Qualiport

[ July 24, 2000 ]

Options at the Qualiport

By Maynard Paton (TMFMayn)

Carburton Street, London -- Last Friday, I contemplated the prickly topic of share options and their treatment within company accounts. The Accounting Standards Board (ASB) is keen for companies to charge the cost of options to their profit and loss statements, much to the disappointment of most finance directors. Meanwhile, investors have a difficult job in determining what effect current option practices have on their companies. Having touched upon Dell Computer Corporation (Nasdaq: DELL) on this subject already, today I'll give a cursory review of the remaining six Qualiport constituents.

Dilution

The first point for the ordinary shareholder to consider is the comparison between a company's basic earnings-per-share (EPS) figure and the diluted EPS figure. The diluted figure attempts to highlight the impact from, amongst other things, all potentially exercisable options.

The greater the difference, the more the investor should be wary of how options are possibly used to fund employee remuneration. Using their latest full-year numbers, here's how the six UK Qualiport members measure up.

Company      Basic EPS        Diluted EPS     Difference
                  (p)              (p)             (%)

Emap              33.8             33.4           1.20
Independent Ins   19.8             19.5           1.54
Lloyds TSB        46.2             45.3           1.99
Misys             16.7             16.2           3.09
MMT Computing     52.8             52.2           1.15
PizzaExpress      33.7             33.0           2.12

From the above table, there doesn't appear to be much to overly concern us. Misys (LSE: MSY) has the greatest dilutive possibilities, with basic EPS only 3.09% greater than the diluted EPS figure.

However, this comparison doesn't entirely take into account the "economic cost" to shareholders of the options that can be converted. As we saw on Friday, whenever options are granted, shareholders are forgoing the difference between the option's exercise price and the market value of the shares.

Although the diluted EPS figure encompasses the possibility of additional shares, underlying profits remain the same. Ideally, a business-perspective investor would consider the lost economic cost in terms of the company's profits, rather than thinking how the "uncharged" profits are to be split between the additional shareholders.

Comparing the basic and diluted EPS does give a quick shorthand way to determine companies that could have damaging share issues in the offing. But the realistic effect on profits from the granted options cannot be readily determined.

Black and Scholes

Calculating a precise present value of an option is tricky. Indeed, the difficulty has been used to argue that the inherent value of granted options should be ignored. But of course, all options have some value.

Let's take PizzaExpress (LSE: PIZ). During December 1998, the six executive directors were granted a total of 560,000 options with an exercise price of 819p. The options can be exercised between December 2001 and December 2005 and are dependent on the company generating earnings growth of 5% above inflation. Ask yourself this question -- what would you pay in exchange for all those options? Okay, you'll have to bear in mind the time-value factor and the chances of PizzaExpress failing to clear the performance hurdles. But the options obviously do have a value. The share price need only be at 998p in 2005 for you to earn £1m.

In its discussion paper, the ASB suggests that "in most cases, an option-pricing model should be applied to establish the fair value of an option". When it comes to option-pricing, the typical method is the Nobel Prize-winning Black-Scholes model, a calculation that is perhaps the most complicated of all Wise formulae. This model may not give the precise value of an option, but a value it will give. And presenting a rough value of the option cost is better than the non-presentation investors currently experience.

Options at the Qualiport

The ASB proposals indicate that the option costs will be accrued over the holding period. In other words, there won't be any "big hit" charge as and when options are exercised and the employees take the money.

Friday's Qualiport feature noted how Dell was affected by a similar accounting presentation to that which the ASB is currently prescribing. In a note to the main accounts, the computer giant declared that earnings would have declined by 13% in fiscal 2000 through the additional option-related charges.

Unfortunately, the remaining Qualiport six don't report a comparable "what if" option charge scenario. And given that I don't have a clue about Black-Scholes either, similar Qualiport profit restatements are out of the question.

But in an effort to consider the impact of options, I've perused the latest annual reports of the six UK Qualiport companies and will present the "big hit" scenario. Essentially, I'll compare each company's stated operating profit to the gains made through exercised options. Carrying out this investigation could alert shareholders to unfavourable developments as and when the "true" ASB options picture comes to fruition.

Assumptions

My investigation had to make several assumptions. Firstly, none of the six companies gave any mention of the total option gains realised in the latest reporting period. Director gains had to be disclosed, but reporting for normal employees is not mandatory.

Thus, calculating the overall gains was based on the stated (or determined) number of options exercised in the year and the estimated prevailing market price at exercise. My estimated market price was taken as the mid-price between the highest and lowest share price during each company's financial year.

Unfortunately, Lloyds TSB (LSE: LLOY) were not too forthcoming in their options disclosure. The bank reports director gains, but absolutely nothing when it comes to the other employees and their options. So, taking into account the varying degrees of disclosure and various other subjective measures, here's how the Qualiport six measure up. The lack of disclosure by Lloyds gives them the distinct edge.

Company       Operating Profit    Option Gains    Resulting profit
                    (£m)               (£m)           decline (%)
Emap                222.6               10.0             4.5
Independent Ins      61.5                9.6            15.6
Lloyds TSB        3,735.0                4.1             0.1
Misys               136.2               10.2             7.5
MMT Computing         8.3                0.4             4.8
PizzaExpress         29.0                8.8            30.3

Certainly it's surprising to note that two of the smaller Qualiport companies rewarded their staff on similar terms to the larger counterparts. But it must be remembered that the above table presents the "big hit" scenario. For instance, although the PizzaExpress directors "suffered" a £4.9m payout in 1999, that payment would have been accounted for over several years under the ASB proposals. Although year-to-year option payments will vary, I suspect both PizzaExpress and Independent Insurance Group (LSE: IIG) will require further inspection on this matter.

Golden Rule

If you believe, as I do, that the granting of options is a cost to shareholders and should be accounted for, then the ASB proposals cannot be implemented soon enough. Having looked through the six UK Qualiport members' annual reports, I can honestly say that the average investor would have little chance of fully interpreting the current impact of options. Non-uniform disclosure, with some companies operating a multitude of employee schemes, gives little help towards making any convincing judgment.

While shareholders wait for the ASB, I guess investors should in the meantime remember the golden rule of investing -- the margin of safety. That is, always minimise the investment downside by conservatively valuing your prospective investments. You don't want to find your company's profits and share price collapsing after the ASB proposals unveil any significant costs associated with employee option schemes.

Any comments about this feature or share options in general can be directed to the Qualiport discussion board, in the Resources section below.

Where Next?

Visit the Accounting Standards Board's website and read their discussion paper on accounting for share options.