Rule Maker Portfolio Cisco: Not A Sale, A Ritual Cleansing
Tired of shoddy shareholder treatment

The Rule Maker Portfolio has held Cisco for well over three years. In this time, the company has sailed to the heights, then plummeted back to earth, complete with the ignominy of a $2 billion inventory writeoff. Bill Mann takes a look at some of Cisco's past sins, and then says goodbye to a company that really, really needs to treat its shareholders better.

Format for Printing

Format for printing

Request Reprints


By Bill Mann (TMF Otter)
July 17, 2002

It's time.

From the moment I took over The Rule Maker Portfolio, I've been contemplating this move. It's just so obvious. We have built up a strategy, then rebuilt it, based on many things. Among the most important are shareholder-friendly management, good corporate governance, and ample disclosure for owners to make good investing decisions.

For some time, various Fools have argued Cisco (Nasdaq: CSCO) did not fulfill these responsibilities to its shareholders. At the outset, Rule Maker determined that the company's spectacular growth overrode some of these considerations. Cisco was the dominant company in one of the most spectacular rocket rides the world has ever seen: the buildout of the Internet infrastructure. Then, I don't know what happened -- complacency, I guess. The time for us to act on our convictions has long passed, so no time like the present to do so.

This is probably a poorly disguised decision. This week, I went into paroxysms over a press release from the AeA, the leading lobbying association of the high-tech industry, in which it hailed its victory over "McCain's assault on stock options." I consider the kleptomaniacal greed shown by many executives in the high-tech industry as proof positive that they could really care less about "aligning shareholder and management interests." They just want to get rich. And Cisco's stock options program has been abusive to the point of comedy.

Given that Cisco is one of the largest, most influential members of AeA, I'm taking out my displeasure on this company first. More will follow. In a Fool on the Hill article yesterday, I provided a list of every publicly traded member of the AeA and a pledge to sell those I own. While my anger over the stance of the AeA may not be logical, the underlying theory definitely is -- shareowners should demand that companies treat them like owners, not sources of funds.

We're selling Cisco. I don't care what the price is, what we've lost, or what's going to happen with the company tomorrow. I want to own companies that reflect my own value system, and this one does no such thing. I think that the way Cisco has treated outside shareholders is deplorable, and it's not going to happen on the Fool's nickel anymore.

Cisco -- the prototypical 1990s company
Let's start at the beginning. In the 1990s, when the Internet revolution was full on, this was a company growing by acquisition -- and growing gangbusters. Dozens of companies, all bought with stock. There's nothing wrong with that, but a company that's so acquisitive should be willing to ensure that investors can determine its internal returns on capital for these acquisitions.

Cisco went the opposite route. They used the now-banned pooling of interest accounting method for purchases, which makes the accounting for the transaction look better by allowing companies to write down goodwill for the acquisition. If an investor can't tell how much money a company devoted to generate a dollar of earnings, then it becomes awfully easy for a company to obscure true costs of capital.

The thing is, there is zero economic difference between the pooling method and the purchase accounting method -- one just looks better. Guess which company was right out in front, pressing the Financial Accounting Standards Board not to get rid of pooling? Yep -- Cisco. CEO John Chambers warned in 1999 that the company might have to curtail its acquisition efforts if pooling were banned. This, even though there was no financial difference at all between the two.

Then comes Cisco's attitude toward stock options. Cisco likes them. A lot. In fiscal 2000, it granted 295 million shares of Cisco stock as employee options. In 2001, 320 million shares. Since the company has a total float of 7.1 billion shares, that means that in 2001 alone, the company granted 4.5% of itself to its employees. That might fly with a small startup with little in the way of revenues, but for one of the largest companies in the world? No, not at all.

What's more, Cisco was a leading participant in the lobbying efforts to keep employee stock options from being recognized as expenses in a company's financials. Once again, we hear the same argument: If we have to expense stock options, our ability to reward employees for their efforts will be impeded. Bull. Once again, Cisco and its ilk are fighting against appearances. Expensing options is nothing more than clarifying presentation -- it has no economic effect whatsoever on the company. This is a bogus, self-interested argument made by people who hope investors aren't paying attention. Well, this particular investor is.

Cisco's not alone here. FedEx (NYSE: FDX) investors, for example, should take note. Its chairman penned an article in opinion pages throughout the country saying much the same thing. I wouldn't touch that company's stock, either.

Then came the big bath last year, when Cisco declared $2.2 billion in inventory to be worthless. Cisco investors ought to be a bit more demanding on how a company that claimed it could close its books in 24 hours ended up holding $2 billion-plus in unsellable gear.

That's $2 billion worth of assets, destroyed. If I'd destroyed $2 billion in assets, you can bet the wife would be angry. What happened at Cisco? Well, John Chambers' bonus of $1 million cash was not awarded, but he still received 6 million Cisco shares as stock options, a market value at the time of some $96 million. That's sickening. It's disgusting, and it's high time we said (and did) something about it.

