On Monday, for the second time ever, Cisco (Nasdaq: CSCO) warned of lower-than-expected earnings -- but that wasn't the kick in the head. A $2.5 billion inventory charge is why investors need a helmet.

Last week, The Motley Fool was handing out helmets when Mike Trigg hit the nail on the head with his story, Indecent Inventory Exposure: "Too much inventory, however, can be risky, particularly in high-tech industries, where rapid technological change breeds product obsolescence. That could force Cisco to take a charge for its excess inventory or slash prices. In either case, the company's gross margins will most likely begin to fall." Mike, you da man.

So what happened?
Management was caught with its hands in the cookie jar, and afterwards it expressed surprise once again over the severity and abruptness of the slowdown that led to the $2.5 billion inventory charge.

Throughout calendar 2000, Cisco was asking its suppliers to pick up the pace with components. It was constantly behind the demand of its customers and wanted to beef up its inventories to meet expected demand. Then, just as Cisco was beginning to get ahead of the product cycle and build up inventory, the demand slowed. In blackjack parlance, Cisco doubled down on an eleven and drew a two. What management should have been paying more attention to was that the dealer (the market in this case) was showing a face card and therefore the risk of doubling down was not worth the payoff.

What now?
Anybody need a few printed circuit boards? Seventy percent of Cisco's inventory charge is related to its service provider business and the remaining 30% to enterprise and commercial businesses. Eighty percent of the $2.5 billion -- that is, $2.0 billion -- is raw materials and the remaining 20% is work-in-process inventory. This is where Mike's insight hits home. The rapid change of networking products leaves Cisco holding a bag full of worthless inventory. Two and a half billion down the tubes, just like that. Management does not expect to reap any revenue from these components. Much of it is custom Cisco products, thereby preventing any after-market selling -- not to mention that management doesn't want its technology in the hands of the competition. The obsolete inventory will be physically segregated and secured in a sarcophagus like nuclear waste from Chernobyl.

High-tech products like the networking routers have a short shelf life and when demand forecasts are inaccurate, the pain is amplified. It's not like building up oil reserves. Eventually the oil will sell. Custom-made circuit boards won't. They become obsolete -- forever.

Cisco's relevance revisited
One analyst asked to be reminded of why networking gear is so important. No doubt, he was looking for some rationalization behind Cisco's unyielding 30%-to-50% long-term growth forecast. In Cisco's quarterly conference calls, President and CEO John Chambers never fails to give his pep talk on the growth drivers behind networking. Chambers once again did not disappoint. He gladly reminded callers of the productivity increases made possible by the Internet, which is powered by networking gear -- Cisco's bread and butter.

He explained that the first wave of networking-driven productivity increases was powered by e-commerce-enabled customer and employee support applications. According to Chambers, the lowest productivity increase Cisco measured from these applications was 15%. Self-guided Q&A sections on company websites and the ability to check bank account balances are examples of this first wave.

The next wave involves virtual manufacturing, virtual closing (of a corporation's accounting books), and e-learning. Regarding the "virtual close," Mr. Chambers was talking about Cisco's ability to close its books in a matter of hours rather than days or weeks. This enables a company to closely monitor its P&L, allowing it to react more quickly to changes in the marketplace. A nimbler company is a more efficient company, in theory. Ironically, Cisco was not able to react fast enough to the current economic slowdown. One can only wonder what a surprise this slowdown would have been to Cisco had it not been able to see the daily impact of sales and expenses.

Ten years ago, a slowdown from 55% annual revenue growth one quarter to negative 5% the next quarter would have paralyzed a company, not to mention severely damaged the credibility of management. Because of improved real-time accounting data, managements and investors are getting a better look at current trends. Companies may still be reactive, but triage comes much earlier these days.

Besides Cisco, Boeing (NYSE: BA) is an example of what virtual manufacturing can do. The 777 was built by engineers using sophisticated computer-aided design software connected over a network -- with input from customers like United Airlines (NYSE: UAL) and suppliers like General Electric (NYSE: GE) -- in a collaborative effort that would have been prohibitively expensive without a computer network. For the first time, Boeing designed, electronically pre-assembled, and tested an airplane before a prototype was built. This increased accuracy, improved quality, and saved millions -- maybe even billions -- of dollars.

E-learning, the third component of the next wave, is everything from online universities like University of Phoenix Online (Nasdaq: UOPX) to a human resources representative delivering information about a new 401(k) plan to employees via a digital video over an intranet.

Lessons learned
Mr. Chambers offered up two lessons learned from Cisco's current debacle:

  1. A 100-year flood can come. As soon as you think it will not happen in your lifetime, it does. It's Murphy's Law!
  2. Too much focus on market share over profitability leads to loose inventory management.

The solution to both of these problems is tighter inventory management, and Chambers hinted that Cisco would pursue this even if it cost market share. Going forward, the company plans to focus more on profitability than market share. Along those lines, the 8,500 job cuts were made by assessing profitability across departments, rather than as a dictate by management for across-the-board cuts.  

What about vendor financing?
Cisco reaffirmed its belief that it has been conservative with vendor financing but is tightening up even more by doing less financing and asking for higher margins when it does make equipment or monetary loans. CFO Larry Carter was also quick to point out that Cisco does not recognize revenue on structured financing until it gets paid. Numbers will be available on May 8th.

Cisco may have survived yesterday unscathed -- shares were down only 3% in regular trading -- but the future is still rocky. That said, it is still a Rule Maker of unparalleled quality with strong management, expanding possibilities, numerous competitive advantages, and a cash hoard of $13 billion. Its relevance and relative market position is greater than ever. The only difference is that now investors are only willing to pay $130 billion for what used to be worth $600 billion.

Todd Lebor can't hit a Titleist Pro V1 any straighter than a range ball. He owns a few shares of Cisco but not enough to retire on. Todd's other holdings can be found in his personal profile along with the Fool's complete disclosure policy.