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Hair Ball Haunts Cisco

Last week, newly publicDreamWorksAnimation (NYSE: DWA  ) released Shrek 2. I love the film for two reasons. First, it captivates my daughter. (You haven't lived till you've seen my 2-year-old running through the house yelling: "Mommy! Daddy! See! Shrek!") And second, the comedy of Antonio Banderas' Puss 'N Boots character. Is there a better moment than when the swashbuckling kitty faces down Shrek only to be completely incapacitated by a hair ball?

Yeah, I know the attack of the giant gingerbread man was pretty cool, too. And, yes, Rupert Everett as Prince Charming was also hysterical. Maybe I'm drawn to Puss' on-screen coughing fit because it reminds me so much of what's going on in parts of the tech industry. Witness Cisco Systems' (Nasdaq: CSCO  ) first-quarter 2005 earnings report issued yesterday.

Though year-over-year the networking giant boosted sales by 17.1% to $5.97 billion and net income by 28.5% to $1.4 billion, inventory and margins remain problematic. Let's tackle inventory first. For the current quarter, inventory rose by 38.3% from the same period last year, but it was essentially flat from July. Though, interestingly, it's the first quarter in a while that inventory hasn't spiked sequentially. Why interesting? Because for five straight quarters now inventory has been rising faster than sales year-over-year.

At first the increases were mild, such as in last year's first quarter. Back then, sales rose 5.3% from the year prior, with inventory up only slightly more at 5.7%. That's hardly worrisome. Yet it would get worse at Cisco and across the industry. Through yesterday's earnings report, inventory growth has outpaced sales by an average of 16.1%. This quarter's gap of 21.2% is the second-highest it's been over that period, trailing only the 24.8% gap from last year's second quarter.

Make more, sell less? Maybe in the past, but this quarter it seems more like this: Make about the same, but sell it for a whole lot cheaper. Indeed, gross margin dropped from 68.4% in July to 67.2% as of yesterday's report. It's probably a safe bet that the competition CEO John Chambers lamented in yesterday's conference call is taking its toll.

Well, maybe two competitors in particular: China-based Huawei Technologies and local kid Juniper Networks (Nasdaq: JNPR  ) . By operating in China and making clear its intention to compete on cost, Huawei is likely putting pressure on Cisco to cut prices on its big equipment for telcos and large companies. Juniper, on the other hand, is attacking Cisco's dominance in its core router market and is on pace to grow sales by nearly 30% over 2003, according to Morningstar.

Investors haven't exactly warmed to Cisco's results, cutting the stock by nearly 6% as of this writing. I can't say I blame them, yet investors ought to take heart in the fact that Cisco prints money like the Federal Reserve. Structural free cash flow for the quarter appears to have been nearly $1.3 billion. (That backs out an estimated $300 million for stock options expense, roughly equal to last year's quarterly average.) At that pace, Cisco will grow cash flow by 13% over fiscal 2004, to $5.2 billion.

That's a healthy clip for any firm but like a bag of catnip for a tech tiger like Cisco. It's a good thing, too, because the networking giant may have a few more hair balls left to choke up.

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Fool contributor Tim Beyers has networked his house, but he owns no Cisco products. He doesn't own any of the stocks mentioned in this story, either. To get a peek at what Tim is invested in, check his Fool profile, which you can find here.

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