If there was any thought that incoming SEC chairman Christopher Cox would undermine the much-anticipated mandatory expensing of stock options, forget it. A long-time critic of the plan to expense stock options, Cox quickly ruled out any interference with the implementation of Financial Accounting Standards Board (Fasb) Statement 123R, which once and for all treats stock options as an expense on the income statement.
Depending on their fiscal year-end, most blue-chip technology companies – a group that provided the stiffest opposition to the rule change – will be expensing when the new rule kicks in on January 1, 2006. The change is by no means US-centric, as companies reporting under international financial reporting standards (IFRS) are already expensing share-based payments.
‘Everyone understands these payments represent a cost, and a recurring cost at that,’ says Roger Taylor, CFO of the Carphone Warehouse, a UK mobile communications retailer. ‘So people are taking it as part of the normalized cost of running their business. We started prepping the investment community about 18 months ago, giving guidance on what the cost would be.’
Companies may be resigned to expensing, but many in the investment community are not. While firms prepare to expense the cost of options, many analysts are ignoring the cost altogether. Consider what happened to Google, which announced earnings of $343 mn, or $1.19 a share for the quarter ended June 30, 2005. Thomson’s First Call, the leading compiler of earnings estimates, published a consensus number of $1.25 a share, which made it appear as though Google had ‘missed’ its number. The First Call number was higher because the majority of analysts covering the company had stripped out the options expense, even though Google included the cost in its income statement.
Not minding the Gaap
‘It does not surprise me that analysts are ignoring the impact [of options] – traditionally, investors have not paid attention to corporate governance,’ says Sarah Wilson, managing director of UK proxy voting agency Manifest. ‘There are also many companies experiencing good performance only because the related index is rising, so even analysts of corporate governance are not looking at the issue. We’re definitely in a period of transition, but I’m troubled that people are ignoring these things.’
Analysts’ reactions to options expensing is by no means uniform. In Carphone Warehouse’s case, for example, most analysts following the firm are using the company’s reported figures, without issuing pro-forma numbers that exclude the cost of options.
‘In terms of analysts, there seems to be confusion about the impact of IFRS and the implications of what to do to get to normalized earnings,’ says Taylor. ‘In our case, all our consensus numbers for next year are including the cost of the options as a normalized cost. We tell people what it is – in our case, £3 mn to £4 mn ($5.3 mn to $7.1 mn) a year.’
But it is precisely the uneven response that is causing confusion. Of course, much of the response is predicated upon the impact of the expense. Many European firms, for example, have not relied heavily on options as a compensation tool.
‘I am including the cost of options, which is pretty standard practice here in Norway,’ says Tore Ostby, a senior analyst at Handelsbanken Capital Markets in Oslo. ‘I only follow Norwegian companies, and the rule change has had a pretty small impact. It is true that if you look at consensus figures, you don’t know whether analysts are including it or not, which is a problem. But most of the companies I follow give guidance, and most did it as a comment when they changed their accounting earlier this year.’
Tom Vermeiren, who covers global technology companies at Fortis Bank in Brussels, has a different observation. ‘My impression is that much of the market is disregarding the cost of options,’ he notes. ‘People were looking for figures that were closer to the past in order to have comparable numbers, so the companies are giving both figures.’
Vermeiren expects to back out the expense of options for both European and US companies, though most US firms are not yet officially expensing. ‘It’s the very large companies that could influence how everyone else responds to the rule change,’ he says. ‘The impact of the expense from options is greater for them, so it’s too early to tell what will happen when they start officially expensing.’
The same assessment is offered by Chad Bartley, equity research analyst at Pacific Crest Securities in Portland, Oregon. Bartley follows internet companies, which have relied heavily on options to recruit top talent. Because virtually none has adopted the rule change as of yet, he isn’t sure exactly how he’ll treat the expensing issue.
