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Technology Stocks : Cisco Systems, Inc. (CSCO) -- Ignore unavailable to you. Want to Upgrade?

To: Don Lloyd who wrote (64565)	9/15/2003 2:17:20 AM
From: Stock Farmer	Read Replies (2) \| Respond to of 77400

Don, I don't think you understood my observation. You presented a fallacious argument when describing two companies, one which loses 10 M$ per year outright and the other which earns 10 M$ outright but also issues 20 M$ in share capital. It turns out that they are equally sustainable and equally profitable and have the same cost of operation. Their business models are identical. Their only difference is financing strategy. To identify the fallacy, let's look at three companies. ABC is an "old economy" company with great management. They pay their employees 10 M$ less than they get in revenue. So they end up with 10 M$ going into the piggy bank every year. Under current accounting they show a bottom line of 10 M$. PDQ is an "old economy" company with terrible management. They pay their employees 10 M$ more than they attract in revenue so that every year their cash hoard dwindles by 10 M$. Under current accounting they show a bottom line of (10) M$. XYZ is a "high tech" company with SV management. They pay their employees a market-competitive wage of 10 M$ less than they attract in revenue. But in order to align their interests with those of shareholders, they are also given 20 M$ in shares every year. Which management claims is necessary in order to deliver the business results. So the net is that their cash hoard grows at 10 M$ per year, but they experience dilution at the rate of 20 M$ per year. Under current accounting they report a bottom line of 10 M$ quarterly and then three months after they announce this wonderful result they disclose a 20 M$ footnote buried in a document that few people remember to read. How well is management increasing shareholder capital? What are the necessary costs to generate a dollar in revenue? How are these costs being met? Is the revenue in excess of the cost? Can the business continue indefinitely? These are all useful questions. Let's follow ABC, PDQ and XYZ through 10 years of sustained operation. After 10 years, ABC has seen its cash hoard increase by 100 M$. This is sustainable indefinitely. Presuming shareholders are dumb enough to keep the doors open for that long, PDQ will see its cash hoard decrease by 100 M$. It's pretty clear that being a shareholder of ABC means you are 100 M$ to the good and being a shareholder of PDQ you are 100 M$ worse off. But what about XYZ? Well the cash hoard has gone up by 100 M$. And assuming insiders flipped their equity comp to shareholders every year, shareholders still own 100% of the company. Only they had to pay 200 M$ along the way to do so. They are better off by owning 100 M$ in increased assets (woo hoo), but worse off by the 200 M$ they had to pay to keep owning it. The net effect is that management has consumed 200 M$ of shareholder capital in order to give them a 100 M$ return. [this assumed an outright grant. Also works for options... but we have to add the option premium paid by the employees (call that "X") to the cash pile of the company, and realize that the fair market value of the shares giving rise to a 20 M$ employee value is 20+X M$. So shareholders are better off by 10+X in cash, but worse off by 20+X in order to buy back the shares, so in any year they are ahead 10+X-20-X = -10... Also we note that XYZ looks like it's generating 10+X M$ in cash flow as compared to 10 M$ of ABC] In other words, management at XYZ is just as capable as management of PDQ. Except they are more clever in how they present their incompetence, and resort to a different strategy for financing the operations. Because in the case of PDQ it's obvious that shareholders should fire management and order the doors shut. In the case of XYZ, only a few people seem to clue in that it costs the same 10 M$ more than revenues for PDQ as it does for XYZ! Indeed, if XYZ and PDQ start with the same cash assets and then PDQ raised 200 M$ equity financing, in 10 tranches of 20 M$ each on an annual basis. After 10 years, both companies would have the same share structure and the same cash asset position. And shareholders of both would be 100 M$ in the hole. Clearly PDQ and XYZ therefore have identical sustainability in terms of business model, because both can resort to identical equity financing and achieve identical returns to their investors. And as long as someone is willing to finance XYZ they should be willing to finance PDQ. Conversely, if someone is not willing to finance PDQ then they shouldn't touch XYZ with a ten foot pole either. In practice, one turns out to be more sustainable than another, but the reason for that is ignorance, not economics. There are enough doofus retail investors who are willing to participate in a stealth equity financing scheme who would not participate in an overt equity financing scheme. Very clever. Where you went off the rails in your previous analysis was forgetting about counting the cost of that 20 M$ dilution. You recognize that it exists, but don't count it anywhere... as if you give it an implicit value of zero... hey... kind of like the current treatment of stock compensation!!! Which is merely perpetuated by keeping the cost of non-cash wages out of the income statement and relegated to footnotes.