Three big things came out of networking giant Cisco's (Nasdaq: CSCO ) fiscal second-quarter results. First, while Cisco delivered bottom-line profits that met investor expectations, it did so on fairly weak sales. Second, even though Cisco bulls seemed to be betting on a serial decline in inventories, it failed to happen, with gear on the shelves coming in at $1.25 billion, up 4%. And third, the company continues to deploy massive shareholder equity to buy back its shares, spending $2.7 billion to retire 140 million shares in the last quarter, for an average cost of $19.28 per share.
Of the three, the inventory buildup is the biggest issue. Last May, Cisco's inventories exploded nearly 20%, up to $1.1 billion. At the time, shareholders were nervous that the company was setting them up for a repeat of 2001, when Cisco wrote down $2.2 billion in inventory as worthless. Inventory buildups are fine, if they happen in conjunction with or in expectation of a pickup in sales. The pickup hasn't happened, and as such, the inventory levels today are even higher than they were last May.
Granted, revenues over that span have risen from $5.6 billion to $6.1 billion, but the pressure from the inventory shows up in Cisco's gross margins: down to 66.7% from 67.3%. Lest anyone thing I'm pooh-poohing this, these are really excellent gross margins, but a decline is a decline, and it's rarely good.
Why does this matter? Well, just like last year (and much more importantly, in 2001), Cisco is joining the chorus in techland by saying that it expects sales to pick up in the second half of 2005. Why is it always the second half? Well, simply, because no one remembers those projections when we get to the second half -- it's like a free call on optimism.
That Cisco continues to buy back stock is good for shareholders: Its diluted share count has dropped more than 6.4% since the same quarter in 2004. But what investors have to be interested in is the net share change, which on a quarter-to-quarter basis (including all in-the-money stock options and any warrants) was 121 million, for an expenditure of $22.31 per net share.
So it seems there's still a disconnect between the amount of gear on hand at Cisco and the level of demand for said products. This, and the uncheerful outlook, are obvious culprits in the company's share torpor. But if sell-through at Cisco's customers doesn't improve, we might have to take a much dimmer view on Cisco's big vendors, namely Jabil (NYSE: JBL ) , Celestica (NYSE: CLS ) , and Solectron (NYSE: SLR ) . At some point, inventory build must reverse itself. The pressure will be released in one of three places: lowered margins, increased demand from customers, or reduced demand at Cisco.
We'll see.
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Bill Mann owns none of the companies mentioned in this article. The Motley Fool is investors writing for investors.
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