Agilent's Stock-Option Drag

The millennium had barely dawned in Silicon Valley, and everything seemed possible, not least for employees with stock options. For Agilent Technologies (A ), everything and more could be seen in its stock price, 162 at one wacky moment early in 2000. A Hewlett-Packard (HPQ ) spin-off, Agilent was all set to carry on HP's tradition as maker of the sharpest tools for the world's smartest scientists and engineers.

Today the stock is near 26. The Palo Alto (Calif.)-based company remains a top supplier of the test and measurement gear -- oscilloscopes, tunable lasers, DNA microarrays, and such -- used in electronics, telecom, and biotech. But there's market talk that Agilent will be shrinking yet again. Agilent, which is due to report fiscal third-quarter earnings on Aug. 15, is keeping mum about rumors that it's selling its semiconductor division. If so, that could lower annual revenue to $5.2 billion. Five years back, revenue was $9.4 billion.

THE PROSPECT OF AN INCREDIBLY shrinking Agilent may have actually lifted the shares, from an April low near 20, perhaps because a sale of the chip group could boost profitability. Yet after looking closely at Agilent, it's hard for me to see it as undervalued. Agilent's balance sheet remains strong -- cash outstrips debt -- and its cash flow this year has grown nicely. What's worrisome is its poorer than average quality of reported earnings. More than most of its peers', Agilent's earnings are poised to suffer next year when stricter rules for employee stock options take effect. Long delayed, the new regulations seem inevitable since incoming Securities & Exchange Commission Chairman Christopher Cox gave them a nod in his July 26 Senate testimony. For the many technology outfits that rely heavily on stock-based pay, that's bad news; for Agilent, it's really bad news.

To see what I mean, note that for the six months ended Apr. 30, Agilent posted net income of $198 million. Yet after deducting the implied cost of issuing stock options to employees, Agilent's net income would have come to $93 million, or 47% of the reported figure. In fiscal 2004, ended last October, the gap was wider. Then, Agilent's net income after stock-based pay came to just 34% of its reported net income.

Is this par for the course? I checked the latest full-year results of 13 rivals. In this group, net income after deducting for stock-based pay averaged 77% of reported earnings. The biggest gaps were at Applied Biosystems (ABI ) and Teradyne (TER ). At each, earnings after the costs of stock-based pay came to 44% of reported net. Most others, however, had smaller gaps. At Affymetrix (AFFX ), net income after deducting for options was 68% of reported earnings; at PerkinElmer (PKI ), it was 81%; at Varian (VARI ), 91%; and at Hewlett-Packard, it was 80%.

How much this might be affected by any sale of Agilent's semiconductor group is unknown. An Agilent spokesman told me, however, that fiscal 2005's difference between reported earnings and earnings after stock-based pay charges should be lower than last year's. One reason is that, like many companies, Agilent now is issuing fewer stock options. He added: "What investors ultimately care about is cash generation, not earnings stuff." That's a fair point, for those investors who look through reported earnings to cash flow. Yet Agilent is by no means cheap vs. its cash flow, commanding an enterprise value of nearly 14 times earnings before interest, taxes, depreciation, and amortization. Its rivals in various businesses tend to trade nearer 10 times.

In any case, there remain legions of investors who don't bother with cash flows. To them, if stock-option expenses were being deducted from reported earnings, how would Agilent look? Instead of $0.76 a share, earnings over the past four quarters would have been $0.31. Agilent's price-earnings ratio would not be 34 but 84. Its p-e multiple, in other words, is one thing about Agilent that's not ready to shrink.

By Robert Barker

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