CISCO Unravels

October 30, 2000 – Back on August 7th in Letter No. 268 I alerted readers to some of the accounting gimmicks being employed by both Cisco Systems and Microsoft. Since then, various reports about their devious accounting practices have presented a damning picture for both companies.

Looking first at Microsoft, a chilling article on October 6th inThe Wall Street Journal – which in my view did not receive enough attention – sent the stock of Microsoft over a period of several days into a 14% mini-collapse to below $50. From this article we learned that the financial fiddling at Microsoft has even more dire repercussions than I was aware.

I had already noted that if its employee stock options expense were properly accounted, Microsoft would have no earnings, which explains why it pays no federal income taxes on its +$20 billion of annual sales. In other words, because it doesn’t have any income, no taxes are payable. Microsoft’s reported earnings are the illusory result of accounting gimmicks. While this observation is bad enough, there is even worse news.

According to the WSJ, “Microsoft has for several years bought back shares of its own stock and employed a complicated hedging strategy to soften the impact” of its employee options program. While the price of Microsoft stock was rising, this “hedging strategy” was contributing cash-flow to the company.

The basic component of the strategy involves Microsoft selling puts on its stock. Because the puts being sold by Microsoft were expiring out of the money as its stock price rose, all was well. But with MSFT well below its $119 all-time high, these puts are a problem.

As its stock price heads south, the puts written by Microsoft go deeper and deeper in the money. Then if those puts are in the money at expiry, Microsoft has to use its cash to buy back its stock. How much cash? The WSJ estimated that at its then closing price of $55, it would cost the company “$11.6 billion over the next ten quarters”, which would consume one-half of Microsoft’s cash.

That was at $55. MSFT recently broke below $50, though it has subsequently rallied back to $67. But what if the tech stocks take another swoon, dragging MSFT along with it? And what if MSFT doesn’t stop next time at $48, and instead keeps slipping, like stocks do when they are in a bear market?

I’ve done a simple sensitivity analysis in an attempt to estimate the magnitude of the problem. By my estimate if MSFT traded at $26, the obligations to purchase its stock would just about wipe out the company’s entire cash position. Given that MSFT closed at $67 on Friday, is it reasonable to expect that it could trade down to $26 as these options expire over the next few years?

Well, it already traded at $48, which is about half-way to $26 from its current price. And if this bear market digs deeper, who’s to say where MSFT will stop? But instead of subjective judgements, consider this objective measure.

By my estimate if MSFT traded at a 15 P/E – a level which is not unreasonable when using historical standards of measurement – instead of the 36 P/E it currently sports, all of Microsoft’s cash would be consumed buying back its stock to meet its obligation for the puts that it has written. And of course, the 15 price-to-earnings ratio assumes that Microsoft indeed has earnings, which it doesn’t if the cost of employee compensation were properly accounted. This no doubt is indeed a very sobering assessment, but as bad as Microsoft’s accounting appears to be, Cisco’s is even worse.

I won’t get into the specifics again about the treatment of employee stock options or the egregious use of pooling to account for the numerous acquisitions it makes each year. But I do recommend that you read the October 23rd issue of Barron’s. An article by a highly respected accounting professional lays bare the facts for all to see. But this article doesn’t focus upon the new problems at Cisco that are rapidly coming to light.

Apparently the quality of its accounts receivables are being questioned. In the haste to book sales, its finance subsidiary extended credit to a number of firms with less than investment grade credit ratings. As I understand it, some of these companies are now unable to meet their debt obligations to Cisco, so if these companies default, Cisco will eventually be forced to take some write-downs of these assets.

At this time we unfortunately do not know how big these problems are, but I think the always prescient stock marketknows, judging by the way Cisco’s stock is being hammered. Back in September CSCO broke critical support at $60, and it subsequently sold off all the way to $48. CSCO has bounced somewhat, but closed Friday just above $50 and its chart is looking very weak. It is my view that a break below $48 will confirm that the top is in place on CSCO, and what’s worse, a break below $48 will send CSCO into a downward spiral.

There’s one very peculiar thing about bear markets. By the time a bear market ends, it will claim a lot of victims, and I am not just referring to investors who overstay their welcome by holding stocks all the way down. Companies can also be the victim, and often is it yesterday’s high-flier that gets clawed the worst. Is Cisco about to be clawed by the bear?

Intuition tells me yes because Cisco has been the quintessential high-flier of the 1990’s bull market, and my years of experience tell me that at least one big name from the good times becomes history when times turn bad. The rickety and deceptive accounting used by Cisco also tells me yes because this stock has been pumped up with air, hype and accounting gimmicks, not solid earnings or cash-flow. And if CSCO breaks below $48, the market will also be telling meyes that the bear is claiming another victim. It is this last event for which I am watching most closely because it will be an important indication that the market has spoken about Cisco’s prospects.

An article in the October 3rd issue of The Wall Street Journal sheds more light on the company. It highlights what most companies would identify to be conflicts of interest by employees, but is business as usual in Cisco.

Particularly telling is a lawsuit from an ex-Cisco employee against employees of the firm. The lawsuit describes “a gold-rush mentality of greed, strong-arm tactics, covert dealings and underhandedness” within Cisco. Sounds like something out of the pages of Wall Street describing Gordon Gekko.