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Counting Their Chickens

Equity-based transactions may save cash, but you don't always get what you bargain for.
Ian Springsteel, CFO Magazine
May 1, 2001

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.

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 Amazon.com. 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 Drugstore.com, Kozmo.com, and NextCard.com, 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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