Cisco Analysis - Snip 1: Stock Options
Last year I suggested that if the stock price were to
decline that Cisco's business model could be seriously
impaired in the 18-24 month time frame.
Well, it happened. And we're about 12 months in. All of a
sudden Cisco is now publishing details on its tax
accounting. Why? Here's an interesting snip from the 10-K:
At July 29, 2000, the Company provided a valuation
allowance on certain of its deferred tax assets because of
uncertainty regarding their realizability due to
expectation of future employee stock option exercises. As
of July 28, 2001, the Company has removed the valuation
allowance because it believes it is more likely than not
that all deferred tax assets will be realized in the
foreseeable future and was reflected as a credit to
shareholders' equity.
Earlier we were wondering about the effects of stock
options on dilution and on earnings.
From the statement of comprehensive income, we can see
stock outstanding
July 29 2000 7,138
July 28 2001 7,324
Change 186 = 2.6%
This is well below the long term average rate of 5.4%
annualized. This is good news.
We also discussed the source (Acquisition vs Stock Option).
Purchase Acquisitions: 46 for $2,163 (Avg = $47.02 /sh)
Issuence of common stock: 140 for $1,262 (Avg = $ 9.01 /sh)
Total: 186 for $3,425 (Avg = $18.41 /sh)
Where did this "issuence of common stock come from? Well,
under compensation we see:
Common Stock Issued 140 @ $ 9.01 = 1,262
Minus Stock options exercised 133 @ $ 7.43 = 988
----------------------------------------------------
Total Other 7 @ $39.12 = 274
Stock options accounted for 72% of dilution in FY 2001,
versus 50% 5 year average. Essentially stock option
dilution has continued at a constant rate while business
combinations have essentially ceased.
At an average stock price of approximately $47 per share,
countering dilution from stock options would have cost
Cisco a total of 6.3 B$ of cash.
In contrast, the cash flow benefit to the company from
stock option exercise is:
Cash Contribution from Employees 988
Tax Benefit 1,755
Total 2,743 positive cash flow
Note that using an effective tax rate of 35% we can
calculate difference of fair market value and strike of
approximately $37.70 Adding this to the average strike
price of 9.01 we have an average stock price of around $47.
So much for the facts. What does this mean to the business,
and thus to us as investors?
The real significance comes from examining the remaining
pool of options.
The hypothetical value of an option pool can be calculated
assuming an average exercise price. Then assume all
options above this price expire worthless and all options
below this price are exercised. Cash benefit to the
company then has two components: (a) contribution from
employees equals average strike price exercised times #
options exercised, and (b) contribution from IRS equals
0.35 x difference between average strike price and average
exercise price.
In 2000 with stock price of 72.56 (all options vest) we have:
Option Pool Contribution
Range Num Average Employee IRS Total
Strike
$ 0.01- 5.56 229 $ 5.23 $ 1,197 $ 5,396 $ 6,594
$ 5.57-12.27 258 $ 9.56 $ 2,466 $ 5,688 $ 8,155
$12.28-28.61 194 $23.59 $ 4,576 $ 3,325 $ 7,901
$28.62-54.53 241 $49.91 $12,028 $ 1,910 $13,938
$54.54-72.56 49 $65.65 $ 3,216 $ 118 $ 3,335
Total 971 $24.19 $23,486 $16,440 $39,925
In comparison for 2001, if the stock price hits $14 a
similar math yeilds
Option Pool Contribution
Range Num Average Employee IRS Total
Strike
$ $ $ $ $
$ 0.01- 8.39 226 $ 4.97 $ 1,123 $ 714 $ 1,837
$ 8.40-18.57 255 $13.98 $ 1,782 $ 1 $ 1,783 *
$ 18.58-50.38 338 $37.45 $ 0 $ 0 $ 0
$ 50.39-67.75 214 $55.85 $ 0 $ 0 $ 0
$ 67.76-74.94 27 $69.35 $ 0 $ 0 $ 0
Total 481 $6.04 $ 2,905 $ 715 $ 3,620
*Note: With weighted average price of $13.98 approximately
equal to exercise price, dollar weighted half expire
worthless and dollar weighted half expire in the money.
With the plunge in their share price, Cisco has lost
approximately 36 Billion dollars of potential positive cash
contribution. Compare that to Cisco's entire 2000 net
income of 2.668 B$ and I do not need to explain the
significance.
Secondly, compare the remaining depth of the entire pool
(3.6 B$ versus the contribution in FY 01 of 2.7 B$). And
consider that 350 million options were exerciseable at
prices under $12.00 at YE FY 00, and only 133 of these
were exercised in FY 01. It is abundantly clear that if the stock
price does not rise significantly, Cisco will lose
significant cash flow within the next 12 months.
The cash rich "selling slices" part of the business has
effectively fallen off a cliff and the cash flow
implications are dire.
Why is this important? I suggest a review of total
comprehensive income.
By 1998 cumulative retained earnings was about 54% of total
comprehensive income: 3.9 B$, versus 3.3 B$ from "Common
Stock and Additional Paid In Capital".
In 2001 this ratio has plunged to 27% (20.1 B$ versus 7.3).
Conclusion: First: the major reason for Cisco's
impressive cash flow and oft cited "18 Billion Dollars" has
been its stock distribution. Second: Cisco has subsidized
the growth of its business from this cash source (they have
less than 20.1 B$ of investment assets). Third: If it goes
away, Cisco will not generate the cash flow necessary to
command an increasing stock price... further exacerbating
the effect; and conversely.
I suggest that if Cisco's stock price does not climb
aggressively that the full effect on cash flow for FY 2002
will be quite noticeable.
John. |
