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Free ride
Tech stocks may have to expense options next year. But Wall Street will probably ignore the costs.
December 30, 2004: 12:41 PM EST
By Paul R. La Monica, CNN/Money senior writer

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NEW YORK (CNN/Money) - June 15, 2005 is D-Day for many big tech companies. That's when a rule requiring them to expense stock options is set to go into effect.

Several large tech companies, most notably Cisco Systems (Research) and Intel (Research), have vociferously protested the rule change, which has been approved by the Financial Accounting Standards Board but could be blocked by Congress.

Techs claim that is difficult to calculate an accurate value for stock options.

What's more, many of these tech companies have argued that companies would give out fewer options and that will make it tougher to attract high profile talent. (I've written before that I think both of these arguments are bunk.)

What they are really worried about though, is that expensing options would reduce reported earnings, which could make already pricey tech stocks seem more expensive.

Intel, for example, disclosed in the footnotes of its latest quarterly filing that if you included the cost of options, profits would have been 17 percent lower.

Cisco's earnings would have been reduced by 19 percent in its latest quarter. Dell (Research) would have taken a 24 percent hit. Ditto for Yahoo! (Research) And eBay's (Research) third-quarter earnings would have been a whopping 44 percent lower.

But I wonder if tech companies really have to worry about these hits to the bottom line.

Before and after
Earnings would be lower if techs had to expense stock options.
CompanyEPS (reported)EPS (incl. options expenses)
Cisco Systems$0.21$0.17
* based on fully diluted EPS figures from the most recent quarter.
Source:Company reports

When push comes to shove, I think that Wall Street will choose to blissfully ignore the cost of options and other equity-based forms of compensation. I'm not saying that's right. That's just the way it is.

"I do believe that options are compensation but I don't think expensing them is going to affect valuations of tech stocks very much," said Ted Parrish, co-manager of the Henssler Equity fund, which owns shares of Dell, Intel and Microsoft.

After all, companies that have already bitten the bullet and either expense options or similar forms of equity-based compensation are given a pass by Wall Street.

Street accentuates the positive

Microsoft (Research), for example, no longer gives out options. Instead it awards employees restricted stock and includes the expense of these grants in its earnings.

To Microsoft's credit, it clearly stated in its third-quarter report that it earned $2.9 billion, or 27 cents a share. But this figure included the stock-based compensation. So what did Wall Street analysts do? They brush aside that charge and say that Microsoft reported earnings of 31 cents a share.

The same thing happens with (Research), which began expensing options in 2002 and now gives out restricted stock instead of options.

Amazon said in October that it earned $54 million, or 13 cents a share. But its pro-forma earnings, which exclude, among other things, $9.3 million in stock-based compensation costs, were 17 cents a share. And that higher number is the one Wall Street focused on.

And one of the more egregious examples of the pro-forma earnings game took place with Google's third quarter earnings report, its first as a public company. Google (Research) clearly stated that net income for the quarter was $52 million, or 19 cents a share.

But analysts backed out several expenses, including $68 million for stock-based compensation, to wind up with an earnings figure of 70 cents.

I don't blame the companies here. Their financial reports are fairly transparent and they lead with the true GAAP net income number, i.e. the lower one.

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By Paul R. La Monica
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Still, if companies have to start reporting options as expenses next year, my guess is that these costs will be added to the litany of so-called "one-time" charges that Wall Street likes to think don't matter. Those changes include legal settlements and restructuring costs.

And since consensus estimates are what most investors use to value companies, then there's no reason to expect that tech stocks will take a big dive once options expensing rules kick in. As long as analysts are willing to keep highlighting the higher numbers, the stocks probably won't be perceived as being less profitable and more expensive.

Again, I'm not saying that's right. It's just how the game is played.

And on that note, I hope everyone has a Happy New Year!

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