By Ian Springsteel CFO Magazine May 01, 2001



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|By Ian Springsteel    CFO Magazine    May 01, 2001 |

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|Counting Their Chickens |

|Equity-based transactions may save cash, but you don't always get what you bargain for. |

|Last summer, when Irvine, California, semiconductor maker Broadcom Corp. was negotiating to buy Altima Communications |

|Inc., its biggest concern was the company's relationships with its customers. As with any small company in the |

|hypercompetitive technology sector, winning and keeping customers is everything. In an effort to strengthen its |

|relationships, Broadcom urged Altima executives to strike product purchase agreements that gave customers like 3Com and |

|Pace Micro Technology performance-based warrants in the company. The more products the customers bought from Altima, the |

|more warrants they were eligible to receive. |

|Broadcom itself pursued a similar strategy prior to going public in 1998, and it encouraged four other private companies |

|it acquired last year to offer such incentives to their customers. When the acquisitions were completed, the warrants were|

|converted into Broadcom warrants. In addition, their cost, considered part of the price paid for the companies, was rolled|

|into goodwill and amortized over a five-year period. "We and the acquisition candidates viewed these transactions as a way|

|to promote and solidify relationships with key customers," explained CEO Henry T. Nicholas III in a March 6 press release.|

|But when the Wall Street Journal and the Securities and Exchange Commission regulators got wind of the transactions, the |

|deals were suddenly viewed in a more sinister light. Existing accounting guidance directs that any performance-based |

|grants of shares or warrants to customers be charged against the revenue they relate to--like a cash rebate--thereby |

|reducing the amount of revenue recognized. Because Broadcom simply dumped the cost of the warrants into goodwill instead |

|of matching it against the revenue earned from the contracts, accounting watchdog groups like the Center for Financial |

|Research and Analysis say the company is inflating its revenues. Ashok Kumar, a technology analyst with US Bancorp Piper |

|Jaffray, suggests that the accounting method may have overstated Broadcom's sales growth rate by as much as 50 percent. |

|Nonsense, say Broadcom executives. Only about $20 million in sales related to the agreements has been recognized by the |

|company, and the initial accounting treatment--which the company announced it would change on March 21-- was cleared with |

|the company's auditors, Ernst & Young. "I don't think there's anything to be concerned about," said Broadcom CFO Bill |

|Ruehle to a Wall Street Journal reporter. "Last time I checked, aggressive marketing practices were OK." |

|But aggressive accounting--even the whiff of it--is another matter altogether. In a market sensitized by scores of |

|share-price meltdowns resulting from aggressive accounting practices, Broadcom's unusual treatment of the transactions was|

|bound to generate bad press and SEC inquiries, not to mention the shareholder lawsuits that have lately been filed against|

|the company. |

|Broadcom's use of warrants in performance-based contracts, however, is by no means unusual. For years, New Economy |

|companies have been testing the tolerance of generally accepted accounting principles (GAAP) in matters of income |

|statement presentation, revenue recognition, and the capitalization of expenses. And while companies in other industries |

|(notably the oil and gas exploration industry) have entered equity-based transactions to share risk and build |

|relationships with customers, technology companies have taken the practice to new, ever more complicated lengths. |

|In the heyday of the bull market, dot-coms threw their equity around like drunken sailors--loading up employees with |

|options, and paying vendors, lawyers, public relations firms--even landlords--with stock. The performance-based deals with|

|other companies produced heady investment profits for the recipients, while cash-strapped issuing companies conserved |

|working capital and got bragging rights to big-name customers. In hindsight, of course, many on the receiving end of the |

|transactions now wish they'd asked for cash. But there were, and still are, good reasons for companies to enter these |

|agreements. |

|The accounting for the deals, however, is now coming under intense scrutiny from the SEC. Many of the contracts are still |

|in effect, and continue to play out in corporate earnings and disclosures. And absent hard and fast rules for the |

|appropriate treatment of the transactions, companies have been finding innovative ways to measure and present information |

|about equity-based transactions. To say the least, regulators have their hands full. "It's like one of those arcade |

|games-- as soon as you knock one gopher back in its hole, another pops up somewhere else," says Lynn Turner, chief |

|accountant at the SEC. |

|In October 1999, the SEC enlisted the help of the Emerging Issues Task Force (EITF) of the Financial Accounting Standards |

|Board to ferret out those gophers, along with several others affecting the New Economy. The EITF issued guidance for |

|companies receiving equity instruments, in EITF 00-8 (on equity-instrument receiver recognition), last year. Two other |

|bulletins, EITF 00-18 (on accelerated vesting of equity instrument payments) and EITF 00-25 (on vendor payments and |

