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Optical/IP

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 prices and 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 in my 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
http://www.lightreading.com
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skeptic 12/4/2012 | 9:59:13 PM
re: Intel, Cisco Fight Options Expense - It is impossible to value options in a
way that is meaningful in terms of earnings.
The models being suggested are used to value
options for "trading" on exchanges. There
isn't a market for un-vested and un-tradeable
stock options. Anyone who tries to apply
Black and Scholes to employee stock options
doesn't understand that an option that vests
over 5 years isn't the same thing as a "put"
on crude oil.

Those models would only make sense if employees
could sell their stock options immediatly upon
grant.

What sense does it make to fully expense an
option at the time of grant when that option
may not be exercised (even in part) for one or
more years. And what sense does it make to
expense it when the employee might be gone
before exercise or the value of the stock might
be so low that the option is worthless.

- In practice, options had little to do with
many of the high-profile debacles. Executives
operating without control will ALWAYS enrich
themselves at the companies expense. Look at
Enron and its limited partnerships. Look at
the Loans to Ebbers at worldcom. What good
would expensing stock options do in either of
those cases?

- Nobody has ever made a convincing case that
stock dilution has diminished shareholder
profitability. If anything, options give
the executives incentives to increase the price
of shares. If you don't have options, you
go back to the way things used to be where
management cared more about empire-building and
personal enrichment than the stock price.

- Your "empty bag" comment suggests your total
ignorance. Lots of people over the past two
decades have done extermly well with their
stock options. The people who get into tax
trouble with options do so because of their
own greed and stupidity. If you don't cover
the taxes by selling at exercise or you hold
the stock after exercise, thats an investment
decision like any other. And how is it better
not to get the options at all? How is that
better for employees?



papabear 12/4/2012 | 9:59:12 PM
re: Intel, Cisco Fight Options Expense So I guess "cooking the books" to make the stock price better has nothing to do with stock options.

Seems to me the executives were doing exactly what options were designed for "improving the stock price". Of course they were only doing that for the benefit of the stock holders and employees not themselves.

The executives normally have the most options so I guess that is a pretty good incentive to "cook the books" to improve the stock price.
softsell 12/4/2012 | 9:59:11 PM
re: Intel, Cisco Fight Options Expense Valuation and expensing (utilizing the Black-Sholes technique)of options do not in any capture the true cost of options. That is unless these corporations turn around and buy a percentage of the overall granted options from I-Banks.

In the end, the pricing method works very well if you were to use it as a sound part of a hedging strategy. This is exactly what the I-Banks would do. Buy 1000 contracts from an I-Bank and they would in turn hedge their risk exposure. Otherwise, what we have is a total lack of cost with expenses.

For instance, Coke will expense their options. They utilize Black-Schole pricing to calculate the expense. If they don't hedge their options, how can anyone know their future liability. Just because the line item for option expense says $1B for 2003 (for example) doesn't mean that is all they will be liable for in the future. If the stock stays flat for 10 years and there is significant turn over in the employee population, the future expense would be less than $1B. If they increase their market cap 500% in 10 years, their expense will be much greater than $1B, even on a time value of money basis.

If these companies are expensing options, they need to match the line item with actual deed (buy options or internally hedge the employee options). Otherwise, we have a worse situation since shareholders will now think options cost are all taken care without realizing that the true cost of options occur when an employee actually exercise the option sometime in the future.


BobbyMax 12/4/2012 | 9:59:11 PM
re: Intel, Cisco Fight Options Expense Both Intel and Cisco have offered a large number of stock options to their top tier management employees. No other company in the nation has acted so outrageously as Intel and Cisco.

Besides diluting share options year after year, it allows corruptions and other form of favortism to prevail. In case of Cisco, "Dr." chambers gets a salary that may be considered nominal but he is bleeding the company by the large number of stock options he has.

Because life time tenure policies of upper management employees, regardless of their competence, makes turn the wheel of corruption even roll faster.

