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New Accounting Rule Causes Headaches for Companies

The first quarter was generally good to greater San Fernando Valley companies, but it would have been better if not for FAS 123 (R). The new accounting rule, that for many companies went into effect with the first quarter of 2006, dragged down earnings at most firms, in many cases by $0.03 or more per share. While public companies generally accounted for the reductions in their planning and guidance prior to the quarter’s close, the complexity of the rules along with differences in interpretations made for headaches and disappointments. “It’s just been a huge headache for our accounting and finance folks,” said Erik Randerson, director of investor relations at Digital Insight Corp., a Calabasas-based developer of online banking software and services. “It’s just created so much more complexity with the quarter close process and additional expense as well.” FAS 123 (R) requires public companies to include stock options paid to executives as an expense. Those who did not do so before found that their financial results were reduced, by an estimated 3 percent for companies overall. Analysts generally reduced their earnings estimates in anticipation of the new rule, but they also tended to evaluate performance on results that excluded the stock option expenses in order to more accurately gauge companies’ performance. Also cushioning the potential impact of the new ruling was the generally strong performance turned in by companies in the first quarter. Earnings at the 15 largest public companies in the greater San Fernando Valley rose by an average of 12 percent in the first quarter, even when the stock option expense was included, keeping the stock performance of these companies generally strong. In that sense, Valley companies pretty much reflected the business landscape nationwide in the small cap arena. “Small cap stocks have given investors a phenomenal six years of strong returns relative to large caps,” said Dennis Jensen, portfolio manager for the Russell 2000 Index, which measures stock performance in the small cap category where most Valley companies also fall. “We’ll see if the shift toward large caps in April has staying power, but for now the Russell 2000 remains the clear leader for 2006,” Jensen wrote in a report on the stock market in April. Among the top 15 Valley companies, only specialty retailer Guitar Center and American Reprographics Co., a provider of copying services and technology, saw net earnings fall in the quarter compared to the first quarter of 2005. Guitar Center Inc., which reported earnings of $15.7 million or $0.55 per share versus net of $15.9 million or $0.56 per share for the comparable period a year ago, logged stock-based compensation expenses of $900,000 or $0.03 per share for the quarter. Excluding that expense, charges resulting from the retirement of its former CFO and stock option expenses the company said should have been charged to the fourth quarter of 2005, Guitar Center would have reported net income of $18.6 million or $0.65 per share for the quarter. The company’s revenues rose 18.8 percent to $470.7 million in the first quarter of 2006 compared to $396.3 million in the like period a year ago. Among Valley companies, the best performers in the quarter were Calabasas-based homebuilder The Ryland Group, which reported a 43.5 percent increase in net income to $90 million or $1.86 per share in the quarter, versus $62.7 million or $1.25 per share for the first quarter of 2005; and workers’ compensation provider Zenith National Insurance Corp., which saw earnings rise 46 percent to $57.5 million, or $1.55 per share, compared to $39.3 million or $1.10 per share in the like quarter of 2005. Zenith said its workers’ compensation net premiums decreased by 9.5 percent in the quarter due to rate decreases and attributed its results to lower loss expenses and higher short term interest rates. Ryland saw its closings rise 13.3 percent over the same period last year, although new orders declined 16.6 percent in the quarter. Ryland also noted that its corporate expenses rose to $16.5 million from $14.5 million in the prior year due to increases in both incentive compensation and the accounting requirements that took effect in the quarter. Many companies reported both their earnings accounting for stock option payments and excluding them. At The Cheesecake Factory, where earnings rose just 2 percent to $19.3 million or $0.24 per share, officials noted that the company would have reported a net income increase of 17 percent to $22.1 million and diluted net per share of $0.27 excluding stock option expenses. THQ Inc., which reported that it lost $7.9 million or $0.12 per share in its fourth fiscal quarter ended March 31, 2006 versus net earnings of $10.1 million or $0.16 per diluted share in the year ago period, also said that it expected its stock option compensation expense to reduce its earnings for its fiscal first quarter 2007 by $0.04 per share. Similarly, Semtech Corp., which has yet to release its earnings for the first quarter ended April 30, said it expects stock option expenses in the first quarter of its 2007 fiscal year to reduce its net income by $4.3 million to $4.8 million or about $0.04 per share. And ValueClick Inc., Internet advertising services and software provider, said stock option expenses in its first quarter totaled $3.3 million due to FAS 123 (R) and reduced its first quarter net income by about $0.02 per share. The company nevertheless reported net income of $9.8 million or $0.09 per diluted share compared to $8.7 million or $0.10 per diluted share in the prior year period. Digital Insight, which saw its net income on a GAAP basis rise to $6.2 million or $0.17 per diluted share, compared to earnings of $5.7 million or $0.16 per share in the same period last year, while on a non-GAAP basis, excluding stock option and other expenses, the company would have earned $9.1 million or $0.25 per diluted share in the most recent quarter.

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