January 12, 2005
New Stock Option Rules To Dent Corporate Earnings and Cash Flows

In an attempt to sure up the Pension Benefit Guarantee Corporation President Bush wants to increase funding (from companies) to the PBGC. In an attempt to sure up Social Security Bush wants to create private accounts and slash future payouts. The particulars of each of these new proposals are lengthy, and likely to change before, and if, they are finalized.  Nevertheless, what no one seems to be mentioning is one apparent contradiction: Bush wants futurte pension fee collections by the PBGC to be indexed to wage growth and future Social Security payments to be indexed to inflation (CPI).  While hardly surprising, it is noteworthy that the U.S. government wants to collect more than they payout (wage growth outpaces inflation).

Bush’s schemes aside, one proposal that no longer needs any selling is expensed stock options. To be sure, with its December 16, 2004 revision of Statement 123 the Financial Accounting Standards Board (FASB) has finally got it right: baring congressional intervention companies will have to start expensing stock options after June 15, 2005 (FASB 123R ~ Deloitte Overview).

Also included in FASB’s statement was an amendment of Statement No. 95, Statement of Cash Flows.  This amendment – which is long overdue (since 1987) – will “require that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid.” What the amendment means with regards to stock options is that instead of the tax benefit from exercised stock options showing up in operating cash flow, it will be pushed down in the statement of cash flows to the financing section.  FASB could have achieved a similar, perhaps simpler, ends by forcing companies to shift treasury stock transactions (done to combat stock options dilution) from financing cash flow up to operating cash flow, yet the result is much the same. 

With the ‘expensed’ issue receiving all of the headlines not much has been said about the amendment to Statement 95 by the mainstream press. This may change in late 2005 as investor’s start to deal with potentially large changes in operating cash flow.
 
Does anyone care about Cash Flow?

The amendment to Statement 95 is not going to decide whether or not a company survives.  Indeed, and not unlike the income statement impact from expensing, cash flow and balance sheet accounting changes usually only effect the perceived, not the actual financial health of a company*. Even so, what could be potentially important is investor reaction to operating cash flow comparisons and/or the popular cash flow valuations. For example, in early 2004 Cisco Systems was trading at 26.57 times free cash flow, but would have been trading at 29.68 times free cash had tax benefits from stock options been shifted down in the statement of cash flows. Do investor’s analyzing operating cash flows care about a year-to-year fluctuations? Is a company that trades at 26 times free cash less attractive than one that trades at 30 times?  I would answer yes to both of these questions, although in the case of Cisco it is doubtful that any current shareholder would be swayed to buy or sell based upon the new stock option rules.

Market Impact of Statement 123R is Negative, But Perhaps Not Profound

It remains to be seen whether or not Wall Street will accept expensing.  As ridiculous as it may sound, analysts could simply ignore expensed earnings and focus on non expensed earnings.  This is exactly what The Street did when S&P started releasing ‘core’ earnings a couple of years ago. You would be hard pressed to find anyone focused on core earnings today.

Even if Wall Street decides to pay attention to actual/expensed earnings, the impact is not expected to be that negative. CSFB says that 117 S&P 500 companies already expense stock options, and expensed stock options are expected to trim S&P 500 earnings only by 3%-5% in 2005 (down from 8% in 2003, and roughly 20% in 2001 and 2002). In and of itself a 3% hit to S&P 500 earnings is worth mentioning, but does not necessarily spell disaster.

Even though the broad impact against earnings is not expected to be great, the impact will be dramatic for some companies. The overused example of Yahoo – which could be trading at a P/E multiple of more than 700 by year end – is worth remembering.  As for Statement 95, the impact to cash flows is an after thought or mild negative for most companies (including Cisco), while an ominous consideration for others.


As for the Wish List, Hancock Fabrics and Intrado will both be materially impacted by S123R. This is not to say that S123R should not be welcomed by Hancock and Intrado shareholders - it should. Rather, only that many valuation matrixes used to value TRDO and HKF will look less attractive by year end.


Is The Anti-Options Clan Preparing Another Attack?

As an example of the uncertainty surrounding the adoption of S123R consider Intel’s quarterly press release and outlook released after yesterday’s bell:

“These statements also do not include any impact related to the expensing of stock options under the Financial Accounting Standards Board's Statement 123R, which is effective for quarters beginning after June 15, 2005. Expensing of stock options would decrease gross margin, increase expenses (including R&D expenses) and affect the tax rate.” Intel

Remember that in the above statement Intel isn’t warning about an unexpected shock such as $100 oil or a collapse in the U.S. dollar.  Rather, the company is warning – quite vaguely I might add - about the impact of upcoming realities.  To be sure, the reality is that Statement 123R “would will decrease gross margin, increase expenses (including R&D expenses) and affect the tax rate.”  Is Intel, which ignored a shareholder vote to expense stock options last year, providing shareholders with all of the information they can for upcoming accounting changes, or are they preparing for one last stand?

Intel’s tone notwithstanding, I don’t think the lobby against expensing will put up another charge.  I could be wrong – the SEC could turn against FASB and Congressmen are up for sale.  However. given that international accounting bodies have already voted for expensing, hundreds of U.S. companies have already voluntarily begun expensing, and FASB has passed its final – before revisions – statement, reality is sinking in.

Perception Shapes Reality. Herz The Hero?

While Statement 123R does not impact the actual financial health of a company, it does have the potential to impact investor perception of financial health. For example, company ABC was profitable in 2004 when the company didn’t expense but unprofitable in 2005 when they did expense…the word ‘loss’ may not sit will with many ABC shareholders, regardless of the explanation attached to it.

Such is why S123R could be more negative than the 3% hit to S&P 500 earnings suggests: investors sell first and ask questions later.  Should a few of the options abusers witness stock price slides this could have a dampening impact on the entire market. 

As for being swamped later this year by all of the cash flow revisions, blame FASB.  After all, FASB – whose predecessor unwittingly allowed companies to not expense stock options more than 30-years ago – is also responsible for the mess stock options/buy backs have created in the statement of cash flows:

“. . . allocation of income taxes paid to operating, investing, and financing activities would be so complex and arbitrary that the benefits, if any, would not justify the costs involved.” Statement No. 95

With S123R has FASB redeemed itself? I am skeptical, and think that further action on SPEs and pension accounting are required before FASB gets in the investors’ good book.  Nevertheless, with S123R it is clear that Herz is gunning to be a hero, and clearly not a zero.