Where Did the Earnings Go?

From Whitney Tilson shining the spotlight on the Coalition of the Greedy to Seth Jayson's skewering of self-serving politicians shilling for the tech industry, the Fool has long been a proponent of expensing stock options. We abide by the apparently absurd notion that a company's financial statements should be an accurate representation of its economic transactions, including compensation arrangements with its employees.

That this very real expense should be hidden in the back corners of 10-K filings never to be spoken of doesn't make a lot of sense. At least not to me, but I'm not a tech executive trying to pump up my company's stock price. I'll leave it at that -- there's no need for me to rehash the arguments as to why options should be expensed when I can point you to Bill Mann's fine articles on the Financial Accounting Standards Board (FASB) and his ideal stock options model.

Instead, what I'm going to do today is show the impact that expensing options will have on the earnings of some of the most prominent names in the biotech industry. The reason for doing this right now is that in December 2004, the FASB issued "Statement of Financial Accounting Standards No. 123R: Share-Based Payment." This is scheduled to take effect in the third quarter of this year, with options expensed according to their fair value as of the date they are granted.

This change is going to affect a lot of companies, including some of the market's favorites in the biotech universe. Now that all of the 10-Ks for 2004 have been filed with the SEC, I wanted to see just how big this effect on earnings would be. I had to wait until the 10-Ks were in because this kind of information isn't put in the much more widely read earnings press releases that came out earlier this year. After you see the gory details, you'll know why.

The table below lists the fully diluted GAAP earnings per share (EPS) of seven prominent biotech companies. The pro forma EPS column is what would have happened if stock options were expensed last year in accordance with No. 123R. Note that both the GAAP and pro forma EPS come from the companies themselves. I just looked them up and recorded them here.

Before I pulled these numbers, I assumed that expensing options would cause a dip in EPS. These are growing technology companies that tend to use stock options in employee compensation packages, after all -- not just for the upper-level execs but also for the research scientists that are doing the grunt work of drug discovery. But the extent to which earnings are chopped across the board after these options are expensed is pretty striking.

The least affected of the group is Amgen, with a 13% decrease in EPS. But that's still quite a significant adjustment. If Amgen reported a 13% decline in earnings for nearly any reason its stock would get creamed. So I don't want to let it off the hook just because it's the best in this bunch.

The worst off is Genzyme. I think Genzyme is a great company with a solid portfolio of both marketed and development-stage drugs. But when stock options expense is included, the company is no longer profitable. That's a staggering revelation, considering it is one of the largest biotechs in the world and is viewed as one of the industry's great success stories.

Future outlook
Even in the biotech world, where investors have a high tolerance for risk and red ink, earnings are ultimately everything. Once these companies turn profitable, any quarter with a slight earnings "disappointment" sends the stocks tumbling. In this environment, I very much doubt that stock option expenses of this magnitude will continue for long. Shareholders will be outraged if stock prices plummet because of massive options expenses keeping EPS down.

I'm expecting a transitional period, which could be rough for biotech stocks. I don't like to make short-term market calls, and I wonder whether this is not already priced into these stocks. Yet while discussion of options is fairly common, how often do you see the raw numbers laid out clearly? The companies certainly don't go out of the way to publicize them. So what's going to happen later this year when the quarterly earnings press releases all of a sudden show GAAP earnings to be quite a bit lower than what the market was used to?

While there will certainly be an adjustment period, I view the increased transparency as a big positive for investors. Ultimately, though, this does not change my view that biotech investors are best served by looking for companies that have the best drugs in areas where there is a medical need and minimal competition. The clarity of the financial statements just makes it a bit more convenient to decide how much to pay for those competitive advantages.

If you're interested in other biotech stock ideas, click here for a free 30-day trial to our Motley Fool Rule Breakers newsletter. And for additional articles on the biotech industry, see:

• Do Good Drugs Guarantee Investment Success?
• The Best Company I've Never Owned
• After the Crash, Is Biogen IDEC a Buy?
• From Rags to Riches
• Is Big Pharma a Bargain?

Fool contributor Charly Travers does not own shares of any company mentioned in this article. The Motley Fool has a disclosure policy .