|rebates), are still in the works. The SEC also asked the American Institute of Certified Public Accountants last November |

|to include related issues on classification and valuation. The problem, says Barbara Carbone, a partner at KPMG LLP, is |

|that no two agreements are exactly the same. "The accounting is driven by the specific terms of the contracts and the |

|securities," she says. "It has become more complex." |

|AN AGGRESSIVE STAND |

|For one of the more complicated performance-based arrangements, consider a deal engineered by Singapore-based Flextronics |

|International with Motorola Corp. Last May, the electronics manufacturing services company signed a five-year, $32 billion|

|deal to make mobile-phone handsets and other electronic devices for Motorola. The alliance between the two companies gives|

|Motorola the option to outsource its manufacturing to Flextronics. In return, Motorola invested $100 million in the |

|alliance for a security that grants it warrants for 22 million Flextronics shares. According to Flextronics's |

|second-quarter 10Q filing last year, the security "entitles [Motorola] to acquire [these] shares... upon meeting targeted |

|purchase levels or making additional payments to the Company." |

|Flextronics took a $286 million charge for the warrants, using a basic options-pricing model to value them, says CFO |

|Robert Dykes. The expense was booked as a one-time charge, because "there is no vesting for these shares," he says. |

|"There's no accounting link to revenue, no ongoing condition for the options to be exercised"--and therefore less |

|volatility in Flextronics's financials down the road. Speaking generally, KPMG's Carbone notes that in agreements in which|

|shares or warrants of one company vest with another company over the period of a long-term contract, they need to be |

|charged at the price on the day of vesting, not the price when they were issued. Thus, revenue and earnings numbers for |

|issuers and receivers of these instruments could be subject to noncash charges or gains as the value of the shares rises |

|and falls. |

|The deal gets more intriguing still. Flextronics agreed that Motorola could buy the right to exercise the warrants for |

|another $300 million, and capped the future revenue discounts related to the warrants vesting at that price. This is |

|significant, as the disclosure gives Flextronics's investors a solid outside number in calculating the impact of the |

|stock-based rebate program on the company's GAAP earnings per share. |

|Dykes and vice president of finance Thomas Smach assert that because Motorola isn't required to use Flextronics's |

|manufacturing capacity, and can buy the rights to exercise the warrants for $300 million, the rules for recognizing the |

|warrant expense over the life of the contract don't apply to the deal. However, the $300 million exercise price is reduced|

|each quarter, based on the amount of revenue the company receives from Motorola. This is not a vesting schedule, says |

|Dykes. |

|Analysts aren't so sure. "They gave away 5 percent of their common stock to get that deal," says Craig Sheets, an analyst |

|at the Center for Financial Research and Analysis. "The $286 million charge should likely be taken over the 18 quarters of|

|the deal, not all at once, and probably as adjustments to revenue, not as an unrelated line item on the income statement."|

|Wall Street analysts are also skeptical about the accounting treatment. "It seems to me that there are a series of |

|triggers, based on the level of purchases Motorola makes from Flextronics, that allow the options to be exercised," says |

|Chris Whitmore, an electronics- manufacturing services analyst at Deutsche Bank Alex. Brown. A rough estimate shows that |

|by taking the $286 million charge up front, Flextronics will boost its future reported gross margins by $57 million a |

|year, on a GAAP basis. Dykes says that Flextronics structured the deal as it did precisely to avoid the future expenses. |

|"To do it [with a vesting schedule that would value the options over time] would result in too large an expense," he says.|

|It doesn't matter much to Whitmore. "What matters to me is cash earnings per share," he says. "Companies like Flextronics |

|are valued on an operating cash-flow basis, not on their GAAP net income." The SEC takes the issue seriously, however. |

|That's why it is still prompting the EITF to provide more-detailed guidance for complicated deals like the one between |

|Flextronics and Motorola. "I would be concerned if any company were recognizing charges for equity shares in advance of |

|actually granting them," says the SEC's Turner. "These things are dependent on the specific terms [of the contracts], |

|though, so we would want management to explain the terms of any such deals in a way that investors [could] make their own |

|judgment about the impacts." |

|CRIME AND PUNISHMENT |

|Does the market really care about how noncash expenses are reflected in the financial statements? Craig Collins, CFO of |

|CoSine Communications Inc., a network- infrastructure products maker in Redwood City, California, doesn't think so. Last |

|September, the SEC forced his company to revise its financials for the first half of 2000 before going public. CoSine had |

|to cut its revenue number from $11 million to $7.8 million to reflect the value of warrants it had previously issued to |

|six customers. |

|Investors, however, hardly seemed to notice--CoSine's IPO priced at $23, and the shares opened for trading on September 26|