Cisco buys back stock at levels that mask dilution of its shares due to options grants. It has a clubby group of directors that has proven to be nothing but permissive to the company's management. And, even in this time of extreme anger among shareholders in general, Cisco's disclosures in its financial statements are obscure and incomplete, at best.

A reflection
Cisco still maintains a strong leadership point in its industry. I think it's priced fairly high. Even from its peak revenue point in 2000, the company trades at some pretty healthy multiples. Build in the potential dilution from those nearly $30 billion in outstanding stock options and their dilutive effect (14% of the total share count of the company is represented in unexercised options, and some of these options never will be exercised), and you're staring at a company that is priced as if the happy times were coming again, and soon.

And they might. There still may not be a technology company with a moat like Cisco's. Whether that will become beneficial for shareholders is another story. I'm skeptical. So, according to Fool Portfolio trading guidelines, we'll sell our whole stake in Cisco in the next five business days.

And, so we're not entirely negative
Next week, I'm announcing a buy. I've got a great company lined up, one that has been hit extremely hard by the market lately. Although I'm not excited about a good number of the companies in the stock market, nor am I sure there will be relief any time soon, I do recognize that there are some really good values out there, as we speak.

But Cisco and its AeA brethren won't be among them. Yesterday, on the floor of the Senate, several legislators used procedural tactics to block Sen. Carl Levin's (D-Mich.) immensely sensible legislation requiring expensing of options among American companies. I think this is despicable, and it tells us just how much money moves things in Washington. This is the best chance for good corporate governance reform in decades, and what Alan Greenspan called a root cause of the pervasive greed in America's boardrooms can't even come up for discussion on the Hill. Shame.

I'd like to close by addressing technology companies in danger of being on the wrong side of a revolution for better corporate governance in America. Shareholders are mad, and instead you're worried about how your financials will look if you have to account for stock options. Wake up, pals -- people don't believe your financials already, and resistance on this matter might come back to bite you. And bad. I don't wish this on anyone, and I still have great faith in the U.S. markets.

But not in you, Cisco. So, in the words of Trinity, from The Matrix:

"Dodge this."

Fool on.
Bill Mann, TMFOtter on the Fool Discussion Boards

We had to send Bill home after he tried to "exorcise" his computer by waving chicken entrails over it. He has beneficial interest in Cisco. Please see his profile for a full list of companies to which he holds an interest. The Motley Fool is investors writing for investors.


Rule Maker Portfolio

We are currently changing providers for our portfolio data. During the transition, we won't be able to show updates of our overall returns. Thank you for your patience.
  Ticker Company Price
 Daily Price
 % Change
  NOK NOKIA 0.53 3.90% 14.12 
  INTC INTEL CORPORATION 1.08 5.88% 19.44 
  PFE PFIZER INC 0.71 2.49% 29.26 
  CSCO CISCO SYSTEMS, INC. 0.53 3.71% 14.80 
  TROW PRICE T ROWE GROUP INC 0.32 1.12% 28.80 
  KO THE COCA-COLA COMPANY (0.37) (0.73%) 50.00 
  JNJ JOHNSON & JOHNSON 1.14 2.28% 51.24 
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 02/03/98 59 MSFT 49.35 51.99  6.21%
 02/15/00 250 NOK 27.21 14.12  -48.11%
 05/26/98 95 AXP 35.38 34.01  -3.64%
 08/21/98 44 SGP 47.99 23.65  -50.54%
 02/13/98 147 INTC 27.44 19.44  -28.73%
 02/03/98 66 PFE 27.43 29.26  7.13%
 06/23/98 182 CSCO 24.72 14.80  -39.91%
 02/03/98 75 TROW 34.12 28.80  -15.33%
 02/27/98 27 KO 69.11 50.00  -27.34%
 04/03/01 10 JNJ 43.65 51.24  17.39%
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 02/03/98 59 MSFT 2,911.79 3,067.41  155.62 
 02/15/00 250 NOK 6,802.85 3,530.00  -3,272.85 
 05/26/98 95 AXP 3,360.87 3,230.95  -129.92 
 08/21/98 44 SGP 2,111.70 1,040.60  -1,071.10 
 02/13/98 147 INTC 4,033.23 2,857.68  -1,175.55 
 02/03/98 66 PFE 1,810.57 1,931.16  120.59 
 06/23/98 182 CSCO 4,498.76 2,693.60  -1,805.16 
 02/03/98 75 TROW 2,559.06 2,160.00  -399.06 
 02/27/98 27 KO 1,865.89 1,350.00  -515.89 
 04/03/01 10 JNJ 436.50 512.40  75.90 

Copyright © 1998-2002 Inc.
Historical and current end-of-day data provided by FT Interactive Data.
Intraday data is at least 15-minutes delayed. All quotes are in local exchange time.
Intraday data provided by S&P Comstock and subject to terms of use.
WorldScope/IBES data provided by Thomson Financial Solutions.

The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.