FOOL ON THE HILL
Cisco in a Time of Paranoia

Cisco reported quarterly earnings of $0.09 per share using GAAP on Wednesday. Investors quickly began to look for points of conflict within the report, a testament to the way investing has changed since Enron collapsed. Bill Mann wanders through the report and throws a few fast balls at Cisco for its rich options program.

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Bill Mann (TMF Otter)
February 8, 2002

[Updated 7:30 p.m., 2/8/02]

Hey, want to watch me make Cisco's (Nasdaq: CSCO) share price drop?

OK, go check the price then come back.

You back? Alright, let's go.

Cisco, Enron.

Go check the price again. See how much it dropped?

That's because every time someone mentions a company in the same sentence as now-defunct Enron, well, people get scared and run away. Everyone, it seems, is afraid of their investments being the "next Enron".

I'm not going to tell you to relax, because you shouldn't. A skeptical mind is one of the more useful tools an investor has. It seems that much of the biggest damage investors have endured are at least in part due to suspension of skepticism writ large.

To wit, the $3.2 trillion that has been excised from telecommunications carriers' collective market caps, or the evaporation of so many Internet commerce companies. (OK, an aside here. Am I the only one who thinks that the term "dot-bomb" ceased being cute or clever about a year or so ago? Here's a concept -- if you want to be clever, well, try to actually think of something clever. "Dot-bomb" ain't it.) Heck, on a relative basis, the losses from the peak for Lucent (NYSE: LU) and Cisco, $220 billion and $376 billion respectively, make Enron shareholder losses of $66 billion look like chump change.

Oops, I used Lucent in a sentence with Enron. Better go check Lucent's stock price.

Why prices were so high in the first place
Cisco, the telecom carriers, Lucent, and the Internet companies fell so dramatically in no small part because investors trusted the projections, unchallenged by most analysts or companies themselves, that the communications revolution was going to be the largest generator of wealth the world has ever seen. Bigger than oil and the Beatles combined. It may turn out to be the case, but some companies made some awfully stupid decisions along the way to essentially take themselves out of the running. There may be no bigger sign of the insanity than the fact that now bankrupt and never healthy competitive carrier Winstar had a credit facility with Lucent for $1 billion for equipment. One billion in equipment on credit for a company that had less earnings than a Coke machine is not my idea of prudent fiscal management, but hey, those were the times.

And now we pay. We're left to hope that Cisco, which has had five consecutive quarters of declining revenues, can figure out how to be profitable. But we're also left to wonder if Cisco, a company that has had the label of aggressive accounter placed on it in the past, is cooking the books. And that's scary for Cisco shareholders. I know. I am one.

But while many investors awaited the results of Cisco's second quarter on Wednesday night with angst and trepidation, I figure I've got a few more weeks to find out what I want to know about the company, when they file their official 10-Q with the SEC. I want to see the cash flow statement, which wasn't included in Cisco's earnings announcement. Sure, they told us about their earnings, magically coming in well ahead of analyst expectations.

I don't particularly give a rip about the income statement, particularly not in the case of Cisco. I certainly don't bother with the company's pro forma numbers. The GAAP earnings of $0.09 cents per share is nice, but does it tell the whole story? I don't think so, and Cisco's management had best get it into their heads that, for the time being at least, aggressive accounting and a cheery disposition do not a great quarter make.

Here are some of my issues with Cisco's report.

  1. First of all, above all things, it does seem like Cisco had a good quarter. A 9% sequential growth rate is not bad, nor is $4.8 billion in sales all that terrible for the type of environment Cisco's sector is mired in. The company took market share from its competitors, and did in fact improve its inventory levels and its days sales outstanding, and inventory, and receivables amounts are down considerably. Though, I do note that the reserves for doubtful accounts went up by 16% and now comprises 22% of total gross accounts receivable. Perhaps this is a sign of the lack of care Cisco was using in granting credit to customers in the late 1990s.

