Last week Cisco Systems (Nasdaq: CSCO) released its earnings for the fourth quarter. On the surface, it was yet another solid quarter paced by dynamic growth in revenues and earnings. I've owned shares of Cisco since the end of 1996 and haven't had many qualms with Cisco's earnings. While both its gross margin and net margin have fallen slightly over time, I understood why and didn't have any real concerns.
This time things are a little different. The sky is not falling, but this is the first time in at least the last 12 quarters that Cisco's Flow Ratio has increased on a year-over-year basis. While this is something I expected, the change was bigger than anticipated. I used the financial statements found on Cisco's website to calculate its Flow Ratio for the year-ago period and found that it was 0.88. It's now 1.07. This is also the highest it's been on an absolute basis since the quarter ended January 1999.
There are two principal causes for the increase: growth in accounts receivable and growth in inventory. These events are viewed negatively by our Rule Maker metrics, as we don't like to see companies give out too many interest-free loans to customers, nor do we like to see them tie up too much money in inventory that's just sitting on the shelf.
If either situation gets out of hand, a company may have increased borrowing costs. When a company's accounts receivable and inventory increase, it has less cash on-hand to run the business. For many companies, this means borrowing money to fund current operating needs, which leads to an increase in interest expense and decreased earnings. In the case of cash-rich companies like Cisco, the result is reduced investment income rather than increased borrowing costs.
Growth in accounts receivable
There are two tools we can use to monitor how well a company is managing receivables. The simplest is comparing growth in receivables to growth in revenues. In an ideal world, revenues grow as fast or faster than receivables. If not, the company may be pushing product into the sales channel and recognizing the revenues too quickly. That means at some point the company will have to face reality and suffer as a result. Two companies that have had this problem to different degrees are Sunbeam Corp. (NYSE: SOC) and Lucent Technologies (NYSE: LU).
During fiscal 2000, Cisco's revenues grew by an extremely impressive 56%, but accounts receivable grew 84%. This is not what we want to see.
We can also take a look at how quickly Cisco is collecting receivables. To do this, we calculate days sales outstanding (DSO) [Accounts receivable / (Sales / 90)]. During the fourth quarter of 1999, Cisco collected its receivables in 32 days. This year, it took 36 days to collect. That's a negative trend. Does this mean we should run for the hills? Absolutely not. Cisco's stated target for DSO is 50 days. John Chambers feels that anything below this number is gravy. Due to the efficiency of its processes and its value engineering efforts, Cisco's DSO is among the lowest I've found.
The bottom line is that this is a trend to keep an eye on. One possible reason for the increase in DSO is that Cisco is granting better payment terms to some of its newer customers, particularly service providers. I wouldn't be surprised to see DSO increase a little more in the future.
Growth in inventory
One of Cisco's current concerns is component shortages, particularly those related to newer product lines (e.g., optical products). One consequence is that Cisco has been increasing its order volumes with suppliers and carrying 5% to 10% more inventory. The expected increases in Cisco's inventory levels are the result of its efforts to provide flexibility, particularly with respect to longer lead times and product availability. By changing the lead times for its products, Cisco is also sharing some of the risk of increased inventory production with its suppliers.
During fiscal 2000, Cisco's inventory increased 87%, significantly faster than sales growth. According to my calculations, Cisco's days sales inventory (DSI) [Inventory / (Cost of Sales / 90)] for the fourth quarter was seven days longer than in Q4 last year. Right now, I'm less troubled by inventory growth than receivables growth. But, if this growth doesn't slow down, it's likely that Cisco will generate less free cash flow and will record a lower Cash King Margin.
For Cisco investors, this can be viewed as just a small chink in the armor; it might even be nothing more than an aberration. But, it's something we should keep a watchful eye on. At present, there are some changes taking place in Cisco's business environment, as it is selling more products to traditional telecom customers. It will be interesting to see if this causes lasting changes in the working-capital dynamics of Cisco, as these dynamics have contributed strongly to its past success.
For an in-depth look at Cisco, check out The Motley Fool Research Report on Cisco.
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