Putting Cisco's Profit Quality to the Test

Cisco Systems (CSCO - commentary - Cramer's Take) recently filed its 10-K for the fiscal year ended July 27, 2002, with the Securities and Exchange Commission, so let's examine its quality of profits.

First, though, I want to review its chart for the 1990s. As we can see, Cisco enjoyed rapid gains in accrual profits (that is, net income as defined by generally accepted accounting principles) that were matched stride for stride by steady growth in defensive and enterprising profits for the first half of the decade.

But then in 1996, Cisco's enterprising profits began to decline, even though accrual and defensive profits kept rising. As this column has noted before, when accrual profits go one way and either or both of our alternate earnings measures go the other, we need to find out why.

A Parting of the Ways Enterprising profits fall as accrual and defensive profits rise

I can identify two reasons for the decline in enterprising profits:

The effects of stock-based compensation. In the enterprising income statement the pretax cost of stock-based compensation is treated as an expense, with a corresponding adjustment made to reduce taxes, just like wages, raw materials and pin cushions for the CEO. As the '90s wore on, Cisco's noncash -- but real -- stock-based compensation charge as a percentage of accrual profits grew rapidly. This reduced enterprising profits but not accrual and defensive earnings.

Management started aggressively exchanging its stock with the stock of companies it wanted to buy. The more stock Cisco issued to buy other companies under "pooling accounting" rules, the bigger its unrecorded goodwill account and capital base grew. All else being equal, the bigger a firm's capital base, the smaller its enterprising profits.

For example, according to Cisco's 10-K for the year ended July 25, 1993, the company issued 1.7 million shares in September 1993 to acquire all of Crescendo Communications' common stock. Since Cisco's stock price was $43.25, I estimate unrecorded goodwill at $74 million.

The 10-K doesn't specify what day the deal closed, so I used Sept. 15. If Crescendo had any net assets, then we would apply the proceeds to reduce unrecorded goodwill dollar for dollar.

Unrecorded goodwill	=Stock price x shares issued
	=$43.25 x 1.7 million
	=$74 million

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].