|at $67. The shares have since plunged--to as low as $2--but then so have most other stocks in the telecom-equipment |

|sector. Collins doesn't believe the warrant deals or the accounting for them has had any impact on the company's stock |

|price. "We want to do [the accounting] in whatever way makes the SEC happy," says Collins. "Our attitude is, let the |

|accounting fall where it may, because the investing community is smart enough to understand the economics of these |

|transactions, and doesn't use GAAP measures to value us." |

|Apparently, the market isn't always so smart or so forgiving. New Era of Networks Inc., of Englewood, Colorado, a software|

|firm more commonly known by its ticker symbol, NEON, was slammed by the market last year when the extent of its |

|equity-based transactions was revealed. In a bid to build revenues, NEON entered three deals in which it invested in a |

|customer's stock, while the customer paid cash for NEON products. In five other deals, the company accepted stock as |

|payments from customers. |

|Accounting rules required NEON to classify such "boomerang deals" as nonmonetary transactions. But the company's |

|executives didn't quantify the deals in a third-quarter conference call, although they accounted for roughly 10 percent of|

|NEON's $50 million in revenues for the quarter. Instead, the company buried the numbers in its 10Q filing a month later. |

|Once investors read the footnotes, the stock dropped like a stone, from $21.44 on November 17 to $6.56 just five days |

|later, and class-action attorneys headed for the courthouse. |

|A contrite Steve Webb, CFO of NEON, explained in January that the earlier omission was an oversight. "We had already |

|explained the deals earlier in the quarter in press releases, and didn't think the information needed to be presented |

|again as part of the conference call," says Webb. "We've since made the decision to communicate very clearly about |

|nonmonetary transactions with our investors." |

|It's a moot point now. The firm's poor performance--$39.7 million in losses on $40.2 million in revenues for the |

|quarter--apparently caught up with it. NEON signed an agreement to be acquired by Sybase on February 20 for $9.50 a share.|

|So, do investors care, and should CFOs care, about the accounting? "Two companies can look very different on an accounting|

|basis, due to different structures in acquisitions or deals made with equity, but on a cash basis they can be the same," |

|says CoSine's Collins. "Investors seem to care only about the cash-flow models, and they value companies that way." |

|Maybe so, but as the experiences of NEON and Broadcom suggest, companies that have entered equity-based transactions had |

|better make the details of the deals very clear to investors and regulators. |

|Ian Springsteel is a freelance writer based in Boston. |

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|TAKING STOCK |

|With the collapse of the Nasdaq market, and the near-worthless shares many companies got stuck with as payment for goods |

|and services, equity-based transactions should be a thing of the past, right? |

|Not exactly. In many cases, the reasons that companies accepted stock rather than cash during the late 1990s still apply |

|today. Consider . Through its Amazon Commerce Network (ACN), the Seattle-based E-tailer has struck commercial |

|deals with at least 12 other E-commerce companies to sell products and services on co-branded sections of Amazon's Web |

|site. Many of the partners, including , , and , paid Amazon for the marketing space with|

|shares that, since the blowout in Internet stocks, have lost most of their value. Amazon took $184 million in investment |

|losses in the fourth quarter, much of which resulted from shares received from ACN partners. |

|Despite the losses, however, Amazon continues to court new partners for the network. Says Tim Stone, director of investor |

|relations at Amazon: "The ACN business is an important way that we can leverage our customer platform. While the margins |

|on this revenue are declining...the economics of the business are still very attractive." He says that an increasing |

|amount of the revenue Amazon receives from ACN partners is in the form of cash, but he also indicated that the company is |

|still willing to accept stock from partners in the future, "should it make sense for our shareholders to do so." |

|Telecom-equipment maker Qualcomm Inc. also sees sound reasons for allowing customers to pay with equity rather than cash. |

|Last December, the San Diegobased company announced a new license program for its Code Division Multiple Access (CDMA) |

|digital wireless technology that permits "selected start-up and early-stage companies" to pay part of their upfront fees |

|for a CDMA license in stock. Qualcomm is in a battle for the hearts and minds of telecommunications providers that are |

|building wireless networks. The more providers that base their networks on the CDMA standard, the better it looks to other|

|prospective customers. The company also reasons that in accepting equity payments, it is freeing up customer capital to |

|improve and develop new CDMA products. "We believe that such resources focused on CDMA around the world help accelerate |

|the overall growth of the CDMA market and wireless usage," said Steve Altman, president of Qualcomm Technology Alliances, |

|in a company press release. --I.S. |

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|© CFO Publishing Corporation 2001. All rights reserved. |

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