[BusinessTeam] for all you Cisco fans out there...

Message-ID: <6B75EF096AE0BE428B8CEDEA89C5F6327822AC@exchange01.lab49.com> · Tue Oct 17 15:50:39 2000 UTC

IT giants who don't pay tax part 1: how Cisco does it
By:  <mailto:graham.lea@theregister.co.uk> Graham Lea
<mailto:graham.lea@theregister.co.uk>
Posted: 16/10/2000 at 12:43 GMT

Cisco is "a modern house of cards, in which the cards are Cisco's stock
and the companies acquired for Cisco stock" according to Barrons. Part of
the problem is that Cisco is not employing astute financial engineering
techniques, so it has been increasing its exposure with little or no
appreciation of the potential downsides. One sneeze from the market, and
maybe the whole lot could go over.

The company's acquisitions are mostly by pooling, which results in
distorted accounts. It also has enormous stock-option debt, and customers'
purchases are financed via related party transactions. So long as Cisco is
on the up, this works, but it's a precarious edifice that stands in peril
if the company were to fail to meet financial analysts' expectations.

Cisco's acquisition trail
In 1993, Cisco was pretty much a one-product company making routers, but
its major customers began to buy switches instead. Overnight, Cisco
decided to become a network company with an aggressive acquisition policy
that became "wired into the DNA of the company". Cisco has made 80
acquisitions so far, with 24 acquisitions in fiscal 2000 and a further
eight in the present financial year, which began on 30 July. Pooling -
using shares - has been used in more than three quarters of the
acquisitions by value, and purchase - using cash - for the remainder.

Cisco's dominant market position results from these acquisitions and
allows it to charge high prices for its products and leverage its Internet
Operating System for its own products. Juniper is the only significant
competitor with routers that are compatible with Cisco's. Although Cisco
claims that 99 per cent of its IOS is based on open standards, it's the
proprietary part that causes the grief. Cisco is squeezing the major
telcos like AT&T and Sprint and shutting them out of the market, so that
they are having to spend $2 on equipment to get $1 in revenue and perhaps
$0.10 in profit (according to a Lehman Brothers' study), with the
probability that this will rise to $3 this year and $4 next year.

Cisco's results have been remarkable: sales of $19 billion in fiscal 2000,
with year-on-year share growth of 55 per cent, net income of $4 billion,
net margins of 21 per cent, no debt, and $5.5 billion in cash. There is
however a staggeringly high price/earnings ratio, well into three digits.
The market capitalisation was at one stage more than half a trillion
dollars, which is extraordinary for a company with less than $20 billion
in annual revenue. It will therefore be extremely hard for Cisco to
maintain its earnings expectations, although so far it has consistently
given the Street around a cent more than expected. Cisco is now in the
position where profits must grow faster than the stock price for a
collapse to be avoided, which puts the company under enormous pressure to
increase profits.

Pooling, or watering the whisky
Some say that using shares to make acquisitions - pooling - is like
watering the whisky, since the shares don't show up in the accounts.
Consequently, investors are unable to see how each investment is doing, or
to make any sensible predictions about cash flow from each acquisition.
What Cisco is doing is accelerating depreciation and keeping the assets
off the balance sheet. The amazing aspect of this pooling is that it is
legal, and it does not have to be accounted for in the financial
statements. Barrons opined that Cisco's profits would have been wiped out
if it had used the purchase method of accounting for acquisitions, instead
of pooling.

Cisco includes in its accounts the sales from the companies it acquires,
but excludes most of the acquisition cost - a technique that forensic
accountant Bill Parish calls "financial deception". Parish claims that
pooling resulted in Cisco having a $13 billion tax credit for fiscal 1999,
despite reporting a gross margin of more than $7 billion. Even when
pooling is not used for acquisitions, in-process R&D can be written off
and used to suppress current earnings and decrease the tax bill, so making
future earnings look better than they are. Thomas Donlan in Barrons in
August suggested that it was as though there were two sets of books when
there is such a divergence between financial reporting and tax reporting.

