Options: One Rule, Many Results


By Amrit Tewary In December, 2004, the Financial Accounting Standards Board (FASB) issued the Statement of Financial Accounting Standards No. 123R (SFAS 123R) requiring that public companies begin recording the fair value of stock-based compensation as an expense in their income statements in the first reporting period after June 15, 2005 (or December 15, 2005 for small businesses). In April 2005, the Securities and Exchange Commission (SEC) deferred the compliance dates for SFAS 123R so that companies will be required to implement the rule at the beginning of their next fiscal year, instead of the next reporting period that begins after June 15.

We believe the new accounting requirements will especially affect reported earnings at semiconductor companies (as well as other technology companies), which rely heavily on stock options to retain employees.

Once the new accounting rules take effect, chipmakers will be required to include stock-option compensation expenses on the income statement as part of their cost of goods sold or other operating expense line items. Under the previous set of regulations, public companies were only required to disclose option costs (under the fair value method) in a footnote in their financial statements.

CONFLICTING VIEWS. Many investors see the new policy as a welcome change, given their belief that option expense is a real cost to shareholders and should be accounted for in a company's income statement. However, a number of semiconductor companies have lobbied strongly against the change (to no avail), saying the new option-accounting rules would lead to less transparent financial reporting by forcing companies to make subjective assumptions about the value of options.

Proponents of option expensing have countered that, although current methods to estimate the fair value of options may not be foolproof, they are a much better alternative than not expensing options at all. The new policy is currently scheduled to go into effect as planned, but Congress retains oversight of the matter and could modify the new rules, should it be deem such action necessary.

We believe investors need to educate themselves about the impact that mandatory option expensing will have on the future earnings of particular chip companies in which they may have an interest. Once options are expensed, reported earnings will be diluted, which in turn will affect earnings performance ratios. In addition, reported earnings under the new rules will no longer be comparable to prior periods, since GAAP results in past periods excluded option expense.

BUYERS' CHOICE. To obtain better "apples-to-apples" comparisons for valuation purposes, investors should compare future GAAP numbers under the new rules to historical "pro-forma" EPS numbers, inclusive of options, for past periods in which options were not expensed in GAAP results. These pro-forma EPS numbers can be obtained from the options-related footnotes of a public company's 10-K documents.

Alternatively, investors may refer to S&P Core Earnings data (both historical numbers and forward estimates) on published companies for comparisons. S&P Core Earnings include valid costs of doing business such as employee stock-option expense, while excluding certain nonrecurring items. (A detailed explanation of Core Earnings can be found at standardandpoors.com, in the Analytical Methodology section under Equity Research.)

On the other hand, if they prefer nonearnings based measures, investors can refer to sales metrics (such as price-to-sales or enterprise value-to-sales) or cash flow ratios (such as price-to-free-cash flow), which will not be impacted by the accounting change.

WINNERS AND LOSERS. Once the accounting change goes into effect, the impact on companies' earnings will vary, with some chipmakers having more option expense than others. We believe many chip companies have option exposure that is similar to bellwethers Intel (INTC

; ranked hold; recent price: $26.25) and Texas Instruments (TXN

; hold; $28.22). According to 10-K footnotes, Intel would have had per-share option expense under the fair value method of 19 cents in 2004, while Texas Instruments would have had per-share option expense of 20 cents in 2004.

Many chip outfits, however, will likely have above-average per-share exposure to options, vs. peers. Analog Devices (ADI

; hold; $37.41), for example, would have had stock option expense of 54 cents per share in its 2004 fiscal year (ending October). Also, memory chipmaker Micron Technology (MU

; strong sell; $10.45) would have had option expense of 31 cents in fiscal 2004 (ending August).

In addition, there are a few chip companies that have very little per-share exposure to options. For instance, discrete semiconductor maker Vishay Intertechnology (VSH

; hold; $11.90) had estimated stock option expense of only a penny per share in 2004.

TWO CHOICES. It will be interesting to see how, if at all, chip companies adjust their compensation policies to account for the new option-expensing rules. Those that move aggressively toward a cash-based compensation policy will likely be able to limit earnings dilution from options, but in the process may risk losing top-performing talent to competing firms.

On the other hand, we believe companies that favor an options-focused policy will likely retain top talent, but could see above-average earnings dilution from option costs.

Required Disclosures

In the U.S.

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.8% of issuers with buy recommendations, 56.7% with hold recommendations and 12.5% with sell recommendations.

In Europe

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 29.2% of issuers with buy recommendations, 50.5% with hold recommendations and 20.3% with sell recommendations.

In Asia

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 34.3% of issuers with buy recommendations, 48.0% with hold recommendations and 17.7% with sell recommendations.

Globally

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.2% with hold recommendations and 13.8% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas ndex.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from INTC, TXN, ADI, MU and VSH during the past 12 months.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results. Analyst Tewary follows semiconductor stocks for Standard & Poor's Equity Research


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