Just like morgage payments are subsidized by the people who are renters and creates a tremendous amount of financial to lower strata of society who do not own homes. Not counting stock options as expense puts a tremendous financial burden of supporting the Cisco and Intel managements. There are over 50 million Americans who make less than $6.00 an hour whereas the Cisco, Tycos, Intel, WorldCom, Ciena, Enron, Adelphi Global Crossing, and QWest loot millions of dollars from the company caufers.

Again awarding and acceptance amounts to looting the company. Board of Directors of many companies is largely inept and incompetent. The board members make a lot of money for doing nothing. Infact so far board members and and the top rank management have enriched themselves at the cost of the homeless. poor and unprivilleged people. I hope, we as a nation, would not tolerate people who enrich themselves at the cost of everyone else.

In passing I must mention the recent organization that took place at Cisco which is very weird and seldom happens in a publicly traded company. Cisco recently promoted four of its employees who had their beggings in a very small company, Cresendo Communications, of 30 individuals. I find it hard to believe that the all talents would be concentrated in a very ordinary company. I have not seen this happening in any other companies.

Intel has also took advantage of its blue collar workers and have deprived them of equal treatment.
Reality 12/4/2012 | 9:59:10 PM
re: Intel, Cisco Fight Options Expense 1. Cisco stock holders have lost more value that any other company. This includes Worldcom and Enroe. John Chambers was then rewarded with 6 Million shares of stock at less that 13 dollars! I guess for a job well done!
kz1x 12/4/2012 | 9:59:10 PM
re: Intel, Cisco Fight Options Expense ... what kind of stock options are we talking about?

Are these qualified Stock Options? Non-quals (56(b)3 ? Or are they simply reduced-price grants? With or without vesting periods? What are the buy-back clauses? Are they issued with / are eligible for 83(b) elections?

People just spout off about "stock options" as if they were all the same. They're not.

One cannot begin to discuss the subject unless one is SPECIFIC about what one is referring to. There is a WORLD of difference in tax treatment and valuation methodology. Too bad the people writing about this topic don't take the time to also include a tutorial on the subject... and, not having this knowledge makes people rush to inaccurate conclusions.

Kudos to Intel and Cisco for having the sense to know that the 'noise' we hear is rooted in ignorance.

jim_smith 12/4/2012 | 9:59:08 PM
re: Intel, Cisco Fight Options Expense I think all we need is increased TRANSPARENCY,
ACCOUNTABILITY, and PUNISHMENT.

TRANSPARENCY:
SEC should force companies to divulge enough
financial information, including the type and
amount of stock options, so that any informed
investor can value the company using his/her
favorite formulas.

ACCOUNTABILITY:
One or more management employees, e.g., CEO/CFO,
must sign off the financial numbers under oath.

PUNISHMENT:
If the management of a company fraudulantly
inflates the numbers, then they should be put in
jail, or whipped, depending on the local custom.

I agree that since one or more of the above
points were not implemented in the past, many
CEOs and the like have ripped off ordinary
investors, but if the above three things are
implemented, then going forward the system should
stay in check.

So, why this stupid socialistic rant (and I'm
not talking about BobbyMax-the-idiot) about
certain folk getting more options than others?
Titanic Optics 12/4/2012 | 9:59:05 PM
re: Intel, Cisco Fight Options 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.<<

The premise is that requiring firms to expense stock options will take options from executives and lead to more scrupulous behavior. Won't the requirement to expense options on the income statement also take options form rank-and-file engineers at a public company? Especially with a big one like Intel, requiring a company to expense options given to rank-and-file employees would have a material impact on its reported earnings. Bottom line--engineers lose stock options at public firms.

Interesting thing about most of the criticism I used to read about stock options (particularly from those with a European perspective) was that stock options helped give a misleading sense of economic reality: America's "productivity miracle" was overstated as employers weren't reporting "true" labor costs, in effect businesses showed enhanced earnings that were due to options accounting more than an actual increase in productivity.

