July 17, 2000

Stock Options Pad Cash Flow Of Soaring Technology Issues

By ROBERT MCGOUGH Staff Reporter of THE WALL STREET JOURNAL

Ah, stock options, the elixir of the technology boom! Employee stock options allow zippy tech firms to attract great workers without the hassle of actually paying them grandiose salaries.

It's widely known that the cost of most employee stock options isn't reflected on the income statement -- indeed, tech companies have fought fiercely against such reporting. Less well known is that companies eagerly record the cost of employee stock options as an expense on corporate tax returns, which saves them taxes.

Even less well known, however, is that this tax benefit in recent years has given a huge boost to the cash flow of some highflying technology companies. That's the conclusion of a new study by Bear Stearns. The research found that this options-related tax benefit contributed 26% of the operating cash flow at Dell Computer Corp. last year, 19% of the operating cash flow at Cisco Systems Inc. and 17% at JDS Uniphase Corp.

The bigger the stock-price gain, and the more employees who cashed in their options, the bigger the boost to a company's cash flow. For instance, Bear Stearns estimated that this accounting wrinkle contributed $144 million, or 79%, of the $182 million in operating cash flow at Qualcomm Inc., the wireless-telecom wonder that last year was the hottest one-year performer in the history of the Standard & Poor's 500-stock index. Qualcomm disputes the size of the contribution estimated by Bear Stearns, but doesn't provide another figure.

But the process also works in reverse. And that means the operating cash flow at many of these same companies could be reduced this year if the market doesn't resume its heady ways, Bear Stearns warns. A lot of once-highflying technology shares have slumped since hitting highs earlier this year, and, if the slump continues, says Pat McConnell, senior managing director at Bear Stearns, investors might be surprised to discover just how badly the cash flow of their favorite companies can plunge. Changes in cash flow "could, in a volatile stock market, be totally independent of the company's operations," Ms. McConnell says.

The striking thing about this accounting twist is that investors often look at cash flow as an unadulterated measure of how a business is faring. Earnings get boosted or reduced by all sorts of accounting maneuvers. But cash is cash, and it's viewed as less subject to accounting distortion than earnings. "Investors do focus on cash flow from operations, what the business is generating," says David Zion, an accounting analyst at Bear Stearns.

And yet, here we have companies whose cash flow was boosted last year --sometimes significantly -- by the performance of their stock price, not by how profitably they sold computers or optical-networking equipment or wireless-telephone chips. To be sure, the extra cash these companies recorded last year really was cash that they could use to build their business or buy back stock, not an accounting fiction. And the accounting that produces this cash is perfectly legitimate, if obscure and open to different interpretations. But it's also true that a reduction in cash flow from this source, which appears likely for some companies this year based on current trends, would mean less cash in a company's pocket, at least from this source.

The report from Bear Stearns -- which Ms. McConnell says was done to address investor confusion on the topic -- is a good reminder that there's a little-noted feedback effect going on between corporate results and the stock market. A big reason for the gains in the stock market in recent years has been sharply rising corporate earnings and cash flow. But one factor driving these measures of corporate health higher is the rising stock market itself. For instance, unexpectedly strong returns on pension investments have allowed many companies to reduce their contributions to pension plans -- and the stock-market gains in the pension portfolios have been so hefty in some cases that they have actually spilled over to boost corporate earnings.

The gains to cash flow from employees' exercise of options can amount to a lot more than chump change. Last year, WorldCom Inc. boosted its operating cash flow by $820 million, to a total of $11 billion, due to tax savings from this options-exercise expense, according to Bear Stearns. Sun Microsystems Inc. saved $222 million in tax expense, helping to boost its cash flow from operations to $2.5 billion. Dell Computer boosted its operating cash flow by a bit more than $1 billion, to $3.9 billion.

Qualcomm and Dell both say that while cash flow does get boosted by the tax treatment of employee options, they generate plenty of cash anyway, and they don't think investors should fret about the matter. Indeed, both firms think cash flow is a secondary concern for owners of their stocks, as the companies don't carry any notable debt. Dell also notes that in years when employees exercise fewer options, the company needs less cash to buy back an offsetting number of shares.

Qualcomm says the figure in the Bear Stearns report overstates its cash-flow benefit from options, because the firm's taxes are also reduced by net operating-loss carry-forwards and research-and-development credits. Qualcomm wouldn't quantify the actual cash-flow benefit from options, saying, "To uncover it, even if we did want to disclose it, would be a difficult exercise." Bear Stearns says in a footnote to its report that its calculation from Qualcomm reflects some guidance from the company.

Yahoo! points out that some companies, such as itself, have accumulated a sizable amount of these options-related tax benefits, and so a decline in stock price in the current quarter might not mean a reduction in cash flow.

Other companies either confirm the report's calculations without further comment, or don't comment -- many because they are in quiet periods due to coming earnings releases.

There are quirks in accounting for employee stock options. Two companies can account for the impact of options in such different ways that their cash-flow statements might as well be apples and oranges. For instance, Microsoft Corp. got a huge benefit from employees' exercise of options last year -- it saved $3.1 billion, according to Bear Stearns. But Microsoft reported the $3.1 billion gain as coming from financing activities, rather than operations. One of the goals of the Bear Stearns report is to encourage regulators, who are beginning to examine the issue, to settle on a uniform way for these gains to be reported.

The report also notes that earnings per share can be affected by employee stock options -- even though the cost of the options doesn't get recorded on the income statement. That's because the number of shares that could be issued due to options exercises gets factored into calculations of a firm's diluted shares outstanding and becomes part of the earnings-per-share equation.

One paradoxical effect of the accounting is that, in years when fewer employee stock options are apt to be exercised, a firm's calculation of shares outstanding might shrink, and that could boost earnings per share. For instance, this year, due to these accounting rules, some companies may record higher earnings per share due to fewer options exercised -- but lower cash flow for the same reason. The net impact on a stock, from falling cash flow but rising earnings per share, would depend on whether investors are more focused on cash flow or earnings per share for that particular company.

Write to Robert McGough at bob.mcgough@wsj.com