Because Cisco uses pooling, it is not allowed by SEC rules to buy back its
own shares to reduce the dilution that results from its stock option
programme. The SEC was going to repeal pooling in December - it is not
allowed in most countries - but Cisco has successfully lobbied to have
this put back by six months. Cisco's controller Dennis Powell told the
Washington Post that the "elimination of pooling will derail the engine
that is driving the strong economy of this country". CEO John Chambers
just happened to make a donation of $210,000 to a group of Congressmen
shortly before they wrote to the Financial Accounting Standards Board
criticising its proposal to scrap pooling. Because both George W Bush and
Democrat VP candidate Joe Lieberman have defended pooling, there must be
some considerable doubt as to whether it will be banned by the next
administration.

Despite its profits, Cisco pays no federal income tax, as confirmed in its
recent 10K filing with the SEC. There is a provision for income taxes, but
"deferred tax assets" from previous years ($1.091 billion in the July
accounts) ensure that no tax is paid. Cisco has also received considerable
tax credits from the now-illegal foreign sales corporation rebates, but
there is no agreement yet with the EU about an alternative export subsidy
scheme.

Stock options
Bill Parish says that Cisco owes more than 800 million shares to its
employees in options. Donlan described stock options as deserving "to go
under the inquisitor's hot lamp as another dubious tax subsidy that
perverts good sense and harms the owners of the corporation that issues
them". The WSJ has put Cisco's stock option debt at $40 billion,
increasing by some $800 million for every dollar that the share price
increases. Cisco is allowed to claim a full tax deduction for the exercise
price of share options paid to employees. A consequence for investors is
that earnings are being diluted as more shares are issued.

Funding the customers
According to Parish, Cisco maintains a pyramid by pooling and manipulating
gross revenues, and undercutting competitors with equipment leases through
its finance company. Not infrequently, Cisco announces vendor financing
rather than product sales, which is indicative of the importance that
Cisco attaches to funding its customers. This implies that the quality of
Cisco's current business is not as good as for competitors who have no
leasing business, since Cisco would be reporting income from leasing
operations two or three years earlier, when in reality the equipment may
be close to valueless because of obsolescence. Cisco has the cash for
leasing because it does not use as much cash as its competitors for
acquisitions or salaries. Cisco Capital is also suspected by Parish of
accepting stock options from customers in lieu of cash, and should any
pre-IPO shares appreciate on listing, there would be no tax liability. The
accounting information disclosed on Cisco Capital is very scanty.

Related party transactions
Although Michelangelo Volpi, Cisco's chief strategy officer, has claimed
that less than one per cent of Cisco-financed transactions go sour, this
does not square with the data and litigation record, for example with
Louisiana telco American Metrocomm. In a major denunciation recently the
WSJ followed up various accusations and found many examples of related
party transactions involving loans to start-ups that were used to pay for
purchases, but with the added spice that Cisco employees were permitted to
get commissions and arrangement fees for loans, as well as to invest in
customers, take part in IPOs, and even receive stock options in customers.
Cisco did require that the company was told of such related-party
transactions, and required that employees with stakes in a supplier or
customer did not make decisions about them. This evidently did not work
very well, since Cisco has had to change its policy on conflicts of
interest, and dismiss some employees.

After Parish told consumer advocate and presidential green party candidate
Ralph Nader about Cisco finances Nader has $1.2 million investment in
Cisco), Nader called a press conference on the steps of Cisco's offices
and called for more corporate accountability, but said he was not selling
the stock because he thought he would be better able to bring about change
from the inside.

If Cisco's financial practices bring about the collapse of its house of
cards, this would have enormous implications for US pension funds because
so many of them pile money into Cisco's stock. Parish notes with suspicion
that PriceWaterhouseCoopers audits Cisco as well as most of the major
pension funds investing in Cisco. The prospect of a possible collapse in
the US pensions system, triggered by a Cisco collapse, is an overwhelming
argument for fiscal reform. Few believe this will happen. ®

Related Stories:
Accounting masterclass:
<http://www.theregister.co.uk/content/7/13852.html> how Cisco and MS avoid
tax
IT giants who don't pay
<http://www.theregister.co.uk/content/1/14017.html> tax part 2: how
Microsoft does it

Luke Flemmer
VP Strategic Ventures
nano
phone: (212) 402-7870
fax:      (212) 430-6374
www.nano.com <http://www.nano.com/>