Options Debate Splits Old, New Economy Firms

THE EXECUTIVE PAY CRISIS

– Big Bucks, Mixed Results

By CONOR DOUGHERTY

Staff Reporter

The debate over stock options has rekindled the battle between old and new economies.

The old guard, represented by locally based Dole Food Co. and Public Storage Inc., say they plan to begin counting stock option grants as an expense an easy enough gesture because it will cost them so little.

Local tech companies, meantime, are looking for the nearest rock to climb under. At Activision Inc. and THQ Inc., expensing options would have cut net income by 30 percent and 51 percent respectively.

With Congress steering clear from any legislation requiring that options be expensed from the bottom line, companies are being left to pick sides.

Federal Reserve Board Chairman Alan Greenspan and billionaire investor Warren Buffett believe stock options are a recipe for corporate greed and often distort a company’s performance. Technology companies claim options are a critical tool in attracting and holding onto talent.

In truth, lots of executives don’t think it’s a big deal, one way or another. “I think it’s flaky accounting to do so, but if the investment public wants it to be recorded, we will do so,” said Public Storage Chief Executive Bradley Wayne Hughes, who noted that his company would follow suit in coming quarters.

Expensing its options would have lowered profits at Glendale-based Public Storage by $4.2 million during 2001, to $320 million.

At Westlake Village-based Dole, expensing options would have cost $1.9 million in 2001, lowering net income by 1.2 percent. It will make the switchover next year.

“The companies leading from the front will put pressure on the others,” said Paul Hodgson, senior research at the Corporate Library, a Washington think tank.

While a few tech firms plan to begin expensing options most notably Amazon.com Inc. most are fighting a pitched battle on Capitol Hill to preserve the status quo of excluding the impact of options in earnings calculations.

“We don’t argue that options shouldn’t be represented,” said Connie Correll, an executive vice president at TechNet, a trade association that counts Microsoft Corp., Intel Corp. and Broadcom Corp. among its members. “We just don’t think they should be expensed.”

Tech insiders say they’re all in favor of disclosure and point out that stock-option impacts has been available for years, tucked away in footnotes but the notion of counting option-based compensation as a cost? Well that’s just blasphemy.

Santa Monica-based Activision has seen its stock price more than double in the last two years, largely due to increased sales and record income levels. Activision reported net income of $52.2 million for the year ended March 31, up from $20.5 million a year earlier.

Had options been expensed, Activision’s net income would have been $39.6 million in the most recent fiscal year and $11.5 million in fiscal 2001. Activision declined to comment.

At Calabasas-based THQ, 2001 net income was $36 million, up from $18.2 million a year earlier. Expensing options, though, would have reduced 2001 earnings to $17.5 million, and $8.4 million in 2000. Officials from THQ did not return calls seeking comment.

One argument against expensing options is that there’s no good way to do it.

“If you expense them and you get the value wrong, that could be as damaging as not expensing them at all,” said Charles Elson, director of corporate governance at the University of Delaware.

Most companies estimate the value of option grants whether they’re expensed or footnoted using the Black-Scholes method, a 1973 formula that takes dividend yields, past stock performance and other factors into consideration. There are several other methods of estimating stock option values that are less widely used. The problem with these estimates, however, is that they project into the future values that are unknown.

A surer way to expense options is to use the intrinsic value method, in which a stock option’s cost is re-calibrated periodically by taking a stock price and subtracting the exercise price. This method, while sound, could cause wild fluctuations in reported earnings each quarter, based on stock-price movements.

Stock options cost other shareholders money when they are exercised. The difference between the exercise price and the current stock price is paid for in dilution; theoretically the introduction of new shares being exercised lowers the value of existing shares outstanding.

In Activision’s June quarter, the company reported net income of $20.7 million. But in the same three-month period company executives cashed out options valued at $23 million. All in all, it could be argued, company executives took home more than they delivered to shareholders.

The confusion is one reason not to expense options at all, Correll said. “We don’t want to see companies putting it on the income statement because that will result in greater distortion,” he said. “How do you value that distortion?”