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Wednesday, May 5, 1999

An Investment Opinion
by Warren Gump

Optionmania II: Impact

In last Friday's column, I demonstrated how stock option grants to employees could affect the income statements of two companies. This simplified example showed how one company could boost its earnings vis-a-vis a competitor by offering stock options instead of market-level salaries. I also mentioned that accounting regulations allow most companies to avoid an income statement impact from issuing employee stock options, as long as the company discloses information about the extent of option grants in its 10-K. Let's take a look at what those disclosures have to say.

The technology sector is known to be one of the most prolific in terms of option grants. We'll start our journey by looking at Microsoft (Nasdaq: MSFT). Following are the figures for fiscal 1998, which ended last June. (1)

Reported Net Income: $4,758 million
Adjusted Net Income: $4,208 million
Impact of unrecorded option expense on Net Income: $550 million

Reported Diluted EPS: $0.89       P/E (5/4/99 price): 87.7x
Adjusted Diluted EPS: $0.79       P/E (5/4/99 price): 98.8x
Difference: EPS 11% lower, P/E 13% higher

If Microsoft had to purchase options that vested during the first quarter, rather than printing them up, net income would have been reduced by approximately $550 million. That's a substantial 12% of the company's reported net income.

Dell Computer (Nasdaq: DELL), another technology stalwart, also has a substantial options burden. Below are figures for fiscal 1999, ended in January. As you can see, Dell's income would have been reduced by 9% if it recorded the fair market value of options grants on its income statement:

Reported Net Income:  $1,460 million
Adjusted Net Income:  $1,324 million
Impact of unrecorded option expense on Net Income: $136 million

Reported Diluted EPS: $0.53     P/E (5/4/99 price): 77.0x
Adjusted Diluted EPS: $0.48     P/E (5/4/99 price): 85.0x
Difference: EPS 9% lower, P/E 10% higher

Technology companies are not alone in being prolific grantors of stock options. T. Rowe Price (Nasdaq: TROW), the financial services firm, also has substantial options obligations. (This fact isn't too surprising, since employees of financial services firms are most informed about the potential benefits of stock options.) Here is the impact of stock options on T. Rowe's income statement for 1998:

Reported Net Income:  $174 million
Adjusted Net Income:  $162 million
Impact of unrecorded option expense on Net Income: $12 million

Reported Diluted EPS: $1.34    P/E (5/4/99 price): 28.6x
Adjusted Diluted EPS: $1.25    P/E (5/4/99 price): 30.7x
Difference: EPS 7% lower, P/E 7% higher

Accounting for options under the fair value method would have knocked T. Rowe's earnings down by 7% in 1998.

Starbucks (Nasdaq: SBUX) is a company with a culture built around employee empowerment and ownership. To build this culture, the company has been quite generous with employees, engendering its well-known loyalty. The following is the hidden cost of this generosity for fiscal 1998, which ended last September. (2)

Reported Net Income:  $82 million
Adjusted Net Income:  $65 million
Impact of unrecorded option expense on Net Income: $17 million

Reported Diluted EPS: $0.44    P/E (5/4/99 price):  82.7x
Adjusted Diluted EPS: $0.35    P/E (5/4/99 price): 103.9x
Difference: EPS 21% lower, P/E 26% higher

Just to make sure you see the important figure, net income would have been 21% lower than the reported figure if options were accounted for using the "fair value" method of accounting.

No Reported Income Statement Impact

Justifications for not requiring companies to record options on their income statements include: (1) no cash outflow occurs when the option is granted, and (2) the true market value of the options is indeterminable. These two arguments are true. Instead of expending cash to issue options, a company "prints" them by assuming the obligation to issue shares upon exercise. No cash changes hands at the time of issuance. Determining the market value of an option is an art, not a science. While current valuation techniques are quite powerful, the results are dependent on several assumed variables. In addition, the market is littered with securities trading at prices much different from their theoretical values. Despite these problems, I think expensing options at a theoretical value is far preferable to ignoring them.

To see the current accounting treatment in practice, let's continue working with the example used in last Friday's column. Sally, an employee of New Age Inc., was granted options on 2,000 shares of company stock (at a $40 exercise price). New Age incurred no cash outflow and no expense at the time of this grant (although it pays Sally $10,000 less in cash compensations than a competitor offered). After spending five successful years at the company, Sally decides to exercise her options since the stock has risen to $70 and she wants to buy a home. When this occurs, Sally hands $80,000 over to New Age in return for 2,000 company shares. She then immediately sells these shares on the market for $140,000, reaping a gross profit of $60,000. Under current accounting treatment, no expense is recorded on New Age's income statement even though $140,000 worth of stock was sold for $80,000. I think this expense is real.

If New Age were to issue those 2,000 shares to a non-employee, the company would have received $140,000 in cash. Because they were issued to an employee under an options grant, however, only $80,000 was realized. Some people might logically believe that the $60,000 difference should be recorded as an employee expense at the time Sally's option is exercised. That solution seems ideal, in that it records the actual cost to the company, but in reality it would result in an inequitable outcome. Companies with strong stock prices would be penalized, while those with weak prices would benefit.

Sally made a profit of $60,000 on our example as presented. If fate had turned its hand another way, however, the outcome could have been much different. If New Age's stock had stayed under $40 throughout Sally's employment, she would not have exercised her options. New Age wouldn't have issued any new shares. Assuming the methodology proposed in the last paragraph, New Age would have incurred $60,000 in expense in the original case and no expense in the alternative situation when the stock performed poorly. Those values are accurate at the time the exercise occurs, but they are after the fact and not indicative of what a rational person would have paid on the issuance date.

At the date of grant, no one knew whether New Age stock would increase or decrease in the ensuing years. Market practitioners use the Black-Scholes option pricing model to determine the value of securities in such circumstances. This model incorporates statistics like an option's duration and the underlying stock's expected volatility to determine a theoretical value. While this figure may not represent the actual price at which an option could be bought or sold (due to market vagaries), it represents the best approximation of the securities' value. To me, the theoretical option value is much more representative of what is happening at the company than nothing, which is what companies are currently recording.

As we saw in the real example above, the difference between reported and options-adjusted earnings is substantial for many companies. EPS for Starbucks would have been reduced by 21%, Microsoft would have taken an 11% hit, Dell would have been knocked for 9%, and T. Rowe Price's results would have dipped 7%. To make sure that investors are aware of these differences, companies should be required to move this cost out of footnotes which are generally ignored and onto the reported income statement.

Options affect much more than a company's income statement. On Friday, I'll conclude this series by looking at how options grants impact the balance sheet and the interaction between stock buybacks and option programs.

Note: "Adjusted" numbers are adjusted for the period cost option grants, as reported in each company's 10-K. The value of options is calculated using the Black-Scholes options pricing model. "EPS" stands for Earnings Per Share. EPS has been adjusted for subsequent stock splits.

(1) Microsoft's earnings exclude $296 million write-off for WebTV.

(2) Starbuck's earnings exclude $13.2 million in merger and integration costs for Seattle Coffee.

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