Riddle me this...
- When is $0.18 in earnings per share really $0.02?
- How can published EPS estimates fall 60% in a day yet the stock remain unchanged?
- When can one analyst forecast $0.40 in EPS, another $0.16 for the same company...and yet they're both right?
The answer...when you're dealing with stock option expensing and the new FASB regulations that take effect next year.
For years, a debate has raged over the appropriate accounting treatment for expensing of employee stock options (ESO). Ultimately the FASB determined that expenses related to stock options must be accounted for on the income statement...a most unwelcome change for companies who have made a common practice of issuing stock options as part of their employee compensation plan.
No sector has been more egregious in terms of stock option issuance than the technology industry, where options are par for the course and an integral component to supporting high rates of head count growth. And the software industry, by virtue of its sales & marketing intensive employee base, have always been among the most egregious.
Yesterday, Goldman Sachs officially lowered the boom on the software companies [sub required] in their coverage universe. In aggregate, Goldman reduced CY06 EPS expectations by 17% for a basket of 21 software stocks. Microsoft [MSFT] and Hyperion Solutions [HYSL] weren't impacted as both already report earnings adjusted for ESO expensing.
The five worst offenders?
- Red Hat Software [RHAT] -- CY06 EPS reduced from $0.36 to $0.19 [-47%]
- Mercury Interactive [MERQE] -- CY06 EPS reduced from $1.66 to $0.80 [-52%]
- Siebel Systems [SEBL] -- CY06 EPS reduced from $0.22 to $0.10 [-56%]
- BEA Systems [BEAS] -- CY06 EPS reduced from $0.40 to $0.16 [-60%]
- Salesforce.com [CRM] -- CY06 EPS reduced from $0.18 to $0.02 [-89%]
Regardless of whether investors agree or not with expensing of options, it has now become the reality. The question we must ask is what this means for the sector? I'm not sure I have all the answers, but here are a few points of consideration...
- The market is generally efficient. Granted, there are minor inefficiencies [without them there would be no reason for active money management] but market forces are very good at anticipating regulatory changes. Debate over ESO expensing has raged for years and we've known for some time that expensing was to become mandatory. Will investors simply factor "pro forma" numbers now and continue to treat ESO expenses as a non event?
- How will reported tax rates differ? As Goldman correctly points out, the tax accounting for stock options is complex and ultimately the accrual of tax benefits by some companies may not be easily realizable.
- The hidden operational cost of expensing options...Thomas Friedman has spoken out against stock option expensing as has noted VC John Doerr [of Kleiner Perkins fame] because they argue the expensing of options provides American companies with the necessary playing field to fuel growth and innovation. Software firms entire business models and hiring practices are largely built on options, it's part of the foundation of the technology ecosystem. With expensing a reality, I believe we'll see a bifurcation in operational results based on the companies that proactively address the issue in their corporate culture [and seek alternatives such as restricted stock grants] versus those who continue to fight tooth and nail and try to pass off the earnings dilution as "non operating."
- Magnitude and trend will be key barometers...investors are always looking for ways to differentiate companies. One of the obvious ways to compare software firms post ESO expense is the magnitude; potentially rewarding firms that rely less heavily on ESO grants. But since the entire industry is guilty to some degree, another key measure will be the TREND from here on out. For example, if two companies both lose 50% of their reported earnings in 2005; but Company A "only" reduces EPS by 35% in 2006 versus Company B at 45%, investors may reward Company A all things being equal.
While the general consensus is that investors will utter a collective yawn over ESO expensing, I'm not so sure. Technology-focused investors may look past the issue in aggregate, but will generalist investors? When funds are looking to allocate to different sectors, won't the sins of the technology sector be prominent comparatively? We're heading for interesting times indeed.
Note: I and/or funds I maintain discretionary control over maintained long equity positions in several companies mentioned in this post at the time of this writing.
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