Wall St. Discounts Option Rule Shift
Earnings reported by major technology companies would be cut sharply by an expected rule change on stock options, but many big investors are saying the change wouldn’t make them less willing to buy or hold tech stocks.
Some say the proposed shift -- a requirement that the cost of employee stock option grants be counted as a business expense -- might even improve the financial image of tech companies with investors.
For firms such as wireless technology giant Qualcomm Inc., there is no sign that the market is beginning to view their shares in a different light. The San Diego-based company’s stock has surged this year to its highest level since 2001, even though Qualcomm may have to slash last year’s reported earnings by nearly one-third if the options accounting change takes effect.
If the market was terribly worried, the tech-heavy Nasdaq composite stock index probably wouldn’t have soared 46% over the last year, experts say.
The new bookkeeping rule, which could be proposed by the Financial Accounting Standards Board as early as today, has been in the works for more than two years. It would address a long-standing controversy over the accounting treatment of stock options, which in the 1990s became a favorite form of employee compensation at many firms.
An option is the right to buy shares at a set price within a specified time frame. If a company’s stock price soars, options can be extraordinarily lucrative for workers who get them.
Under current accounting rules, firms aren’t required to formally deduct option expenses from net income -- even though critics say there unquestionably is a long-term cost to any business, and its existing shareholders, from issuing more stock. Many companies have argued that there is no fair way to value stock options.
The FASB, which is responsible for setting U.S. accounting standards, is expected to propose that all companies must estimate option costs and include them as a normal business expense on income statements.
Technology companies, which have been heavy users of options, would be hit hardest by the change, analysts say. Qualcomm, for example, reported fiscal 2003 net income of $827.4 million, or $1.01 a share. If it had been forced to charge the cost of employee options against income, Qualcomm said, profit would have been $567.7 million, or 69 cents a share.
EBay Inc., the Internet auction company, said its 2003 profit would have been 37 cents a share with options costs, or 45% less than the 67 cents reported.
In theory, if investors have bid up technology stock prices based in large part on the companies’ bottom lines, the shares could face a markdown if earnings are shown to be far less than originally reported.
That’s one of the arguments Silicon Valley has used in its fight to stop the FASB from instituting the rule change.
Rick White, chairman of the International Employee Stock Options Coalition, whose corporate members are opposed to option expensing, said companies feared that investors would penalize their shares because “over a long period of time, the earnings would have to be lower” if option costs are deducted.
But some money managers say those concerns are overblown. They note that Wall Street has been expecting the rule change in the wake of the corporate accounting scandals that began with Enron Corp. in 2001. So there’s no element of surprise in the proposal.
Also, all companies are now required to include an estimate of option expenses in the footnotes to their financial statements, so investors already have a sense of what the costs to tech firms would be.
“You always look at that number as if it were a cash expense,” said Peter Goldman, a principal at Chicago Asset Management in Chicago.
More important, some money managers say, is that the fast-growing technology companies that are among the biggest grantors of options generally don’t attract investors based on the actual bottom-line profit they report.
Most growth-oriented investors focus on how fast a company’s sales and earnings are rising, not the numbers themselves, Goldman and other money managers say. The bet is on the company’s long-term promise.
For those investors, “what matters is the trend” in growth rather than how many pennies per share are earned, said John Buckingham, president of Al Frank Asset Management in Laguna Beach.
Other investors say they favor formal expensing of options for one of the same reasons tech firms oppose it: the idea that the accounting change might cause companies to be less generous with their option grants.
“This might make these companies stop giving away ridiculous amounts of options” to executives and other workers, said John Kornitzer, head of Kornitzer Capital Management in Shawnee Mission, Kan. “This would be more honest accounting. We’re all for it.”
Opponents of option expensing say that if companies cut back on option grants to avoid slashing earnings, the firms might have a harder time attracting talented workers.
Elizabeth Bramwell, head of Bramwell Capital Management in New York, said younger tech companies in particular could be hurt because “they may not have the cash to pay [workers]. Options have been very important to them.”
But Ralph Wanger, a veteran money manager at Columbia Wanger Asset Management in Chicago, said that if option expensing were uniformly required, he doubted that the effect would be too dire on any one group of companies. Many firms, he said, would probably shift to using other forms of compensation, such as outright grants of stock rather than options.
As for investors’ view of technology stocks in general, Wall Street isn’t likely to abandon any sector just because of an accounting change, said Brian Eisenbarth, a money manager at Davidson Investment Advisors in Great Falls, Mont.
“The markets are efficient enough to assign value where it should be assigned,” he said.