I don't buy that argument, and think stock options are fine.

Old method:
Diluted EPS = Earnings / # of diluted shares outstanding
(The options are in the denominator)

Proposed "solution" to executive cheating:
EPS = Earnings-as-reduced-by-options-expense / # of shares outstanding
(The options work in the numerator).

Boy, that was complex! The method of putting the options in the denominator is closer to the truth than the "proposed solution" of putting options in the numerator. Sometimes options are worthless, so the numerator method would be wrong in that case, and earnings would be understated. The concept of "diluted" EPS (if need be I can explain but this does get more complex) always correctly values the denominator, whether the options are worthless or not.

Most companies (and all of the lightreading index companies) report both EPS and diluted EPS on their press releases.

Yet, due to a few instances of fraud, options will be taken away from some poor sap living in overpriced Silicon Valley the opportunity to buy nicer furniture from Ikea for his $800k 1 bedroom bungalow.
Titanic Optics 12/4/2012 | 9:59:05 PM
re: Intel, Cisco Fight Options 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.<<

The premise is that requiring firms to expense stock options will take options from executives and lead to more scrupulous behavior. Won't the requirement to expense options on the income statement also take options form rank-and-file engineers at a public company? Especially with a big one like Intel, requiring a company to expense options given to rank-and-file employees would have a material impact on its reported earnings. Bottom line--engineers lose stock options at public firms.

Interesting thing about most of the criticism I used to read about stock options (particularly from those with a European perspective) was not that stock options led to a moral hazard for executives, but that stock options helped give a misleading sense of economic reality: America's "productivity miracle" was overstated as employers weren't reporting "true" labor costs; instead, businesses showed enhanced earnings because they did not report true labor expenses as the rank-and-file employees were compensated with both cash and options. Thus, the "productivity miracle" owed more to options accounting than to an actual increase in productivity by American firms.

I don't buy that argument, and think stock options are fine.

Old method:
Diluted EPS = Earnings / # of diluted shares outstanding
(The options are in the denominator)

Proposed "solution" to executive cheating:
EPS = Earnings-as-reduced-by-options-expense / # of shares outstanding
(The options work in the numerator).

Boy, that was complex! The method of putting the options in the denominator is closer to the truth than the "proposed solution" of putting options in the numerator. Sometimes options are worthless, so the numerator method would be wrong in that case, and earnings would be understated. The concept of "diluted" EPS (if need be I can explain but this does get more complex) always correctly values the denominator, whether the options are worthless or not.

Most companies (and all of the lightreading index companies) report both EPS and diluted EPS on their press releases.

Yet, due to a few instances of fraud, options will be taken away from some poor sap living in overpriced Silicon Valley the opportunity to buy nicer furniture from Ikea for his $800k 1 bedroom bungalow.
Nomoredemo 12/4/2012 | 9:59:03 PM
re: Intel, Cisco Fight Options Expense Washing the window while the house is on fire may not be the appropriate action at this stage.
First, lets clean up the book (push the button reset) so we have a fresh base of numbers using accepted accounting practices and lets get everyone saying YEA to it ( May be the sign off by CEO will accomplish that we'll see).
Second, when we know where we are (fresh books clean) lets address executive behaviors. There is certain behavior that we want to get rid off and others that we want to keep. For example, we want to keep innovation, some level of risk taking, visonaries etc.. and we want to get rid of book cooking, inflating the values of stock with illusions ( a la D. Coperfield)etc...
Stock option contribute to stimulate some that we want to keep and some that we want to get rid off, so the question becomes how do we use it so we dont throw away the baby and the water ? Answer is i dont know and by judging on that article and the posts, people dont know.
With all do respect to Coca-Cola and Citigroup , probably changing their accounting system to discount options of their book will be their biggest project of the year and the biggest one since Coke change their recipe.
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