April 28, 2003
Herz May be Hercules & Greenspan May be a Chimp
It is not as simple as saying that once stock options are expensed that the markets will crumble because of the negative impact on earnings. Rather, and as was the case with the end of amortization of goodwill (enacted last year), companies can report huge shortfalls due to accounting changes, but so long as the term ‘non cash charge’ is touted this can help offset near-term investor concerns of overvaluation. For example, AOL loses $100 billion in a quarter – but how much of that loss was ‘cash’? (This was a question everyone asked when AOL took its huge goodwill write-off. Sadly, few asked this question when the company previously pooled goodwill to pad earnings).
That said, unlike goodwill write-downs, which were largely a 1-time event (baring the quarterly intangible impairment tests), stock options bring a new wrinkle: when stock options begin being expensed this will be a permanent, ongoing expense for many companies. Accordingly, when stock options are expensed – and after a couple of quarters of ‘earnings would have been 18% higher without expensing stock options’ - common sense should prevail. To note: I stress when stock options are expensed because I believe FASB will win the battle to expense (as opposed to the early 1990s expensing battle that corporate America won).
What is ‘common sense’ when it comes to stock options?
Despite what some diehard tech CEOs, accountants, and some paid off Congressmen have been suggesting, stock options are an expense. For example, Intel CEO Craig Bartlett holds 5.8 million options, and Intel reports $3.117 billion in net income (47.66055 cents per share). If Mr. Bartlett had exercised his options INTC would have only earned 47.61832 cents a share. A fifth of cent may not seem like much. However, in 2002 if INTC options were expensed the company’s headline earnings number would have been 38% lower than reported (78% lower in 2001, and 7.6% lower in 2000). Quite frankly, common sense says that since options are being issued year-after-year – and whether the options represent a fifth of a cent or 78% of earnings - that at least some expense should be recorded in the income statement.
That said, it is true that no formula can accurately predict how many options will be exercised in the future. Is this a reason not to record any expense? Some people, although their number is diminishing, seem to think so. Consider what Chairman Andrew Grove said in Intel’s 2002 Annual Report:
“The real issue highlighted in the events of 2002 is excessive compensation for executives, no matter what currency is used—cash loans, apartments, options, whatever.”
As any sane individual would, Mr. Grove realizes that options are a form of ‘currency’. He goes on to say:
“People who focus on accounting for stock options risk harming investor interests. Current proposals to change the accounting would tinker with financial statements to the detriment of meaningful disclosure. The result would be distorted financial information and new opportunities for abuse. We do not need to follow an era of “virtual profits” with one of “virtual expenses,” and we do not want to under cut the ability and willingness of companies to use broad-based option plans when we should be trying to appropriately solve the actual problems in executive compensation.”
It is uncertain exactly how expensing stock options would ‘harm investor interests’. After all, Grove believes (says he believes) that shareholders read all the footnotes, wherein options are already expensed. As such, if the removal of option expenses from the footnotes to the income statement were to ‘harm investor interests’, the initial theory that investors read footnotes becomes completely shot.
Regardless, in Mr. Grove’s attempt to deflect focus from expensing options – he argues that excessive compensation is the real demon - what he neglects to mention is that not recording any stock options expense is what creates a virtual profit. How can Mr. Groove admit that options are currency, be outraged by virtual profits, and then proceed to argue that no options expense should be recorded in the income statement? It boggles the mind…
Dilutionary Considerations and Looking at the Real Problem of Buy Backs
Intel CFO Andy Bryant notes:
“Options do not alter the overall financial performance of a company. They do not reduce earnings, but they do increase the potential number of shares that could have a claim to those earnings.”
Not surprisingly, what Mr. Bryant does not mention is that if companies use shareholder funds to repurchase stock the dilutionary impact of stock options is never realized. Such is why Bryant throws in the word ‘potentially’ – because until options actually dilute EPS, in his warped opinion, they do not reduce earnings.
In fact, what many companies do, including Intel, is doll out stock options to employees instead cash, and when the outstanding share base is about to be diluted use cash to repurchase shares. The stock options are not expensed and neither is the cash used for buy backs (what a wonderful world of virtual profits!).
More to the point, the argument by Intel that options should not be expensed begins to crumble when you factor in that the company has repurchased $4 billion in stock during each of the last three years. Think about this for a second: during the last three years Intel insiders have been religiously selling and exercising stock (not buying), yet the company has determined that the best use for its cash has been to buy $12 billion of stock while issuing a measly $1.5 billion in dividends? Forgive me for asking a basic question – but if no insiders are prepared to buy stock how can these same insiders be so certain that the best use for shareholder money is to buy stock?
Without belaboring the point, the basic dots to connect are that buy backs are used to cover up stock options dilution. If you take away the reckless buy back policies of the Intel’s you are, in affect, expensing stock options (exercised shares would dilute the float and impact earnings).
Incidentally, neither FASB nor the SEC has attempted to attack the options problem in this round about way: that being to intensely regulate buy backs (as was being done before 1982) to ensure that insider and shareholder interests are aligned. Furthermore, shareholders, many of which have come to learn that buy backs are part of the ordinary run of business, have not revolted against buy backs (most shareholder believe that all buy backs are good news as they support a company’s stock price). Needless to say, buy backs are being used – as currency – to covertly compensate executives and employees, and the evidence is clear (as companies project stagnate or declining growth rates and still buy back copious amounts of stock), that boards do not necessarily enact repurchase programs because they have the shareholders interests in mind.
