Beware companies that downplay the cost of employee stock options
NEW YORK » Wouldn't it be nice if you could say a whole category of your regular expenses, such as your utility bills, don't really count? If you could convince someone that those expenses, even though they showed up in your bank statement, should be added back every three months?
That's what some companies, including eBay Inc., are trying to do when they ask investors to ignore expenses such as employee stock options when they report their quarterly earnings.
Don't buy it. Regard with suspicion the pro-forma or adjusted earnings numbers that emerge after "certain expenses" are stripped away. Some companies want to use these malleable measures as a benchmark, but they are the accounting equivalent of a stew recipe -- if a company doesn't like a number, it just leaves that number out.
Under new rules, companies whose fiscal years began on or after June 15 must record their employee stock options as an expense. This is a change corporations, especially in the technology business, have fought since 1993. They lost, but now they're trying to pretend otherwise.
"Stock option expensing -- the battle has been won; now comes the aftermath," Goldman Sachs said in a March report. "Transition will be messy: Use of pro forma earnings likely to increase."
Why? Because employee stock options are expensive. The options, which give workers the right to buy shares of the company's stock, usually well below the market price, were the fuel of the go-go Internet and telecom boom. They were often used by companies that didn't have the cash to pay top-dollar salaries.
The best part: Options were free, at least as far as reported net income was concerned, since options weren't counted as an expense. With the accounting change, options' impact on the bottom line will be clear.
If Sun Microsystems Inc. had counted stock options in fiscal 2005, its loss would have widened by $747 million, according to the company's filings with the Securities and Exchange Commission. Schering-Plough Corp.'s loss per share for 2004 would have increased from 67 cents a share to 74 cents. Siebel Systems Inc. said expensing existing options would reduce its earnings by up to $35 million a quarter each quarter in 2005.
If all Standard & Poor's 500 companies expensed options, the S&P 500's earnings would have been cut by 5 percent in 2004, according to a UBS report based on calculations by Thomson Financial. That drop is on top of any expenses booked by companies that already included options' cost in their earnings.
If options levels in the tech sector stay the same, UBS predicts options expense will lower earnings per share for S&P 500 technology companies by 15 to 20 percent into the future.
That's why eBay's sleight of hand earlier this month was no surprise.
When eBay announced its earnings last week, it also announced pro forma results that were "adjusted to exclude certain items, primarily stock-based compensation expense and related payroll taxes and amortization of acquired intangible assets."
Does this want to make you go shopping using your "pro forma" checking account balance, which excludes certain items, such as car payments?
"It's easy to dismiss such charges as a simple non-cash charge, but it's getting to the point where we're almost talking about earnings before costs," said Jack Ciesielski, author of the popular industry newsletter the Analyst's Accounting Observer. "If you're going to back out all the non-cash items, then how about the sales you haven't been paid for yet?"
Some companies have also started pulling out the expense for stock grants, an accepted compensation cost they used to book without a whimper. Some, like eBay, have also removed the impact of expensing options from their guidance.
For investors, and for news organizations including the Associated Press, this is tricky territory, because many analysts are playing along, stripping options costs out of quarterly estimates.
Thomson Financial, a unit of Thomson Corp., will be rolling out two sets of estimates for all its customers next year, one stripped of options expenses, one with options expenses baked in. (Its product for investment managers already includes two estimates.)
But the primary estimate from Thomson will be whatever method the majority of analysts use, said Mike Thomson, director of research at Thomson Financial.
"The majority of estimates will be compliant" with generally accepted accounting principles, which include the cost of options, he said.
Zacks Investment Research Inc., like Thomson, also gathers analysts' estimates. It will use the same method the majority of analysts use. In some cases, Zacks will also calculate "two flavors of expenses," said Steve Scala, vice president of operations.
If the majority of analysts strip out options costs, Zacks will "normalize" other estimates, Scala said.
Some analysts are doing the right thing. Investment banks including UBS, Merrill Lynch and Bear Stearns are including options in their earnings estimates, Ciesielski said.
Problems with estimates are one more reason why serious investors should read not just the puffery in companies' quarterly press releases, which often bury the bad news, but also companies' actual quarterly earnings reports.