Gary, interesting article about the CSCO's growth rate, if options are taken into account.
Cracking the Books: Cisco: Talk About
Wage Inflation!
By Kevin Petrie
Staff Reporter
9/21/98 10:14 AM ET
Companies can relax in the knowledge
that most Wall Street pros won't bother to
read the fine print on profits and the value
of stock options.
To delve into the prickly issue of
employee stock options and their true hit
to profits, look no further than Cisco (CSCO:Nasdaq).
Like many of its Silicon Valley peers, Cisco attracts and
keeps talented employees by serving up stock options. And
like others, Cisco can hide this compensation cost from
Wall Street until final audited numbers appear after a fiscal
year ends, thanks to a comfortable loophole in accounting
standards.
Many investors believe they own shares of the only
networking company that has grown earnings consistently.
But read one footnote in the 1997 annual report, and discover
that Cisco's net income hardly budged from fiscal 1996 to
1997. According to the footnote, Cisco's net income crept up
only 3% to $898 million "if the company had elected ... to
recognize compensation
cost based on the fair
value of the options
granted" in each year,
according to the report.
Since the 1998 annual
will not be released until
later this fall, investors
still cannot check the
reported 29%
year-over-year growth in
profits for the July fiscal
year. Cisco reported
those numbers on Aug.
4. (Cisco did not
calculate figures for
1995, saying they were not yet required.)
"That is a little bit
disturbing," says Daniel
McKelvey with Forte
Capital, a Cisco
shareholder. McKelvey
says CEO John
Chambers manages a
superb operation, and is
heartened that Cisco
firmed its dominance of
networking in 1997.
However, he believes
companies should be
forced to disclose this
compensation cost in a
more forthright fashion. "It gives the investor a much better
picture of ... the true growth of the company."
Cisco declined to comment for this story.
Wall Street doesn't pay much attention to this matter. Equity
analysts generally measure a company's performance by its
operating earnings, which means tossing out one-time
charges for things like restructuring and acquisitions. And
the cost of options seldom even crosses their radar screen.
They figure the operating-earnings model works just fine as
long as it's applied uniformly. So First Call, the benchmark
for quarterly performance, doesn't incorporate the cost of
options into its estimates.
But Silicon Valley tells a different story if you study this
cost. Investors (and analysts) value stocks based on the
earnings a company produces, and the rate of earnings
growth it can achieve. They value Cisco for consistently
meeting expectations, quarter after quarter. What happens
to the consistency when options are incorporated? On a
quarter-to-quarter basis, investors don't know.
And the rulemaker on the matter, the Financial Accounting
Standards Board, is unlikely to force a change anytime
soon, according to FASB fellow Mark Neagle. FASB ignited
a firestorm with companies and accountants by proposing in
1993 that companies account for options in annual reports,
contending that they aren't discretionary but rather a
necessary expense to be counted against net income.
But Silicon Valley revolted and FASB retreated. As a
compromise, the required disclosure was relegated to a
footnote, starting in 1995.
Economist Daniel Murray with the London-based firm
Smithers & Co. contends the annual report footnotes don't
even tell the full tale. For one thing, the pro-forma calculation
methods often assume that a company buys stock to cover
options as soon as it issues them. If the company waits
while the stock price rises, it pays an extra cost that might
not be reflected in the footnote. The problem is, it's tough to
ascertain just when companies purchase stock. Murray
says some companies buy back the necessary shares from
the public market, others issue new shares -- it all depends
on management's judgment.
Professor J. Edward Ketz at Penn State University argues
that companies should count the expense of granting
options as "a component against net income" on the income
statements that are published in quarterly press releases
and corresponding filings with the Securities and
Exchange Commission.
While Cisco is the biggest, easiest target in networking, it is
hardly the only example. Counting the cost of options more
than doubled the net loss for competitor Ascend
(ASND:Nasdaq) in 1997. It increased Bay Networks'
(BAY:NYSE) loss by 23% in the June 1997 fiscal year, and
trimmed 3Com's (COMS:Nasdaq) bottom line by a relatively
modest 17%.
Other tech companies would feel varying effects. Microsoft
(MSFT:Nasdaq) says its net income was 23% lower last
year after options were fully calculated, while Dell's
(DELL:Nasdaq) net
income, on a per-share
basis, fell only 9 cents
to $1.28 after the
calculation. Murray with
Smithers says most
companies comply with
the FASB standards,
although some reveal
fewer details than
others. And all sectors
are affected.
"It's across the board,
really," Murray says.
Silicon Valley startups
might feel it more
acutely, but Delta Air Lines (DAL:NYSE), Morgan Stanley
Dean Witter (MWD:NYSE) and others also have doled out a
lot of options.
Cisco remains the networking king. Even in a world of full
disclosure, it's still hard to advocate selecting 3Com instead
of Cisco. But this disclosure does say new things about the
stock's price. Cisco trades at 94 times the earnings it
reported for fiscal 1997, but 110 times its net income after
options are taken into account. Both numbers are high, of
course, but a gap like that can matter in jittery markets.
Yet many Wall Street analysts decline to penalize Cisco on
this point.
Bill Rabin with J.P. Morgan says options might even cost
less than the alternative -- it's unclear whether paying with all
cash, no stock would prompt some employees to walk.
Rabin, whose firm is not a banker for Cisco, remains a bull
on Cisco. He declines to say whether the company should
put options costs in its quarterly statements.
In fact, you could say that it's a topic most Wall Street
players prefer to see as optional. |
