Fool.com: The Scant Problems of Cisco's Earnings[Fool on the Hill] May 12, 2000

FOOL ON THE HILL
An Investment Opinion

The Scant Problems of Cisco's Earnings

By Bill Mann (TMF Otter)
May 12, 2000

Cisco Systems (Nasdaq: CSCO) shareholders were thrown into an absolute tizzy this past weekend when Barron's ran a front page feature describing the acquisitive nature of Cisco's growth, the tremendous premium shareholders are paying for its revenue stream, and other threats to their investment dollars. In fact, the Barron's writer, Thomas Donlan, went so far as to tightly link the rise in stock price, the acquisitions, and its revenues, and suggested that if any one of them should fall, then the rest of Cisco's value premium is likely to collapse with it.

Umm, stop the presses. Cisco is paying for companies with highly valued stock? While I like cash payments best, this doesn't sound so bad to me.

In reading through Donlan's piece I got the sinking suspicion that he was trying to fulfill his journalistic mission by creating a really, really strong and enticing argument against Cisco. I am cognizant of the fact that Barron's needs to create eye-grabbing content using universally recognizable symbols to sell papers, so there was certainly some self interest in selecting the topic. But I also think that Barron's and its sister publication, the Wall Street Journal, both owned by Dow Jones & Co. (NYSE: DJ), have enough historical integrity that the Discussion Board accusations that they had a hidden agenda or were tied to the evil forces that sell short good companies are entirely misplaced. In the end, I think Donlan overreached in his argument, and in so doing negated a few really significant concerns, ones that I share.

In Japan there is a dish called fugu, which consists of raw pieces of puffer fish. The problem is that other parts of the same fish, the liver, the eyes, contain substance that is fatally toxic to humans even in small doses. So part of the rush of eating fugu is wondering whether you're going to die from the experience. The Japanese have a saying: "The only man crazier than the one who eats fugu is the one who does not eat fugu."

Investing in Cisco reminds me of the same principle -- people who invest in Cisco are exceeded in their daftness only by people who do not invest in Cisco (though it could be the other way around). A brief look at Phil Weiss' Rule Maker earnings report from Cisco will bear this out. Sales growth of 55% year-over-year, net margins of 20.9%, no debt, $4 billion in cash, all in a market segment sporting spectacular growth.

So what's to worry? This is where Donlan's delivery would have been much more effective with a subtler approach, because, in fact, there are clouds in the Cisco investors' skies. For one, just what about this valuation issue? Cisco has a $420 billion market cap and trailing twelve-month earnings of about $3 billion with a P/E of about 140. P/E ratios in the hundreds are not that uncommon. A triple digit P/E ratio for a company that already has $3 billion in earnings is unheard of, and makes some earnings growth assumptions that will be very difficult for the company to meet. Not impossible, mind you, just really, really difficult. For an investor who is looking to buy right now, it is also highly relevant to understand that this pricing means that all of the beautiful prose about where the market is going has already been priced into Cisco.

That concerns me. I look at my share holdings and think that Cisco at this price is a sizable risk, so in doing my risk-adjusted analysis I demand a return of at least 18% per year. That means that in 10 years Cisco must be worth $2.198 trillion dollars. This is a distinct possibility. What is much more difficult to discern is the profits the company would need to generate to a) support that valuation and b) decrease the P/E to a level more appropriate to a slower growing company.

Let's just say Cisco drops to a 40 P/E, which is still quite high. This means that the company would have to have a net profit of $54 billion ten years out to support that goal of 18% annual share appreciation. Currently the companies with the highest level of annual profits are Citigroup (NYSE: C) at $9.9 billion and NTT (NYSE: NTT) at $9 billion. That's aggressive.

Because the stock price has been rising at a faster percentage than profit growth, at some point the profits must grow faster than the stock price. Even if the company sales do grow at a ferocious pace (40% plus), to swipe a phrase from one of my Favorite Fools, FatOtt, the stock price may still grow like a bond to allow the business to catch up. It HAS to. Stock prices are built upon business fundamentals. Grow ahead of earnings, great, but at some point earnings have to back up those assumptions already made.

But this is an argument of risk/reward. Some people are comfortable here. I'm sticking with Cisco, but I'm a little queasy from the heights.

The second concern, the one Donlan should have driven into the ground, was the one of the accounting methods used by Cisco for its acquisitions. This is the area that gives me the most trouble with this stock, and here's why: It seems so bloody unnecessary. Cisco has spectacular earnings growth, why use pooling to account for purchases? It's not like the company's financials would fall to pieces if we could see the true cost of capital for these acquisitions. The fact remains that it is highly difficult to do so. Donlan screwed up here by focusing on the price paid, since there really should be no question at this point about John Chambers' ability to find great additions to the Cisco service offerings from a business standpoint. From an accounting standpoint, though, Cisco misses the mark. Donlan treats this as an income statement issue. To a much larger degree, it's a balance sheet issue.

Cisco is buying intellectual capital when it purchases other companies. By not using purchase accounting, Cisco makes it impossible for investors to determine how much cash flow has been derived from each purchase of intellectual property. And because of this, it becomes awfully tough to make a systematic prognostication of future cash flows. But because so little of the purchase price of Cisco's acquirees is assets and so much is intellectual property, by using the pooling method Cisco can accelerate depreciation and keep these assets off its balance sheet.

It is mystifying to me why Cisco would bother to obfuscate this so much. The company is growing like gangbusters. It just produced earnings that would reduce most analysts to tears. Why does it need to hide the true cost of capital for its acquired cash flows?

In the end, I guess this isn't as exciting as calling Cisco a "house of cards," invective that only manages to blur some solid points. I also worry about the severe options overhang (1.19 billion options at an average strike of $11.26 as of July 1999), the dilution of earnings (shares increased by 12% year over year), the company's growing list of competitors, and the rising expense of acquisitions.

These types of issues are real. They exist and Cisco shareholders should be concerned about them and mindful of them. Knowledge of the risks is the best way to improve your potential for gains.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards