Updated from 10:12 a.m. ESTFor 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
|Taking a Bite Out of Profits |
Figuring in the expense of employee options
|Company||2004 EPS (Estimate)||2004 EPS w/options expense||Change|
|Source: Goldman Sachs|
Timing-wise, companies could conceivably have to start expensing options in 2005 -- just as the highly cyclical chip industry is expected to enter a downturn. The SIA predicts global semiconductors revenue will shrink 6% in 2005, after three years of growth. In what's already likely to be a lean year for the chip sector, the accounting shift should shave an additional 25% off profits, estimated SG Cowen. Of course, that outlook assumes companies maintain their current policies on options. But many tech outfits have already pushed through sweeping reforms in their compensation programs, either decreasing options overall or reducing the number of employees eligible for them. Dell ( DELL) and Siebel ( SEBL) have both significantly cut their option grants. Others have changed the terms of their options. IBM ( IBM) said in February that it will only issue out-of-the-money options for executives, meaning they won't realize any gains until the share price rises at least 10% from the date of the grant. Standard & Poor's expects so many companies to change their policies soon that it declines to project the impact of expensing options on 2005 earnings. "We expect the overall value of options expense will go down and the number of options granted will also go down. We believe there will be a lot of announcements over the next couple of months" as companies rein in generous options policies, said Howard Silverblatt, editor of S&P quantitative services. To be sure, the residual financial impact of options is felt long after companies reform their policies. For example, last year Microsoft ( MSFT), the world's largest software maker, made a ground-breaking decision to replace employee stock options with restricted stock. But its earnings outlook is still weighed down by options the company has already granted.
For 2004, Microsoft's earnings would fall 21 cents, or 18%, to 98 cents after accounting for the cost of options. Meanwhile, Wall Street's reaction to reforms at Microsoft underscore that it's not just corporate policies that matter. Equally important is whether analysts pay any attention. Microsoft's move last year to begin voluntarily expensing options when it reports earnings has been largely ignored, with most analysts leaving the options expense out of their estimates. Thomson First Call has followed their example. Sanford C. Bernstein analyst Charlie Di Bona wanted Thomson First Call to post Microsoft estimates that include options expensing, but the firm rejected his request. "My feeling is if they are not going to take responsibility for setting the rules themselves, they should at least let the buy-side determine it -- not the sell-side," Di Bona charged. (He has a buy rating on Microsoft; his firm doesn't do investment banking but its parent, Alliance Capital, holds Microsoft shares.) Right now, those who exclude Microsoft's option expense argue that it makes for an easier apples-to-apples comparison with software vendors that don't expense options. Until the accounting rule change actually goes into effect, Thomson First Call said it will not break out earnings estimates that include stock options expenses if the majority of sellside analysts don't want to provide them, according to research analyst Ken Perkins. To be sure, plenty of money managers say they already figure out the impact of options, leading some to argue that the shift to expense options is
mostly factored into tech stock prices . Todd Ahlsten, manager of the Parnassus Equity Income fund, said studying Intel's ( INTC) spending on options-related share buybacks has helped him more accurately estimate the company's discounted cash flows and therefore value the stock. (He doesn't currently hold the stock because he considers the valuation relatively high, but says he likes the company and has owned it in the past). At Stein Roe Investment Counsel, buyside technology analyst Chuck Jones said he already tracks trends in options issuance and considers what earnings would have been after expensing, also noting how much companies generate in cash flow and what they spend on share buybacks. In that sense, the focus on options expensing is part of a broad trend toward a more cautious evaluation of tech companies' prospects. "Whereas before we were driven by this vision of unlimited opportunity, now investors in technology still have optimism. But today they are starting to realize it's not unlimited," said Vadim Zlotnikov, chief strategist at Sanford Bernstein.
| Dude, Who Took My Profits? |
Estimated percent decline in profit at leading chipmakers
|Advanced Micro Devices||58.3||38.8|
|Source: SG Cowen. |
Option expense estimate based on Black Scholes.