The Securities and Exchange Commission’s recent decision to extend the deadline for expensing stock options means that most companies won’t see the hit to their income statement until next January. Ahead of the SEC’s decision, however, scores of companies announced strategies to reduce stock option expenses, say consultants, and will continue to do so between now and the compliance deadline.
“I can’t think of any companies that are not at least concerned about it and that are looking at ways to manage that cost,” says Ellie Kehmeier, director of Deloitte & Touche Tax.
Grant Reductions
One of the most popular ways to whittle expenses is by simply reducing the number of grants. A Goldman Sachs report issued in March estimates that unrecognized options expenses has declined from about 15 percent of S&P 500 operating EPS in 2001 to about 5 percent in 2004, in part because fewer options are being granted.
Companies have accomplished these grant reductions both by restricting the number of employees who are eligible for the grants, and by shifting to other forms of compensation.
Kehmeier
“Based on the importance of workers, companies are being more strategic about who they really need to give options to,” says Kehmeier. “And even when companies are continuing to grant options broadly, they’re scaling back on the size.”
Microsoft, notably, shifted entirely from options to restricted stock in 2003. A host of other companies, such as Time Warner, McDonald’s and Pfizer, have cut out options for all but the most senior executives.
Lombardi
Others, such as Barnes & Noble, took a hybrid approach. In anticipation of expensing in 2005, the bookseller continued its policy of granting options to manager-level employees and above, but reduced the level of grants and added restricted stock to its retention packages. “The push to make it a smaller number is one factor, but the push to have employees be part of our stockholder base is another,” says Barnes & Noble CFO Joe Lombardi.
The options expense would have taken an estimated 7 percent out of 2005 EPS, Lombardi says. But that's a big improvement over the 14 percent hit that the options would have created in 2004.
Since the expense is amortized over time, even those companies making reductions now will still face expenses related to the Financial Accounting Standards Board's stock option expensing rule—known as FAS 123R—for years to come.
Accelerated Vesting
To deal with more immediate expenses, a number of companies have shortened the lives of their options through faster vesting, shorter exercise periods, or both.
McConnell
An April 7 report by Bear Stearns analyst Pat McConnell estimated that “over $1 billion of future stock-based compensation expense has been eliminated as a result of the accelerated vesting” of options, based on a survey of about 100 companies.
The move is a boon when options are out-of-the-money and unlikely to be exercised, since it brings the expense for those options to zero. For options that are priced below the current market rate, however, companies may face a large one-time charge as the value of those options goes up. For that reason, experts note the move makes sense only if a company is planning to phase out or significantly reduce its options programs.
Whole Foods Market, for example, plans to vest all outstanding options except those granted to executives some time before the rule takes effect, even though it anticipates a one-time $10 million charge. Further, it will limit future grants to keep FAS 123R expenses under 10 percent of earnings in future years.
Mackey
The strategy “limits future earnings dilution from options while at the same time retains the broad-based stock option plan which we believe is important to team member morale,” said Chairman and CEO John Mackey in a February conference call, adding the caveat that “if Congress chooses to intervene and overrule FASB 123R, our strategy regarding accelerated vesting and future option grants may change.”
RF Monolithics, a $48.5 million wireless equipment maker, took an even more dramatic approach. It reduced vesting periods for its employee stock options from four years to one, and cut the terms in half from 10 to five in response to 123R. The move will reduce the income statement expense, said CEO David Kirk in a press release, adding that “from the employees’ perspective, the faster vesting contained in these options offset, to some degree, the detriment of a shorter term.”
"Normal And Acceptable"
Long term, more companies may be able to put a smaller price tag on their options by using the lattice model, say experts. That model takes into account actual exercise patterns and can assign lower costs for options that are unlikely to be exercised. However, that’s unlikely to happen on a large scale this year.
Eichen
“I’d expect a lot of companies to still be using Black-Scholes at the end of the year, since most need more time to collect data,” says Mercer Human Resource Consulting senior consultant Susan Eichen.
Ironically, companies that have already begun expensing stock options generally say investors are willing to ignore the non-cash expense in assessing their companies, a trend that research has validated as well. So why are companies going to such efforts to reduce the cost?
“What it is really drawing attention to how much of the equity is going to employees,” says Kehmeier. “People don’t want to be beyond the range of what’s considered normal or acceptable.”
Regardless of the magnitude of the size, experts note that companies would be well-advised to clearly communicate the impact, as IBM discovered. The computer giant early-adopted 123R in April as its new fiscal year began. Having previously projected a $0.14 per share hit for stock options, the computer maker came under fire from analysts for not clarifying that the number had been subsequently revised to only $.10 per share, thereby leading analysts to attribute too much of its April earnings shortfall to the options expense.
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