On May 8th Barrons published a cover story on Cisco Systems, claiming that the company could be grossly overstating earnings. They have become a "house of cards" due to the use of an acquisition loophole called pooling, the article noted. This claim by Barron's did not include consideration for the impact of stock options, which makes the situation look much worse. With almost 8 billion shares now outstanding, including employee stock options, a $2 increase in Cisco's stock price would increase the company's market value by $16 billion or roughly the amount of the entire gross annual sales.
Perhaps more astonishing is that Fidelity Investments owns more than $15 billion in Cisco Systems stock, per Yahoo.com, with the Magellan fund owning the largest position. Magellan still lists a 3 percent sales charge on Yahoo.com and maintains an expense ratio of .67 percent or roughly three times that of a top quality index fund such as the Vanguard Index 500. Fidelity also now earns fees from direct stock traders on Cisco transactions and aggressively advertises the ability to conduct such trades via cell phone, laptop computer or palm pilot. It is not uncommon now for Cisco Systems to be the most heavily traded stock on the Nasdaq stock exchange.
An obvious question becomes, who is fleecing whom? Are investors being fleeced by Cisco Systems, Fidelity or both. Fidelity funds are prominent in many pension plans and one might also ask if Fidelity has gotten lazy with respect to fiduciary responsibility and financial analysis and instead become focused on fee generation? Perhaps Fidelity recognizes Cisco to be a massive "watered stock fraud" and is simply posting fees off the excess valuation as long as possible? Only Fidelity knows the answers to these questions. All we know is that they certainly do not appear to agree with Barron's. Charles Dow, Barron's founder, was also in the minority when he first tried to expose the various pyramid schemes of Charles Ponzi in the 1920's.
Not discussed in the Barron's article, in addition to Fidelity's position, was Cisco Systems stock option program and its additional effect on the financial integrity of the company. Due to the success of a remarkable pyramid scheme at Microsoft involving employee stock options, now being emulated at Cisco Systems, neither company now pays any federal income tax. Cisco has even booked an asset of $900 million titled deferred taxes which is effectively a prepaid tax credit based upon the success of the scheme.
This report will examine both the stock option and pooling areas, beginning
with the following chart summarizing 5 years of financial results through
7/31/99 based upon 10K reports filed with the SEC. These results
are prior to considering the significant negative impact that adjusting
for pooling would create.
The company claims a tax deduction for wage expense on its tax return for options exercised and retired but does not charge any of this expense to earnings. This is one of two adjustments made to restate earnings. The second adjustment is to recognize the changing value of the remaining stock options outstanding.
Financial Perspectives on Pooling and Stock Options:
Perhaps the easiest way to understand the pooling technique for acquisitions is to imagine someone sitting in Cisco's accounting department with there index finger firmly rested on the copy button of a photo copy machine. There job is to print stock certificates to pay for acquisitions. This accountant knows that no cost for this activity need be reflected on the income statement or balance sheet.
The problem with pooling is that it can result in too many shares outstanding, as seen at Cisco, or what was referred to as "watered down stock" in the 1930's. President Roosevelt was so incensed back then that he tried to nationalize the accounting profession with the belief that only government auditors could be relied upon to maintain adequate standards. One has to wonder what it will take when Microsoft's auditing firm, Deloitte and Touche, is now the lead advertiser on the Louis Ruckeyaser show.
At its recent peak, Cisco Systems had a market value, including stock options, in excess of $450 billion. This represented 25 percent of the United States entire annual federal budget. Equally astonishing is that for every $1 increase in Cisco's stock price, the company incurs stock option wage debt of $850 million to employees. If the stock climbs $3 per share, that would eliminates the entire net income for the most recent year, net income which is ficticious to begin with due to the use of pooling for acquisitions.
Investors do not see that this breakdown in accounting standards has left them in a mathematical vice. If the stock climbs $10 per share, that will increase the market value $80 billion or five times gross sales. This would also generate a liability to employees of $8.5 billion, $10 times the 850 million shares in stock options outstanding. Meanwhile, investors are bombarded with public relations campaigns designed to extract trading revenues and mutual fund fees in order to sustain a classic financial pyramid scheme. Many investment houses, including Lehman Brothers, are still issuing "strong buy" recommendations on Cisco Systems.