Can a company try to predict when its shares are undervalued and only then buy back stock? Well, insiders – or the board of directors that votes on repurchase programs – have no problem timing their own purchases…
FASB’s New Leader Takes Charge
FASB Chairman Jenkins, who served for the 5-years ended June 2002, accomplished nothing noteworthy during his term. To understand his fighting spirit - or lack thereof - consider what he had to say following the Enron debacle on the topic of off balance sheet financing:
“We have been working on a broad, multifaceted project on consolidations for 20 years. And in the last 10 years, we've issued two exposure drafts for comment that would have addressed SPEs. In both cases we received significant criticism from companies and the accounting profession, such that we felt that we couldn't go forward.” CFO
Perhaps Mr. Jenkins should have tried to map out accounting standards based upon investor interests and not the interests of corporate America and accountants?
Needless to say, Jenkins spent most if his term as FASB boss trying to stuff more intangibles into balance sheets. He reckoned – and to paraphrase some of his writings – that since stock prices had escalated to historical high valuation levels that there must be some fundamental reason why, and FASB should be the one to discover this reason and adopt the appropriate standards. Quite frankly, Jenkins was, and this is hopefully the greatest insult possible, even worse at his job than Harvey Pitt.
Flash forward to new FASB boss Robert Herz, formerly a senior partner at PricewaterhouseCoopers, and co-author of The ValueReporting Revolution: Moving Beyond the Earnings Game. Less than 1-year on the job and already Herz is upsetting many interests around him - proof that he trying to do something other than the television circuit to help investors. His first order of business was to tell influential interests (notably the SEC and EITF) that while their opinions are welcome, FASB is in sole charge of setting U.S. accounting standards. His next order business was to do what FASB and Jenkins couldn’t accomplish in two decades…Herz became FASB boss on July 1, 2002 and by January 2003 new consolidation rules were in place.
I’ll be the first person to admit that FASB’s consolidation rules are a band aid solution to the problem - there is the question of controlling interest and which company’s need to consolidate and how. Nevertheless, Herz appears to be a man of action, something that has been desperately needed for a long time at FASB. Along with his initial SPE victory, Herz has slammed pension accounting practices and is gunning to bring in new standards this year, and he has also stated, with the complete backing of FASB, that companies must expense options (likely to take place next year).
It may be too early to jump on the Herz bandwagon. However, if by the end of 2004 companies are expensing options and reporting coherent annual changes in their pension plans (as opposed to spreading pension assets over many years and manipulating future earnings), he will have done more in two years than FASB had done in the last 20 years.
I don’t buy into Herz’s principle based accounting approach – this only works when companies have principles - but I am nonetheless starting to believe that Herz can be Hercules; that he can accomplish what so many before him have tried to accomplish and failed. His first order of business should remain expensing stock options: something both Jenkins and Pitt should be ashamed of for not tackling.
Again, the premise that all shareholders read footnotes is the reason why forcing all companies to expense stock options should be easy – anyone who believes investors read footnotes and does not want to expense options (everyone at Intel), is attempting to argue that investors are highly intelligent individuals one moment, and brainless the next…
“The existing models do not necessarily provide a reliable single measure of the fair value of employee stock options.” Intel.
Herz should reply that the model of virtual profits, created by unexpensed stock options being funded via share repurchases, is a much worse alternative for shareholders than a footnote upgrade.
This Week
There will come a point when the downtrodden economic estimates will overestimate weakness. When this happens - when a handful of stats beat to the upside - the markets will likely rally. However, when – more importantly ‘will’ - this happen?
This week’s flurry of reports, many of which are for April, will surely impact stocks. Specifically, the employment reports – the seemingly crucial weekly jobless claims and Friday’s jobs reports – should be watched closely. If another ugly payrolls number is released the markets will undoubtedly tank. However, if the number is ugly, as a couple of Wall Street firms predict that the Fed will cut rates at the upcoming FOMC meeting (May 6) we may get the expected pre-Fed cut bounce higher, to be followed up by the post-Fed cut plunge.
* Alan Greenspan will testify before the House Financial Services Committee on Wednesday. Those that thought Greenspan’s image had been tarnished by the stock market debacle, the recession, and two years of sluggish growth were surprised last week when the market cheered news that Bush will reappoint Greenspan. One day people will look back and argue that a chimpanzee randomly pressing down on two buttons – one labeled ‘cut’ and the other labeled ‘print’ - could have done what Mr. G has done since 2001. That day is not today.
In the last couple of words I have been optimistic about the possibility for an enlargening bear market rally. This optimism has almost completely vanished (the short selling stats are now dated and May is not a great month for fund inflows). Quite frankly, the economic stats remain horrible. As a quick example, when are weekly jobless claims going to dip below the psychologically important 400K level?
The post war economic recovering is not materializing, and I don’t believe it is because American’s are huddled around their televisions watching SARS. Rather, SARS serves as an excellent excuse for poor economic performance at a time when any excuse is desperately needed. Such is why Greenspan is a little bit more valuable than a chimp – he is good at making up excuses…
In sum, the one single hope for the markets – twisted as this logic may seem – is that the upcoming economic reports are negative. This would undoubtedly lead to a conclusion by market participants that the Fed will cut interest rates in May, and traders may attempt to position themselves early for an anticipated rally ahead of the FOMC meeting. Beyond this hope, the market looks set to drift into the summer doldrums sideways – the threat of a plunge to new lows ever imminent.
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