Stock options may be the lifeblood of the technology industry, but now that companies have to include options costs in income statements, they're finding a way to cut back on grants, a new report indicates.
Overall, the biggest companies in the industry are reducing the number of options they hand out to employees, and recognizing smaller expenses related to those grants, according to a survey by financial research firm Sanford Bernstein.
A broader look at the industry indicates that as a portion of net income, options expenses are now at their lowest point since the late 1990s, when technology companies -- and particularly Internet start-ups -- went on an options binge, according to Bernstein.
But Bernstein warned there was more to the data than just the surface numbers. Many companies appear to be lowering their options expenses not by handing out smaller grants, but by adjusting the assumptions they use in estimating the costs of those grants.
Meanwhile, Wall Street analysts have been inconsistent about incorporating options costs into their earnings estimates, making valuation comparisons even among companies in the same sector difficult or impossible.
"Options expense as a percentage of net income has decreased for technology companies for the last three to four years, and grant activity suggests this trend will continue," wrote Bernstein analyst Vadim Zlotnikov in the report.
Zlotnikov said that the exclusion of options costs can sometimes have a "significant" effect on forward earnings estimates, which could lead to an indeterminate effect on valuations.
"This is important as only half of the companies we surveyed have option expense included in their First Call
earnings estimates," he wrote.
Among 222 technology companies Zlotnikov surveyed, the total options expense they recognized in fiscal 2005 was $12.9 billion. That was down from $14.5 billion in fiscal 2004 and $18.7 billion in fiscal 2003.
With earnings improving at technology companies, tech companies' options burden as a portion of net income fell even more dramatically over that time period, Zlotnikov wrote.
In fiscal 2003, options costs represented 63% of those 222 companies' combined net income, excluding one-time items. By fiscal 2005, options costs constituted just 17% of combined net income excluding costs.
And for the 56 technology companies that avoided net losses between fiscal 1998 and fiscal 2005, the decline in options costs in the last two years was particularly notable.
Those companies spent $4.6 billion on stock options in fiscal 2005, down from $5 billion in fiscal 2004 and $7.4 billion in fiscal 2003. As a portion of net income minus costs, options expenses fell from 21% in fiscal 2003 to 10% in fiscal 2005 at those companies, according to the report.
, which adopted stock-options expensing and dramatically reduced its options grants long before the rule took effect, the largest 59 technology companies handed out 1.25 billion options in fiscal 2005, down from 1.41 billion in fiscal 2004 and 1.6 billion in fiscal 2005, according to the report.
Among the companies that led the cutbacks last year were
Advanced Micro Devices
, which dropped 69% to 8.1 million shares;
, off 62% to 18.1 million shares; and
, down 80% to 4.4 million shares, according to Bernstein.
But cutting back on the number of options wasn't the only way that companies decreased their options expense. Many tinkered with the key assumptions made to determine the value of their options.
According to the report, 93% of the 59 largest technology companies last year decreased the value they assigned to the assumed volatility of their stock. Some 37% decreased the expected time period they assumed before the options would be exercised.
And 7% decreased the interest rate they assumed would be the normal rate of return in coming years. All three changes serve to decrease the estimated cost of the options handed out.
Less Is More?
The report also said that
all granted more options in fiscal 2005 than in fiscal 2004, but each recognized a lower overall expense for those options.
Intel, for example, which gave out 3% more stock options in fiscal 2005 than the year before, but estimated that the combined value of those options was 42% lower than those it handed out the year before, assumed that the stock's volatility had fallen considerably, from 50% in fiscal 2004 to 26% in fiscal 2005.
Intel and Cisco "are among companies that appear to be using dramatically different assumptions to reduce estimated grant value," Zlotnikov wrote.
Meanwhile, Zlotnikov wrote that there's the potential for a lot of confusion among investors about how options expenses are factored into company valuations. Among a universe of 242 technology companies with a market capitalization of more than $1 billion, Thomson First Call was including options costs in the earnings estimates of just 55% of them.
And the decision on whether to include or not include options costs was inconsistent both across the industry and within particular sectors, he wrote.
First Call, for instance, includes options costs with the earnings estimates for Microsoft, but not
, but not for video-game publishing rival
; and for
, but not for
The inclusion of those costs for one company could have the effect of making its expected earnings growth significantly slower than that of a rival whose estimates did not include options costs.
Stock options entitle employees and executives of a company to purchase the company's shares at a set price. Typically, the options vest over a period of four or five years, meaning that employees can't exercise their option and buy the stock for a set period of time.
Most options are exercised and immediately sold on the open market.
After years of debate, accounting regulators finally
mandated in late 2004 that companies begin recognizing the estimated cost of stock options in their income statements.
And as far back as nearly two years ago, before the expensing rule took effect, analysts were already saying that companies were
tinkering with their assumptions to lower their estimated expensing costs.