My research supports the premise that this situation at Cisco Systems is sadly an effect of financial practices used by the Microsoft Corporation. Cisco was forced to compete with Microsoft and thereby emulate certain financial practices Microsoft has legitimized. Perhaps financial corruption is indeed the most destructive characteristic of Microsoft's monopoly, an issue that was not even discussed in the DOJ trial.
Product Considerations:
In the mid 1990's Microsoft and Cisco Systems were prepared to enter into a significant partnership yet it was quickly scaled back when Cisco saw that Microsoft could incorporate key software features from its IOS operating system into Windows NT. This could reduce Cisco to a hardware only focused vendor. Cisco's response was to go into an acquisition frenzy, trying to constantly stay ahead of competitors and knowing full well that Microsoft loomed on the horizon.
Research and development at Cisco has become a game of having the accounting department print up stock certificates and passing them out to pay for companies with promising technologies. Unlike other companies that develop technology internally and are forced to include this cost as a charge to earnings, Cisco is using stock minted on their photo copy machine to purchase key technology and due to an accounting loophole most of this cost is not charged to earnings.
Cisco's monopoly over data transmission equipment in the IP protocol environment has largely been created by leveraging this IOS operating system and selling "end to end" solutions that shut out competitors. The IOS is good software but could also easily be incorporated into other operating systems, including NT.
Just as Microsoft's margins will plummet from increased competition, so will those of Cisco Systems. While Microsoft is waging war with the free market forces of the Internet, Cisco Systems is similarly struggling with the convergence of voice and data and discovering that they can not control this convergence with its IOS operating system.
To Microsoft's advantage it does have a monopoly over key segments of the software industry while Cisco Systems is highly vulnerable to competition. This week Cisco signed a deal to partner with a major Chinese telecommunications company with much fanfare but in reality it will probably be nothing more than an opportunity for the Chinese firm to learn and then later copy Cisco's key business practices. Unlike Qualcomm, Cisco does not have a defensible product based monopoly over a key technology area.
Cisco's primary focus has been on transmitting data over the Internet. This has provided excellent growth yet Internet users now also want to transmit voice and video and more importantly mix the two forms of data. Cisco clearly lags in this area and has become a bottleneck. Nortel Networks and Lucent are leaders in the voice area and are quickly developing strong data transmission businesses. The strategy for catching up at Cisco is to fire up the photo copy machine and offer new stock to a variety of companies with promising new technologies.
No matter how you feel about Cisco, management has put the company in a mathematical vice. Perhaps it is time to tune out the noise and respect basic math skills learned in grade school. Most importantly, 8 billion shares is a lot of owners when it comes to sitting down at the dinner table and dividing up earnings.
An extended study regarding Microsoft's financial practices, much of which is applicable to Cisco Systems, is available at http://www.billparish.com/msftfraudfacts.html. The report explains how Microsoft is pilfering the retirement system just as Charles Keating plundered the Savings and Loan System.
Bill Parish, President of Parish & Company, has been quoted extensively in a variety of major news publications, as well as The Tech Review, a Canadian investment journal, Bild, the largest paper in Germany, The Fleet Street Letter, a prestigious investment publication, The Spotlight, a conservative newspaper and free market advocate and The Independent, a major British newspaper. He has been interviewed by the New York Times, Infoworld, ZD Net, Wall Street Journal, Newsweek and USA Today in addition to appearing on ABC news and various radio stations including KUIK in Portland, KIRO in Seattle and Aspen Public Radio in Colorado.
Mr. Parish is a Registered Investment Advisor and former CPA providing fee based investment management services in addition to assisting companies structure their 401k plans to meet their fiduciary obligations and provide top quality well diversified investment choices at the lowest cost. Please consider hiring Bill to be a permanent member of your 401K committee and thereby utilize the services of a top investment professional in order to clearly communicate your commitment to managing your employeesÂ’ 401K plan or what can now be called there "Mutual Savings Bank."