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Debt Valley Days


Silicon Valley is famous for its gizmo gurus, the men and women who dream up disruptive technologies and killer apps. For most of the 1990s, they were a big reason why shares of tech companies seemed to defy gravity. But lately, tech companies are relying increasingly not on electrical or software engineers to drive their stock prices but on financial engineers.

They have little choice. Revenue growth has fallen to around 10% a year, half the rates of the go-go '90s. That slowdown has turned tech shares into laggards. The info tech stocks in the Standard & Poor's (MHP) 500-stock index have gained just 5% since December, 2003, vs. 15% for the whole index.

And so, for better or worse, tech companies are putting aside their long-standing aversion to debt in order to execute share buybacks, issue dividends, and make acquisitions to juice their share prices. Cisco Systems Inc. (CSCO), the big communications gear vendor, in February obtained a credit rating for the first time and sold bonds to raise $6.5 billion in what is thought to be the biggest-ever tech debt offering. The proceeds were more than enough to cover Cisco's $5.1 billion net cash outlay for one of its biggest acquisitions, the February purchase of Scientific-Atlanta Inc., maker of television set-top boxes. Oracle Corp. (ORCL) sold $5.75 billion worth of bonds in January to fund its takeover of rival enterprise software vendor Siebel Systems Inc. (SEBL). Together, the Cisco and Oracle bond sales increased the amount of outstanding investment-grade tech debt by 25%, according to JPMorgan Securities. "Oracle and Cisco are beginning to break new ground," says Laura Conigliaro, stock analyst and leader of the Technology Strategy Research Team at Goldman, Sachs & Co. "In order to create shareholder value, they have to do things that are different."

Other tech players are thinking about following the industry leaders. Symantec Corp. (SYMC) just hired a new debt-savvy CFO from American Airlines Inc. (AMR) for that very purpose. "Software companies need to think differently about how they use their balance sheets," says Symantec CEO John W. Thompson. "In a consolidating industry, maybe you want to have more debt so you can have more cash and do more things." Eric Ball, Oracle's treasurer, says finance executives are comparing notes and taking calls from investment bankers urging them to tap the hot corporate credit markets. "People disagree on what the appropriate level of debt is, but arguably it is not zero," says Ball.

The trend underscores how extraordinarily easy it is to borrow right now. Investors, especially from Asia and Europe, crave yield any way they can get it. Cisco's deal was way oversubscribed, attracting offers of $20 billion, boasted CEO John T. Chambers at an investment conference on Feb. 28. Oracle, too, turned away money, executives say. Investors are so desperate, in fact, that they're accepting the thinnest yield spreads above Treasury bonds in four decades, says Dan Fuss, vice-chairman and bond fund manager at Loomis-Sayles & Co.

What's more, the change continues Corporate America's long-running movement toward more leverage -- and lower credit ratings. The number of U.S. nonfinancial companies with AAA ratings is down to 6 from 32 in 1983, according to S&P, and many of the downgrades were matters of choice. Some AA companies are opting to move down, too. In October, DuPont (DD) traded its AA rating for an A to undertake a $5 billion stock buyback.

TESTING THE WATERS

So far, the big tech borrowing has been prudent. Cisco's bonds were rated A+ by S&P, which noted that its debt is less than its earnings before interest, taxes, depreciation, and amortization during the past 12 months. Oracle's debt, rated A-, is still only 10% of the company's stock market value of $66 billion. Its cash flow is 34 times its interest expense, or three times better than the average coverage ratio for S&P 500 companies, according to Merrill Lynch & Co. (MER) estimates. Still, some smaller companies are being much more aggressive. Affiliated Computer Services Inc. (ACS), a Dallas-based data processor, took out $5 billion in loans in January and trashed its investment-grade rating to fund a buyback of 45% of its stock after a leveraged buyout plan fell through.

In the past, it was the rare tech executive who dared to think about carrying debt, and for good reason. Product cycles came and went too quickly, and upstarts appeared out of nowhere with radical innovations to take market share. Stalwarts IBM (IBM), Hewlett-Packard (HPQ), and Motorola (MOT) occasionally sold debt over the years, but they were exceptions. With tech it's hard to predict who the leaders will be in five years, much less 10, when nearly half of Cisco's and Oracle's bonds mature, says Dave Novosel, senior investment analyst at Gimme Credit LLC, an independent research service. Then again, Cisco and Oracle are so firmly established that rapid change isn't such a threat, says Novosel. "They are very large, and [size] brings more stability," he says.

But for the borrowing companies themselves, there is a downside: The stability that bond investors like alienates stock investors who once bid up their shares on rapid growth. Last year, for example, shareholders pressured slow-growing Siebel Systems to do something dramatic to boost its share price. It finally complied, selling out to Oracle in a deal funded by Oracle's bond sale. (Before the Siebel deal closed on Jan. 31, Oracle had spent a large portion of the cash on its balance sheet buying other companies, including rival PeopleSoft Inc.)

STOCK SUPPORT

Ball, Oracle's treasurer, says that as the corporate software industry matures and gets more revenues from recurring fees under service contracts, more companies will likely borrow. They'll use the money to buy competitors or bolster their stocks to avoid being bought.

Cisco is making its own adjustments. Its shares are around $21, just like they were four years ago, when CEO Chambers was talking about growing 30% a year. Now his stated goal is 10% to 15%, and Cisco is using its balance sheet to try to create value. It issued bonds to pay for Scientific-Atlanta after spending one-fourth of its cash pile on $31 billion of share buybacks. Most of Cisco's remaining cash is in Europe and would be taxed if brought back into the U.S. to pay for the takeover or additional buybacks, Chambers told investors at a Goldman Sachs conference on Feb. 28. (Cisco officials declined to comment for this story.) Chambers said that given the tax on repatriating cash, the cheapness of Cisco stock, and the attractive interest rates available in the bond market, it makes sense for Cisco to use leverage. It has said acquiring Scientific-Atlanta will increase earnings per share, albeit "slightly."

During the boom, Chambers could boost profits by reinvesting cash in the business and by issuing the company's hot stock for acquisitions. Cisco shares were trading at twice current levels. Now corporate credit is all the rage, and Chambers is issuing debt. It only makes sense to change with the markets. And issuing debt brings some balance to Cisco's stock-based capital structure. But raising money this way isn't quite the same. Debt, after all, must be repaid.

By David Henry, with Sarah Lacy in San Mateo, Calif.


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