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Options Rule Also Hits Operating Cash Flow
by Michael Rapoport - May 15, 2006

NEW YORK (Dow Jones)--The new rule requiring the expensing of stock options is lopping chunks off some companies' earnings, as expected. Here's something that wasn't widely expected: It's doing the same to a lot of companies' operating cash flow.

That seems counterintuitive. Options are noncash expenses, aren't they? Even when companies treat them as an expense that reduces earnings, as the Financial Accounting Standards Board's recently implemented rule requires, that shouldn't affect operating cash flow.

But a provision in the new rule - separate from the basic expensing requirement and unnoticed by many investors - is slashing tens or hundreds of millions of dollars off operating cash flow at some companies, and boosting financing cash flow instead. That could have major implications, since many investors see operating cash flow as a measure of a company's performance that's more trustworthy and less cluttered than earnings.

The figures are impressive. Cisco Systems Inc. (CSCO) saw its operating cash flow cut by $260 million in the latest quarter because of the move. Google Inc.'s (GOOG) dropped by $77.3 million. Some smaller companies are seeing operating cash flow cut by big chunks on a percentage basis. And unlike the reductions in earnings the new rule is causing, the cash-flow changes are happening mostly under the radar.

"I think investors are well aware of the impact it's going to have on the income statement, but there isn't as high a level of awareness among investors about the cash-flow impact," said Dane Mott, an accounting analyst at Bear Stearns & Co.

Shifting Cash Flow

The provision requires companies to shift certain options-related tax benefits from operating cash flow to financing cash flow, a less-important part of the cash-flow statement. Operating cash flow goes down; financing cash flow goes up by the same amount. Total cash flowing into or out of the company is unchanged, but the lower operating cash flow makes the company's performance look worse and could affect some calculations of a company's value that are based on cash flow.

When a company's employees exercise stock options they've been granted, that's a compensation cost to the company, and it's tax-deductible. That reduces the cash that companies pay in taxes, and so these deductions are recognized as tax benefits on the cash-flow statement. Until now, they've been categorized there as operating cash flow, as tax-related items typically are.

But in deciding stock options should be expensed, FASB also decided that not all of those tax benefits belong in operating cash flow. After all, what typically makes an option worth exercising, and thus creates a lot of those tax benefits, is a rise in the company's stock price. And that, FASB said, is a financing transaction, not an operating development. So these "excess tax benefits" - the tax benefits the company realizes from the options over and above those it expected to realize when they were first issued - belong in financing cash flow, not operating cash flow, the board decided.

To some observers, this is merely the way things should have been all along. Options exercises and stock-price increases are inherently financing transactions, they argue, and should never have been allowed to boost operating cash flow in the first place. Ken Broad, a portfolio manager with Delaware Investments in San Francisco, said the new setup is "a more accurate reflection of underlying economic reality."

Significant Effects

The effects - especially for companies with lots of options outstanding, runups in their stock prices or both - can be substantial. Cisco's $260 million in excess tax benefits in its fiscal third quarter which ended in April, for instance, would have boosted its $2.3 billion cash from operations by about 11% if they were still part of the operating figure. A Cisco spokeswoman said the company was "in full compliance" with the options-expensing rule and declined to comment further.

Google's $77.3 million in excess tax benefits in the first quarter would have boosted operating cash flow by more than 9%. Genentech Inc. (DNA) had $49 million of the benefits, which would have raised first-quarter operating cash flow by nearly 11%. A Google spokesman declined comment. A Genentech spokeswoman stressed the move is a reclassification that doesn't change total cash flows.

It isn't just giant companies feeling the pinch. Cymer Inc. (CYMI), a supplier of lasers used in semiconductor manufacturing, had $10.2 million in excess tax benefits moved out of the operating section, which helped cut its first-quarter operating cash flow to only $869,000. Cymer declined to comment.

Nor are only high-tech companies affected. Select Comfort Corp. (SCSS), a mattress maker and retailer, had $4.2 million in excess tax benefits in the first quarter. Its reported operating cash flow of $9.1 million would have been about 47% higher if those benefits were still counted as an operating item. A Select Comfort spokeswoman declined to comment.

The move also can reduce companies' free cash flow, another important metric most companies define as operating cash flow minus capital expenditures. But a handful of companies, notably Yahoo! Inc. (YHOO), are still counting the reclassified tax benefits as part of free cash flow - thus boosting the reported free-cash figure - even though they're no longer part of operating cash flow under generally accepted accounting principles, or GAAP.

These companies aren't violating the rule; free cash flow is a non-GAAP measurement that the rule doesn't cover. Still, some observers think such a move defies at least the spirit of the rule change.

"When investors think about free cash flow, they think about, 'What is the business generating?,' and that's not what this is," said Charles Mulford, a Georgia Institute of Technology accounting professor.

When it announced first-quarter earnings, Yahoo reported $40 million in excess tax benefits, an amount that made up nearly 12% of its reported $342.9 million in free cash flow. Company officials couldn't be reached.

In its quarterly report filed with regulators, Yahoo later boosted its first-quarter excess tax benefits to about $100 million, with $60 million related to "options exercised in prior periods." The company didn't explain the move further.)

Rockwell Automation Inc. (ROK) is another company that counts the excess tax benefits in free cash flow. During its fiscal second quarter, the company had $27 million of the benefits, accounting for 18% of its $150 million in free cash flow.

Rockwell said when announcing its quarterly earnings that it kept the benefits in free cash flow to stay "consistent with our historical presentation." Tim Oliver, Rockwell's vice president and treasurer, said the company had already issued its guidance for the year when the new rule took effect and didn't want to have to revise it, so "we simply put a new disclosure in there."

In doing so, Rockwell at least addressed the issue, which is more than a lot of companies have done. Many have detailed it only in a line item on their cash-flow statement, or a quick reference in a Securities and Exchange Commission filing, without any further indication about the impact on their operating cash flow.

Investors may want to probe a little deeper, especially if their company has been a big options issuer in the past. They may not like what they see.

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