Rules of the game change

Computer Industry Report, June 9, 1999

Imagine watching a contest in which one team plays by the rules of rugby and the other team plays by the rules of touch football. To compound the chaos, the rules of touch football have been tightened. Can the touch football team compete? How do the onlookers keep score? Now imagine playing on the touch football team.

The analogy isn't so farfetched when one looks at the playing field of ecommerce. Many established public companies are finding it puzzling when the rules by which they have played, such as demonstrating improved profitability on a consistent basis, are ignored by the upstart "dot com" companies that instead play by the rule of "cfimitym" or "cash flow is more important than your mother." In this world, players have snagged high market caps because of the assumption their losses reflect progress in pursuing long-term growth.

HAVES AND HAVE NOTS

The upstarts have better liquidity from market capitalization to make aggressive acquisitions. We're rapidly approaching the bifurcated world of haves and have nots, with the have nots enviously eyeing what might be called the "funny money" of the upstarts. The established companies are increasingly facing the prospect that the upstarts will be the acquirers rather than the acquired.

Some established companies in the industry are mulling their options, which include:

* Staying the course as an established company

* Spinning off a portion wrapped in the dot com mystique that can play by the new rules and potentially gain sizable market cap

* Initiating a "tracking stock" for a portion of its business that relates to the Internet arena to potentially gain sizable market cap

RULES - BUT WHO CARES?

The Financial Accounting Standards Board (FASB) has been tightening the rules regarding acquisitions. In one of those seminal twists of fate, these rulings, which are officially called "tentative decisions" really impact only the established public companies that are judged on their profitable bottom lines calculated on net earnings. The FASB rules are relatively meaningless to the upstarts, whose plans don't include profitability on a net earnings basis anytime soon.

One recent FASB ruling amounts to a cattle call for mergers by setting a deadline of late 2000 when it will eliminate pooling of interest accounting for mergers. The FASB has said companies that announce a merger in advance of the new rule and complete the deal one year from the announcement may use the old rule. (If one wondered why this spring was marked by particularly frenetic merger activity, perhaps the FASB was an inspiration.)

When mergers are based on a pooling of interests, they are done by exchange of stock, and balance sheets are merged. The procedure entirely avoids the future need to write off goodwill, the merger-related premium paid for acquired assets.

After that deadline, companies will have to make their mergers/acquisitions via the purchase method, which entails goodwill. Thus, after late 2000 when the pooling method ends, the players will be unable to make inflated acquisitions without showing the negative impact on their balance sheets if they report on a net earnings basis.

After signaling that companies won't be able to use pooling and thereby avoid goodwill in the future, the FASB is in the process of establishing a new policy that will dictate that companies must spread their goodwill write-offs on a straight line basis over 20 years rather than indulge in the somewhat common practice of accelerating the write-off so that it impacts results for the first few years only. However, if established companies trend toward cash basis reporting, they can mitigate, or eliminate the impact of the FASB rule governing terms of write-offs.

IF YOU CAN'T BEAT 'EM ...

The rules of the playing field may evolve, and more established companies may choose to state their results on a cash basis, which excludes various costs. This method makes the startups look especially good because the results exclude various costs. It's the old "if you can't beat 'em, join 'em" routine. However, there needs to be a single definition of cash basis - there are now several, apparently.

Cash versus net earnings makes a huge difference for the upstarts playing by the cash flow rules. For example, First Call estimated Mindspring's fiscal 1999 results were a loss of $0.93 per share on a net earnings basis but a profit of $0.94 per share on a cash EPS basis.

When using the cash basis reporting, companies sidestep being judged on the effects of the forthcoming requirement for a longer period of goodwill write-off. Both old-line and upstart companies will benefit, but the upstarts will benefit more because the method helps legitimize their life style. And the advantage still goes to the upstarts because the traditional firms will continue to be plagued by lack of "funny money" from high market caps. For full details, see www.fasb.org.