During the boom years and beyond, many companies enticed employees with piles of options, which allow recipients to buy stock at a set price. And why not? If share prices rose, employees profited. Unlike a cash salary, options weren't treated as an expense and didn't dent the bottom line.
That accounting maneuver is on its way out. After losing a decade-long battle with regulators, U.S. companies will finally be required to deduct the cost of options from their earnings starting in fiscal 2006, which for most means the quarter beginning in January.
Some companies are taking steps that will moderate the hit to their earnings. One gambit is tinkering with the formulas used to assign options a value, which can result in lower costs. A more popular strategy has been to accelerate the vesting of options. That, too, has the effect of pumping up future profits. "It's smoke and mirrors," warns Bear, Stearns & Co. () analyst Christopher Senyek. "Options expenses could be understated for years ahead."
The amounts at stake are substantial. For the Standard & Poor's 500-stock index as a whole, expensing options will cut earnings per share by roughly 3% for fiscal 2006, according to Credit Suisse First Boston (). Tech and other options-happy sectors could face much bigger income reductions.
Some companies are responding by simply issuing fewer options. Others are making less direct adjustments. That's possible, in part, because the expense attributed to options is an estimate. Using esoteric formulas, companies weigh how long an option might be held, the volatility of the stock, and other factors. Rejiggering the assumptions can lower estimates of what options will cost when recipients ultimately exercise them. Changing the assumption about volatility can have a particularly significant effect. Options for more volatile stocks are worth more because of the greater chance that recipients will exercise them when prices bounce up. Many companies have reduced their volatility estimates, apparently to whittle down options costs, according to David B. Trainer, president of investment research firm New Constructs LLC.
In 2004 alone, roughly 200 companies in the Russell 1000 cut their volatility estimates by an average of 17%, according to New Constructs. That lowered their average options expenses by 23%, saving $1.5 billion. Trainer believes that many more companies have done the same this year, although the number won't be clear until yearend financials are filed.
Some stocks are moving around less than they used to, making it appropriate to reduce volatility measures. Whatever the reason, a lot of companies are making changes. Time Warner's lowering of its expected volatility in 2004 cut its options expense by $72 million, a 28% drop, according to New Constructs. Wireless service provider Nextel Partners slashed estimated options expenses from $41 million to $33 million. A Time Warner spokeswoman says the new calculation accurately reflects the more stable range in which the company's stock now trades. Nextel Partners declined to comment.
Another tactic hundreds of companies have used is accelerated vesting. Options traditionally become effective over a period of years after they're granted and are canceled if the recipient leaves the company. By making options vest in 2005 rather than in future years, companies can bury the cost in the footnotes of their 2005 paperwork. That boosts earnings in 2006 and beyond.
The number of companies employing the practice has almost doubled since midyear, from 234 in July to 439 by late November, according to Bear Stearns. The activity has slashed $4 billion from expenses for 2006 and later years. Senyek of Bear Stearns projects that 600 companies could speed up vesting by the end of 2005, boosting future profits by over $5 billion.
Tech companies have been the biggest speedvesters. Sun Microsystems Inc. () cut future expenses by $400 million by moving up the vesting of some 45 million options early this year. In recent months, integrated-circuits maker Analog Devices () slashed its future expenses by $188 million, while Micron Technology Inc. () and Symbol Technologies each trimmed $100 million from future costs. Health-care companies have also gotten in on the act: Hospital giant HCA whacked $83 million out of future expenses by accelerating 19.1 million options.
Offering a common explanation, HCA Chairman and CEO Jack O. Bovender Jr. has said that the moves to protect future earnings are "in the best interest of the company and its shareholders." Spokespeople for Sun, Symbol, and Micron make similar arguments and add that acceleration pleases recipients. "We felt it would enhance employees' situation and ultimately encourage them to stay," says Micron's Daniel Francisco.
That reasoning is at odds, however, with the more familiar corporate argument that it is the future vesting of options that creates an incentive for top people to stay. If options vest early, says Kurt Schacht, managing director of the nonprofit CFA Center for Financial Market Integrity, "you don't need to stick around."
Some companies accelerating vesting, including Analog and Sun, stress that most of the options in question aren't immediately worth anything to employees and therefore didn't merit a big drop in earnings. In late October, Analog vested 18 million options that recipients could convert to stock at prices between $40 and $59. At the time, Analog shares traded at only $33, so there was no reason for recipients to make a move. "The expense associated with the options would have been disproportionately high compared to the perceived value to employees," says Maria Tagliaferro, Analog's director of investor relations. She adds that, unlike most companies, Analog excluded the options of officers and directors from the acceleration.
But even if options aren't valuable today, that doesn't mean they have no value in the future, when stock prices may rise, or that they are a free form of compensation. Analog shares are now trading at more than $39, so the accelerated options could soon be exercised at a profit.
Other companies' options have already paid off. The average exercise price of options that HCA speedvested was $43.96. With its shares now trading at about $52 -- and they have been as high as $58.40 -- all those options are in the money. An HCA spokesman plays down the importance of the faster vesting, saying that 65% of the options were set to vest in 14 months. By Jane Sasseen