Options Rule Is the Latest Headache for Tech

Updated from 10:12 a.m. EST

For years, the technology industry has politely steered discussions away from its aggressive use of options. Now a rule change proposed Wednesday by an accounting oversight board could require many of the sector's biggest companies to reduce sharply their reported profits and state clearly how much options really cost them.

Under the draft proposal published Wednesday by the Financial Accounting Standards Board, any public company that pays employees this way would be required to estimate the fair-value cost of the options using a pricing model, and then subtract the cost as a business expense on its earnings statements.

Previously the cost of options could be more loosely calculated and needed only be disclosed in footnotes in companies' filings with the Securities and Exchange Commission. For the majority of tech companies, it stayed out of the conventional profit and loss picture.

The upshot is that profits at a representative pool of chip companies would nosedive 37% this year if options were expensed, while software outfits would see their net income plummet 65%, according to respective estimates from SG Cowen and Goldman Sachs.

By contrast, 2004 earnings for the S&P 500 would shrink a relatively paltry 9% if member companies expensed options, according to Standard & Poor's.

The accounting shift would mark another setback for the industry, coming only a year after the leading chip trade group and tech giant Hewlett-Packard (HPQ Quote) separately counseled investors to expect more-modest long-term returns.

Not only could tech companies see their P&Ls suffer more as a result of the rules change, but the shift would suddenly make them look a lot more expensive than in the past. That could force investors to rethink traditional notions of how much they're willing to pay for their stocks.

For example, the average GAAP price-to-earnings ratio for software makers would jump to 56 from 32 after the accounting rule change, noted Goldman. In the past, a P/E ratio of 30 was a common yardstick of valuation for software stocks.

The accounting proposal comes as industry players have already sought to reduce expectations about their long-term growth outlook. In May 2003 H-P predicted that future tech demand overall will grow at only one or two times gross domestic product, compared to more than four times in the prior three decades. In an increasingly saturated market, the Semiconductor Industry Association, or SIA, said in November 2002 that sales are likely to grow only about half as fast in the future, or around 8% to 10%.

Taking a Bite Out of Profits Figuring in the expense of employee options
Company	2004 EPS (Estimate)	2004 EPS w/options expense	Change
Siebel	0.30	-0.45	-254%
VeriSign	0.58	-0.32	-155
Informatica	0.19	-0.09	-146
Mercury Interactive	1.13	-0.47	-142
Oracle	0.51	0.47	-8
SAP	1.32	1.21	-9
Microsoft	1.19	0.98	-18
Source: Goldman Sachs