsoft. Rudy has an accumulate rating on Microsoft and his firm doesn't do investment banking business.

Still Opposed After All These Years

Semiconductor giant Intel remains one of the high-profile tech opponents to expensing employee options.

Last year Intel spent just over $1 billion on options. Though the expense didn't show up on its income statement, stock options effectively would have consumed most of the company's profits in a lean year.

If Intel had expensed its options in 2001, net income would have been slashed from $1.29 billion to a mere $254 million. Meanwhile, profits would have dropped 79%, from 19 cents to four cents.

What a Difference a Year Makes Intel's options expense would gently nibble 2000's earnings, but would have been huge in 2001
Year	Net income(billions)	Options expense (billions)	EPS before options expense	EPS with options expense	% Change
2001	1.29	1.04	$.19	$.04	-79
2000	10.5	.836	$1.51	$1.40	-7.2
Source: Intel 10-K

To be sure, the impact was all the more pronounced last year because the chipmaker's profits were smaller than usual, nose-diving 88% from their 2000 levels.

By comparison, in 2000, Intel posted hefty profits of $10.5 billion. At that point, expensing options would have cost $836 million, a smaller percentage of net income -- but still a whopping sum, by most accounts. It would have cut earnings from $1.51 to $1.40.

An Intel spokesperson said the company is "definitely not in support" of expensing stock options. "Like the rest of the industry, we currently support the FASB-approved accounting treatment of stock options," says Christine Chartier.

One objection to expensing options, she says, is that it's tough to find an accurate way to value them. "If you expense them at grant date, that leads to inaccurate financial reporting. The Black-Scholes [model] doesn't work because it's designed for freely tradable short-term options, for which there's a very clear market, but not for employee stock options, which typically have a much longer [holding] term and there is no market."

Nevertheless, the company uses the Black-Scholes model to arrive at the options value given in its 10-K footnotes.

Intel isn't one of the worst offenders when it comes to options grants, says Mark Grossman, an analyst at SG Cowen, though like many tech companies, it relies on options to help retain talent. "I think it's important [there], but it's not like a startup where people join primarily because of the options and hope to cash out," he says.

From an investment policy, he adds, Intel's growth rate matters more than its options policy. "We've had a neutral on Intel for a while, anyway, based on the fact that they haven't really grown significantly since '98. The last time they grew more than 15% in a year was 1997. Their margins have come down, yet the multiple has actually expanded."

All the Kids Were Doing It

Biotechnology firms, like their brethren in the broader technology sectors, dish out hearty helpings of stock options to employees. So, biotech sector earnings will be dragged down if stock options are expensed.

Genentech would go from net earnings to a loss. The company earned $150.2 million in 2001, but its estimated stock option expense totaled $152.8 million, which translates into a 2001 net loss of $2.6 million, or a net income adjustment of 102%.

AmgenAMGN reported 2001 net income of $1.2 billion and had an estimated stock option expense of $189.1 million. Adjusted net income: $930.6 million, or a 17% adjustment to net income. The figures for both Amgen and Genentech come from a recent Lehman Brothers research report.

And so the argument is polarized. Those pushing the expensing of options paint it as plainly as a matter of honesty. Those opposed posit a business culture where the forces of innovation collapse, stopped dead by an inability to pay the troops with the currency that matters most -- stock options.

What has changed is the context. Companies realize that the taint of dishonesty is all over the market, and even a whiff can make their shares sick. Furthermore, no one -- no, not even Congress -- is buying the growth blather that tech companies were flogging so freely most of the '90s. And, probably, many companies realize that options costs are already priced into their shares.