‘Company managements have been prepping analysts for the change, but most have not guided us on what the expense will be,’ notes Bartley. ‘Some have modest expensing in the income statement, but the rule change on January 1 will lead to a much bigger number. I suspect analysts will look at the results both ways: Gaap and on a pro-forma basis.’
No consensus
Some of the loudest criticism has been aimed not at securities analysts or the companies themselves, but at those firms that track and publish earnings estimates. First Call was singled out in a New York Times article in August for its policy of taking the analysts’ estimates as is – so that those excluding the cost of options are published as such, alongside estimates that take the cost into account.
First Call is by no means alone in facing a difficult situation given analysts’ widely divergent methods for treating stock options expensing. Nor is there a consistency in the inconsistency, such as a uniform treatment of options expensing by industry or across individual research firms.
‘We are finding that there is a mix in how it is treated even on a company-by-company basis,’ says Steve Scala, VP of operations at Zacks Investment Research. ‘We thought it would perhaps differ only by industry, or that brokerages would have a policy, but it’s mostly on a company or analyst basis. I’ve even seen some analysts include on a quarterly basis and exclude on an annual basis.’
Scala adds that Zacks is waiting to see the different models analysts are using. In the meantime, the firm is taking a company-by-company approach as it compiles the estimates. ‘For now we’re taking a look at what the majority of analysts are doing for each company,’ he says. ‘We don’t have a set policy yet, though I’m getting calls all the time asking whether we do. We’re hoping the companies or the Street will go one way or the other, though I think the analysts don’t want to be the first to make the call. Our policy is to include and normalize the numbers rather than exclude any analyst, but we just can’t do that yet.’
This lack of consistency is frustrating, even for professional investors. ‘It would certainly be better if there was a stronger standard at this point where everyone does it the same way,’ says Bruce Geller, a portfolio manager at Dalton Greiner Hartman Maher in New York City. ‘Even First Call and Zacks don’t have a standard to apply across the board. It makes it confusing, as the analysts don’t always tell you what they’re doing.’
Time will tell
Just which interested party will be the first to blink, so to speak, is still an open question. Will analysts begin following a uniform set of rules, or will companies try to proactively address the issue by demanding analysts include the expense in their forecasts? Or will it be a First Call or Zacks that reacts first?
Some organizations have already taken steps toward standardizing the treatment of options expensing. For example, First Call recently announced it will publish the majority and minority consensus estimates, rather than just the majority.
‘Events have already advanced rapidly,’ says Rebecca McEnally, director of capital markets at the CFA Centre for Financial Market Integrity. ‘You have the First Call decision. A second event is Merrill Lynch saying its analysts will include the expense of stock options in their estimates. UBS, Credit Suisse and a few others have announced similar policies, but Merrill’s move adds considerable weight because the company is a major player in sell-side research. Then there’s Microsoft, which has stepped forward and said if you issue a forecast for us, we expect you to include expensing.’
For now, Microsoft is a rare minority – and, given its clout, it stands a better chance of chiding analysts taking a particular direction. But the issue is one many IROs are grappling with. ‘We believe in transparency,’ says Jeff Lilly, senior manager of IR at Citrix Systems in Fort Lauderdale, Florida. ‘Regardless of what sell-side firms do, we want to provide as much data as possible to the analyst community so it can decide what to do with the numbers. We don’t want to tell analysts what to do.’
Lilly has been busy talking to other IROs, trying to sort through how best to deal with the expensing rule change. Citrix is not yet expensing but will commence in March 2006. Lilly expects, given the existing level of disclosure, that analysts will look at earnings both ways, with the expense and without. ‘Each sell-side firm is unique in how it handles expensing – it’s really too early to tell how this will play out, ‘ he says. ‘But I imagine over the next couple of quarters this will be sorted through.’
For proponents of options expensing, including McEnally, the long road to a conclusion is nearly over. ‘We’re optimistic the current situation – the ambiguity over how the expense is going to be treated by the Street – will change,’ he observes. ‘It’s going to be business as usual soon, and everyone will move on to the next issue.’
