Broadcom Corp. has been gobbling up small start-up companies for the past two years to help fuel its sizzling growth. But the way the maker of communications chips is accounting for some aspects of certain transactions is raising concern among some analysts, investors and accountants.
The questions surround Broadcom's accounting for warrants -- or rights to buy stock -- issued to customers of companies that it acquires as an incentive to buy products.
The transactions are complex. But the thrust of the criticism is that Broadcom effectively is providing a discount to these customers that isn't clearly reflected in its financial statements. The discounts are the latest signal of the hypercompetitiveness of the technology sector, especially commodity areas like chips.
Among critics' questions: How sustainable is Broadcom's sales growth without these discounts?
Broadcom maintains that both the tactic and its accounting are correct, and that the amount of sales in question is insignificant.
Here is how it works, in summary: When Broadcom begins to negotiate with a privately held target, it sometimes urges the company to strike deals with its customers that offer warrants in exchange for sales commitments over several years. After Broadcom completes the acquisition, those warrants convert into Broadcom warrants; the customer now gets rights to buy Broadcom stock if it buys a set amount of products from Broadcom. The warrants cost the customers almost nothing and vest over the duration of the sales agreement as customers make purchases; as the warrants vest, they can be exercised and exchanged for the shares.
On Broadcom's books, most of the value of the warrants is wrapped into the "goodwill" that Broadcom puts on its balance sheet as an asset after an acquisition, rather than as a reduction to sales when they occur. Goodwill -- which represents the amount of a deal price over the actual value of acquired assets -- historically has been written off over time by companies and often is ignored by investors and financial analysts because it is considered extraneous to operating results. So the issue, some critics say, is that Broadcom doesn't specifically record a warrant-related expense when a warrant-related sale is posted.
"There's reason to question the legitimacy of that revenue and net income," says Howard Schilit, a former accounting professor and the president of the Center for Financial Research and Analysis in Rockville, Md., speaking generally about warrants being used but not reflected as an expense associated with sales. "In all cases, the warrants should be discounted from revenue."
But Broadcom's chief financial officer, Bill Ruehle, responds: "I don't think there is anything to be concerned about." He adds that the company worked extensively with its accountants on how to treat the contracts and the acquisitions. The company sometimes encourages the use of warrant-related sales agreements at target companies, and Mr. Ruehle says it makes sense for Broadcom to get these commitments so that it can be sure the acquired company can meet its financial goals. "Last time I checked, aggressive marketing practices are okay."
Broadcom says deals that included warrant arrangements in the past year include the acquisitions of VisionTech Ltd. and Altima Communications Inc. Customers who have signed such warrant agreements include networking-equipment maker 3Com Corp. and set-top box maker Pace Micro Technology PLC.
Shares of Broadcom have fallen about 25% since the beginning of the year, compared with a 7% decline for the Nasdaq Composite Index. Shares of chip makers have been pummeled as a slowdown in demand crimped sales. As of 4 p.m. in Nasdaq Stock Market trading, Broadcom shares were off $6.44 to $63.
Some analysts say the existence of the warrants could potentially add hundreds of millions in sales for Broadcom; Broadcom's revenue last year was $1.1 billion. Broadcom says it doesn't think the contracts, or the way it treats them, inflate its revenue or its gross profit margin, calling revenue related to such agreements "insignificant."
But analyst Ashok Kumar of US Bancorp Piper Jaffray estimates it is inflating the sales-growth rate at the chip maker by as much as 50%. "Are they buying revenue? That is the question," adds portfolio manager John Spytek of BancOne Investment Advisors, which owns Broadcom shares. "If [revenue related to the warrants] is a significant portion of sales, I'd hope they'd disclose it." Broadcom says the amount is too small to disclose.
While there aren't suggestions that the transactions or the accounting methods used by Broadcom are illegal, analysts and accounting experts say they are aggressive. "Clearly what they are doing does not represent the intent" of the Securities and Exchange Commission's rules, says Tracy Lefteroff, head of the private-equity and venture-capital practice at accounting giant PricewaterhouseCoopers. "But the areas are vague -- there can be a divergence of opinion."
Jim Kroeker, a staff member at the Financial Accounting Standards Board, a rule-making body for the accounting industry, says that, in general, not deducting from revenue the cost or value of warrants as they vest would be "troubling."
SEC officials declined to comment on Broadcom's use of warrants. Last year, following discussions with the agency, CoSine Communications Inc., which used warrants granted to customers without reflecting that incentive in reported revenue, amended its financial statements to adjust its revenue downward prior to its initial public offering.
One apparent difference between Broadcom and CoSine is that the warrant-issuing companies acquired by Broadcom haven't been publicly traded. Broadcom, based in Irvine, Calif., notes that it doesn't use warrants as incentives for its own customers, only those acquired through deals of these nonpublicly held companies. Broadcom says it values the warrant-related contracts at the time a deal closes, assigning a value to the warrants at something higher than the nominal face value and something less than Broadcom's stock price at the time. When the value of the warrants increases as they convert to Broadcom stock, that becomes part of goodwill and is depreciated over time, Mr. Ruehle says.
When Broadcom bought Altima in September, it paid more than $500 million in stock for the closely held maker of chips used in networking gear. In a footnote to its 10Q filing, Broadcom noted that it also set aside 2.89 million shares -- worth more than $689 million at the time the transaction closed -- for warrants on Altima shares that had been issued to customers who agreed to buy a certain amount of Altima products. Altima had issued 41 million warrants in July at an exercise price of $0.001, according to SEC filings. Broadcom's agreement to buy Altima was announced on July 31. The 2.89 million shares exceeded the 2.5 million shares Broadcom paid to buy the company. Broadcom had about 220 million shares outstanding as of Dec. 31.
3Com is one such Altima customer. In its SEC filing for the quarter ended in December, 3Com said it agreed to buy $360 million worth of networking products in the next three years from an unspecified company that was bought by Broadcom. A 3Com spokesman confirms the company was Altima. As it buys the networking products, 3Com will receive warrants to buy 992,000 shares of Broadcom, valued at about $244 million, according to the filing.
In its purchase last month of Israeli-based VisionTech Ltd., which makes chips used in personal video recorders, Broadcom said in a news release that it would issue about 7.96 million shares, which Mr. Ruehle says includes more than five million shares tied to warrants given to VisionTech's customers. One of VisionTech's customers, Pace Micro Technology, a set-top-box maker based in the United Kingdom, said in a news release issued in early January that it received 277,154 shares of Broadcom stock that vest over the next two years as it meets certain purchase requirements and obligations for new chip development. It didn't disclose how much product it agreed to buy.
For rivals, it can be difficult to compete for business against a company that is in talks to be bought by Broadcom, because customers buying with warrants increase their gross profit margin. How so? A customer who gets warrants worth, say, $40 to buy $100 of products records the cost of goods at $60, not $100. If the customer is selling the products for $120, then its gross margin is 50%, compared with 17% if it didn't get the warrants.
Piper Jaffray's Mr. Kumar estimates that 3Com effectively receives a 69% discount on the price of the product it buys from Broadcom. Also, 3Com says in its filing that there are "significant disincentives" for not meeting the purchase requirements. According to Broadcom, if certain companies don't buy the amount of product they are committed to, or buy from another supplier, there is a cash penalty.