  2. In the conference call, Cisco made big noise about cash being king. Yep, it is, and Cisco's increase of its cash and equivalents hoard to $21 billion by adding $1.9 in retained earnings this quarter alone is quite a feat. But what are they going to do with the cash? Well, buy companies, for one thing. They're also going to buy back $3 billion in stock. The former issue is just part of Cisco's strategy, but the latter ticks me off something fierce. Not that buying down shares isn't a good thing, but a quick look at Cisco's options grants for 2001 shows that, using Black-Scholes (which is an imperfect model, but the best one going), the theoretical cost to earnings was $1.7 billion. When a company uses real cash to buy back shares to offset dilution caused by options, that theoretical expense becomes awfully real. At least half of the money going to share buyback provides minimal benefit to outside shareholders. I'm not opposed to options in any way, but $1.7 billion in a year? Wow.

  3. I'm greatly disturbed by where Cisco achieved some of its cost savings, most particularly its reduction of Research & Development spend by nearly 20% compared to last year. Cisco has acknowledged that it is trying to branch into new markets such as wireless that are less mature than its core businesses. Wouldn't the perfect time to jack up research efforts be when you've got a ton of cash and no one else does? I'd most certainly give up several pennies in "earnings" in order to beat the fire out of the competition when technology spending begins to rebound, even if it does not happen for years. That Cisco seems to feed the ignoramuses' focus on quarterly earnings rather than long-term strategy is deeply troubling.

  4. The benefits from that big bath inventory write off made earnings look great. To their credit (and I can't believe I'm saying this), Cisco's management did not focus on GAAP gross margins rather than pro forma, because sales of some of that previously written down $2 billion of inventory would have really skewed results. Still, that's pretty slick, generating $195 million worth of gross savings from inventory that had been declared "worthless." That makes for gross margins of 100% in theory, with the theory not taking into account that even though that inventory had no assigned book value, it still had cost billions to produce at some time in the past.

  5. Cisco didn't give guidance. Good. I'm happier with companies that do not guide. Of course, Cisco is normally very solicitous with its guidance, so I need to translate for you what "no guidance" actually means in this case. What John Chambers was saying was "We see the future, and the ugly stick got to it first."

  6. Deferred Revenues of $790 million, which is higher than last year's $744 million, in spite of a significantly lower top line. Deferred revenues generally mean that a customer has agreed to pay for something, but will not actually fork over the cash until Cisco has completed installing its equipment. It's not a big deal, but noteworthy.

As an investor, you have to be willing to be skeptical, even adversarial to the companies you own. If the rich stock options program at Cisco tells me anything at all, it is that Cisco does not consider outside shareholders as part of "us." We are "them," the outsiders, and as such we should be prepared to ask those who are "us" the tough questions.

I firmly believe that the best path to avoiding another Enron is by looking at full financial data and saying "does that make sense?" I like Cisco, sort of. I've long been bothered by its reporting, ludicrous stock option grants and Wall Street gamesmanship, but I know of few companies with better economics. But Cisco has been widely accused of using aggressive accounting in the past, and as such must be looked upon with added skepticism. It begs the question: "Would Cisco and its shareholders be better off if the company used more transparent, more conservative accounting?"

An unrelated rant
Finally, a completely unrelated rant. Tonight is the Opening Ceremony for the Winter Olympics in Salt Lake City. I know NBC paid a truckload of money for the broadcast rights, but you would think, you would hope that in this melting pot of a nation, where so many people have deep ties to someplace else, that NBC could broadcast the parade of nations without commercial interruption. I know Latvians who have now waited 60 years to see their nation's flag come in, but in every single Olympic event since their country has regained independence, they got the Budweiser frogs or some such instead. Can we not, just this once, watch this moment in the sun for so many people unimpeded? Put a bug up in the corner just like the network does for the World Cup. Please. I beg you.

Fool on!
Bill Mann, TMFOtter on the Fool discussion boards

Bill Mann was invited to light the Olympic Flame, but had to defer because he could not get time off from work. Bummer. Bill has beneficial interest in Cisco. Please see his profile for a complete list of holdings. The Motley Fool is investors writing for other investors.