Reform of Options Has Costs, Benefits
If the force of investor outrage, accounting regulation and possible legislation in Congress changes the way corporations report the costs of stock options, the result could be sharp declines in the stock prices and earnings of hundreds of major companies.
That’s because those costs generally are not included in reported earnings, on which stock prices are based. Earnings look higher than they might otherwise be, helping to push stock prices up.
This is not really a secret. Companies state the implied cost of stock options in footnotes to their annual reports. Microsoft Corp., for example, where many employees have grown wealthy on stock options gains, explains in its 2001 annual report that if it had charged an expense for stock options, its reported earnings would have been 91 cents a share instead of $1.32.
Likewise, Amgen Inc. explains that its earnings would have been 86 cents a share instead of $1.03; Northrop Grumman Corp. would have reported $4.65 a share instead of $4.80.
The difference was not the result of deception. There are many reasons options costs haven’t been included. But change is coming because of abuses of the stock options system by many top corporate executives.
Reform should help remove distortions and give investors a clearer picture of profits and companies’ finances. But reform will carry costs and unintentionally could be anti-entrepreneurial.
Reported earnings for the firms in the Standard & Poor’s index of the 500 major blue-chip companies could decline by 10% on average, estimates a study by Merrill Lynch Global Research.
Other consequences could crop up, such as a mad flurry of stock buyback programs to offset the effect of officially counting more shares in the calculation of earnings per share.
Stock options for broad ranks of employees--a compensation innovation that has grown in recent years--probably will be cut back.
“Companies will have a disincentive to be generous with stock options,” says Rep. Brad Sherman (D-Sherman Oaks), a certified public accountant and a member of the House Banking and Financial Services Committee.
Reform could increase the costs of setting up a business and could slow the creation of innovative companies, says Brad Jones, founding partner of Redpoint Ventures, a major backer of high-tech start-ups.
The course of reform is far from certain, as public officials, pension fund managers and members of Congress grapple with the need to reform corporate practices and restore confidence in investment markets.
But stock options--which grant the right to buy company stock in the future at a fixed price--are under fire partly because they were the biggest source for the explosion in executive compensation in the boom decade of the 1990s, when average pay soared to $15 million for chief executives of big U.S. companies.
Retired General Electric Co. Chairman Jack Welch has
noted that objections to high front-office salaries in the 1980s led
executives such as himself to go for stock options--which made them rich beyond their dreams when U.S. companies grew with the global market and share
prices rose in the stock market. In
2000, his final full year at the helm, Welch’s total compensation,
which includes salary, bonus and
stock options gains, was
$136 million.
Executive Payoffs
But in the bust that has followed the boom, suspicion is arising that such outsized rewards were not earned.
“Some option plans were not incentives, but payoffs for executives at the expense of shareholders,” says Frank Glassner, head of Compensation Design Group, a New York-based consulting firm.
Glassner cites Tyson Foods Inc., which last year took hundreds of thousands of options that had lost value and replaced them with grants of stock to executives.
The now-infamous Kenneth L. Lay, former chairman of Enron Corp., had loans from the company along with stock grants that he could use to repay the loans, thereby lowering his tax liability and avoiding requirements for reporting transactions to the Securities and Exchange Commission.
Such loans to executives may be prohibited in legislation the Senate is likely to pass Monday. Of course, all company loans to employees may be outlawed.
“Major decisions on company practices are made because of abuses, and good firms get hurt along with the bad,” says Dan Marcus, head of compensation at Mercer Human Resources Consulting in Los Angeles.
The use of options has grown throughout corporate America and so has the distortion of reported earnings. Mercer experts calculate that if all the shares reserved for options were added to common stock outstanding at the 350 largest firms, average earnings per share could be reduced by almost 15%. That’s about 50% more than the effect would have been five years ago.
And the effect could be much greater at high-tech firms, which have used the incentive pay of stock options extensively. Cisco Systems Inc., for example, could see earnings per share reduced by 67%, according to the Merrill Lynch study. Dell Computer Corp.’s earnings could fall by 42%, those of Intel by 25% and earnings of biotech firm Chiron Corp. by 23%.
All the calculations assume no action such as stock buybacks would be taken to offset the potential effect of calculating per-share earnings on additional shares.
The routine and extensive use of stock options by some of the most innovative companies in the nation benefited the economy. The incentives helped to build Microsoft, where the spectacle of relatively young people retiring as “Microsoft millionaires” was a mid-1990s advertisement for options. And options helped Microsoft founder Bill Gates become the richest man in the world.
The Value of Options
“Company founders, by definition, always have stock at an initial price,” venture capitalist Jones points out. “The real value of stock options is in their ability to attract those key personnel you need to help develop the company. Options give them a chance for the big score they cannot get at big companies,” which can offer salary, security and perks.
But within the next several years, the cost of stock options probably will be counted as an expense, as wages and salaries are now. The International Accounting Standards Board, a global professional body, is likely to recommend this fall that options be expensed.
Support for reform is growing.
“I fear that the failure to expense stock option grants has introduced a significant distortion in reported earnings,” said Federal Reserve Board Chairman Alan Greenspan in a recent speech to bankers.
Distortions have grown along with the increased use of stock options. For example, companies get tax deductions when employees cash in stock options.
“But huge tax deductions, with no expense on the other side of that, doesn’t make sense,” says Peter G. Peterson, chairman of investment firm Blackstone Group who is leading an effort by high-level business people to reform accounting practices and other aspects of the corporate system.
So companies will have to change their accounting practices. But use of stock options as incentives for all employees certainly can continue.
Many experts favor lengthening the duration of options, making them exercisable only after a five-year wait instead of one year or less, which is common. That way, corporate managers have to work for the long-term development of the company, not merely for the earnings of the next quarter.
In any event, reformers, members of Congress, company executives and their employees should keep in mind that the purpose of compensation is to “create value,” says consultant Marcus.
They might look at solid companies such as Worthington Industries Inc., a specialty steel producer based in Columbus, Ohio. Worthington has had profit-sharing plans for all its employees since it opened its doors in 1955. Through a system of incentives and targets, an employee can add one-third or more to base pay.
The company, which has grown to $1.7 billion in annual sales and 6,800 employees, is continually successful in a tough business.
May the reforms to come produce many more like it.
James Flanigan can be reached at jim.flanigan@latimes.com.
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Optional Earnings
As calls rise in Congress and from investors to require companies to include the cost of options in their reported earnings, investment experts are calculating what the effect would have been if major companies had ‘expensed’ options in 2001. Below is a selection of firms from the Standard & Poor’s index of 500 blue-chip companies.
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Reported 2001 EPS including
earnings options Percent
Name per share charge change
Amgen $1.03 $0.86 -17%
AOL Time Warner (1.11)* (1.43)* -29
Bank of America 4.18 3.96 -5
Broadcom (10.79)* (13.42)* -24
ExxonMobil 2.21 2.17 -2
General Electric 1.37 1.33 -3
General Motors 1.77 1.38 -22
IBM 4.35 3.69 -15
McDonald’s 1.25 1.13 -10
Microsoft 1.32 0.91 -31
*( ) denotes loss
Source: Merrill Lynch Global Securities Research
