Intel and Cisco say they won't expense employee stock options. What's it all mean?

August 8, 2002

6 Min Read
Intel, Cisco Fight Options Expense

Intel Corp. (Nasdaq: INTC) today declared that it won't be accounting for employee stock options as an expense item in its financial statements (see Intel Execs OK Financials), which adds to the momentum of technology companies standing firm against options accounting reform.

The move puts Intel, along with Cisco Systems Inc. (Nasdaq: CSCO) and other technology companies, squarely in the middle of an ongoing debate about how firms account for employee stock options -- a debate that's moved to the top of the corporate reform agenda. Many larger industrial companies, such as Coca-Cola and Citigroup, have announced they will expense for stock options.

On one side are various legislators, indignant investors, and a growing roster of non-tech American companies that say it's time to change the widespread practice whereby companies issue stock options, particularly to top executives, without listing them as an expense.

This practice, reformers say, was one of the causes of today's high-profile debacles, since it allowed execs to enrich themselves, often unjustly, at shareholders' expense. In issuing piles of options without expensing them, there was little accountability.

It worked like this: Companies issued big blocks of options to keep executives satisfied. Without claiming any expense, the firms took tax deductions on the options that were exercised. Earnings reports stayed free of options expense encumbrance. As the stock price inflated -- often with executives issuing unrealistically optimistic projections -- the execs sold off their shares at huge profits and went happily to the bank. The net cost in compensation to the company was minimal. Over time, these options diluted the share base and diminished shareholder profitability.

Rank-and-file employees, in the meantime, often cautiously prepay tax on smaller amounts of options, then keep them, sometimes in retirement accounts. As the bottom dropped out of the economy, these folk were left with -- you guessed it -- an empty bag.

Intel, Cisco, and almost all of the so-called high-tech sector built the case for stock options in the first place. They maintain that the Financial Accounting Standards Bureau approves the practice of giving stock options their face value at the time they're awarded, regardless of what happens to their value later. They already account for the dilutive impact of stock options in their shares outstanding figures, they say.

It's not surprising that companies such as Cisco would protest the move to expense options. Most experts say the company's earnings would be substantially lessened if the rules changed. (At press time, we were working on more detailed numbers; stay tuned.) The bottom line is that because stock options are such a large part of corporate culture and an even larger potential expense in the tech world, the stakes are higher for such companies.

Companies like Intel and Cisco say expensing stock options isn't the solution. "We believe the current debate... is misdirected," says Intel's CFO, Andy Bryant, in today's prepared statement. "Rather than focusing on the accounting... the debate should center on excessive executive compensation." Intel, he says, gives just 2 percent of its shares to executives.

A change in rules also might reduce the amount of options open to executives. And that could step on quite a few corporate toes, as a random sampling of companies in the telecom sector shows. According to Thomson Financial Network and Securities and Exchange Commission (SEC) filings, five Cisco executives sold enough shares to make over $38 million in 2001. And those five represent just a third of the 16 officers and directors who held 1.8 percent of Cisco's shares at this time last year.

Cisco's not alone, either. Between May and September of 2001, one Ciena Corp. (Nasdaq: CIEN) executive, chief strategy officer Steve W. Chaddick, sold over $8 million worth of shares. A handful of Riverstone Networks Inc.'s (Nasdaq: RSTN) officers and directors sold more than $5 million in shares in the first two months of 2002.

Public companies in the optical space vary as to what they dole out in executive shares. Lucent Technologies Inc. (NYSE: LU) reported to the SEC that as of October 1, 2001, 14 of its top execs and officers held just 0.5 percent of its shares outstanding. ADC Telecommunications Inc. (Nasdaq: ADCT) reported that at the end of 2001, 2.95 percent of its shares outstanding were owned by 25 of its top team. Ciena divided 6.162 percent of its shares outstanding among 14 top executives at the end of 2001, according to its SEC filings. And at Corvis Corp. (Nasdaq: CORV), a whopping 24.8 percent of outstanding shares were owned by just one person, founder David Huber, in February 2001.

Reformers say the issue isn't just how much compensation is going to executives in the form of stock options. If it were accounted for properly, the issue wouldn't rankle so much. "If one looks at the exercised options traded at the strike price, my sense would be that reflects the real value," says David Blitzer, chief investment strategist of Standard & Poor’s. He says he's "a little disappointed" with Intel and others that choose to stand against expensing. Standard & Poor's recently decided to start expensing options in their own reports on corporate earnings.

One argument against expensing options is that the new procedure would call for estimating the worth of options, which becomes a tricky proposition in these economic times. "I have a problem with expensing options given the volatility in stock pricesand the fact that the vast majority of options given out in the past 3+ years are now worthless and will likely remain that way," writes one fund manager, who asked not to be named, in an email to Light Reading. "I include them inmy fully diluted share count and incorporate them in my valuation whether they are in the money or not."

Cisco's CEO John Chambers agrees with this approach. On this week's earnings call (see Cisco Beats the Street, Ups Repurchase) he said he holds "very strong views" against expensing options and gave an example of how estimates can vary: Using the most widely accepted model for calculating the worth of stock options, the Black/Scholes model, he says Cisco's outstanding options would have been worth $3.3 billion last year and would have been expensed over a five-year period. But the same set of options would be worth $141 million today using the same model.

As an alternative to the expense approach, Chambers advocates "shareholder approval" of share awards and stock repricing. "You don't want to throw out a basic tenet of ownership," he says.

Standard & Poor's Blitzer, however, is among those who think time has tested stock option modeling and that an increasing number of companies are choosing to go the way of reform. "Option pricing models have been around for 30 years," he says. "Black and Scholes won a Nobel prize for their paper. The model's been widely used and studied."

In the end, it remains to be seen how much pressure advocates of the expense approach can bring to bear on corporate holdouts. That's an issue that will play out in the courts and in legislative investigations over the next few months.

— Mary Jander, Senior Editor, Light Reading

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