Post of the Day
May 8, 2000

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Cisco Systems

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Subject:  Tearing Apart the Donlan Barron's Article
Author:  gmatsumoto

What's most alarming about the Donlan's piece in Barron's this week is not what it means for Cisco's future, the implications for Cisco's shareholders or any broader implications regarding the technology market�since in this investor's view, the article adds nothing constructive to any of these things. What's really alarming is how a very poor piece of journalism gets such a prominent cover story position in what many consider one of the elite financial publications. This piece says much more about what Barron's is doing to try to get reader's attention and as such has substantially reduced the creditability of Barron's for this investor; and when the dust settles, I suspect for millions of other serious institutional and individual investors around the world.

My problem with the piece is very simple. No insight regarding the company's operations or ways of doing business to support the conclusions, the use of eye catching detailed historical facts to attempt to color a weak overall analysis of the company's prospects, superficial P/E calculations where he jumps to conclusions to support his overall hypothesis but where such conclusions are not supported by any facts, analysis or meaningful research. As a long-term investor, I am always looking for good research and analysis, either in support of or counter to my investment philosophies and assumptions. I believe that to be a successful investor, one needs to constantly reexamine the reasons why you own a stock, how the market characteristics are changing and how a company is evolving. Although Donlan considers Cisco Systems to be a "house of cards," my view is that Donlan's journalistic ability is the real house of cards. It's a shame that hours and hours of analysis and discussion will result out of such a shabby piece. Now for some of my specific criticisms.

House of Cards. Donlan quickly jumps to his conclusion that Cisco is a "modern house of cards" based on its acquisitive ways. A stronger analyst might take a couple of moments to consider the market in which Cisco competes. Most networking and telecommunication investors know that this world has been evolving very very fast over the past decade. Cisco recognized early on that the convergence of the networking and telecommunications world was a natural evolution brought about by the movement to IP technologies, the need for efficient utilization of bandwidth, and above all, the growth of the internet. With the drastic changes resulting from these multiple forces, corporations, telecom carriers and the communication needs of the home market are changing very fast. Cisco has taken its roots in networking, added its extensive investment in R&D, and has perfected the art of M&A to acquire new technologies and first class engineers to allow it to stay at the forefront of what their customers demand from communication equipment vendors as this environment evolves.

"Cisco stock has all the trading power that a boy in the 1950's would have had if he could print his own Mickey Mantle rookie cards. Beyond routers, switches, software and services, that's what Cisco does for a living: It prints its own trading cards."

You know at first I thought this was at least a cute literary comparison, but on second thought, the insinuation of this statement is so ludicrous that its not even that. Unlike a "boy in the 1950's�" printing Mickey Mantle rookie cards, Cisco's stock represents ownership in the discounted future projected cash flows of the company. If the company issues additional shares to acquire a company (and the incremental discounted future projected cash flows associated with that acquired company), then the real question is whether these acquisitions can indeed generate these anticipated incremental cash flows�or even do better�.after being folded into the Cisco world. Mr. Donlan, your article tells investors nothing to indicate that Cisco has NOT been able to realize these incremental cash flows from acquisitions. In fact, Cisco's financial performance over the 40 quarters that they have been a public company, under some of the most intense investor scrutiny possible, leads most investors to conclude exactly the opposite.

"One target company that had $10 million in revenues at the time of acquisition provided Cisco with technology that now generates more than $1 billion of revenues. But not all acquisitions are so successful, and for most of them, it's hard for an outsider to gauge success."

What information can Donlan provide to inform us about the less than successful Cisco acquisitions? It sure would have been interesting if he could have discussed one or more acquisitions that were NOT successful. Perhaps he might have taken the trouble to talk to one or more of Cisco's customers to see if Cisco has not been able to deliver technology and products that they require in the rapidly changing marketplace, that their technology is obsolete overpriced or not always delivered on time. In short, where's the beef here, Mr. Donlan?

Cerent. "Even with Cisco's market cap of 39 times revenues, Cerent ought to have $176 million of revenues to join the Cisco family on a basis that's equitable to Cisco's existing shareholder's."

Now Mr. Donlan, exactly how much revenue can we attribute to the Cerent acquisition for the current year or can we anticipate for FY 2001? It could be $20 million of revenue in each of the next 5 years and then Mr. Donlan would have a very good point. Or it could be $150 million in the current year and $275 million in FY 2001 and then Mr. Donlan's conclusions would be completely off base. My hypothesis is that when you combine cutting edge optical technology with the global reach of Cisco's sales force and growing customer base plus bundle with other technologies, that this type of package might be exactly what Cisco's customers are looking for and in fact demanding of their equipment vendors. In my view, Mr. Donlan's analysis is as superficial and as incomplete (and therefore as wrong) as concluding that Federal Reserve Chairman Alan Greenspan has Alzheimer's disease based on an observation that the average person on the street is unable to understand Greenspan's discussions about the wealth effect, supply side economics, or the process governing the Fed's decision to hike the discount rate by 50 bp instead of 25 bp.

Financing packages. "In order to close their deals, they are giving generous financing packages to their customers � sometimes to customers whose ability to pay ought to be more closely explored."

Perhaps its apparent by now that Mr. Donlan is throwing everything he can to see if anything can stick. "In order to close their deals�", Mr. Donlan, where's any evidence at all that Cisco's sales growth would not be what its is without financing support? Are we talking about 90% of their sales or 2% that are dependent upon financing support? If its 90%, then maybe there is something here that investors need to understand better; if its 2% and growing slowly, then your wasting our time on this issue. "Generous�"? Well, if you make this type of statement, you must have done some analysis, right? Have you talked to the borrowers of this financing? Have you talked with other vendors that lost business due to Cisco's "generous" financing terms? Have you consulted with some commercials banks that have told you that Cisco's financing practices are leading to big trouble in the future? Boy, this is getting monotonous Mr. Donlan, but my question to you continues to be: where's the beef?

The competition. At least Mr. Donlan was able to name a couple of Cisco's key competitors, Nortel and Lucent! So he must have done at least a little homework for this piece. But, there you go again Mr. Donlan, trying your scare tactics in lieu of anything resembling in-depth analysis:

"If Cisco sold at multiples of its competitors, investors would be shocked. If the market valued $1 of Cisco's earnings the way it values $1 of Nortel's earnings, at a multiple of 100, Cisco stock would be selling for $35 a share. If it could command Lucent's multiple of 46, Cisco's share price would be around $16."

Other than giving Mr. Donlan credit for having a calculator that seems to be able to crunch some numbers, this type of analysis, without even attempting to go another step deeper, is amazing for a cover article published in a publication of the reputation of Barron's. Perhaps Mr. Donlan could have gone through the trouble to investigate the differences in the product lineup and major sources of revenues of these companies. Which companies, Mr. Donlan, are struggling to transition from revenue dependence from legacy telecommunication equipment such as circuit switches? Which of these companies have integrated multiple acquisitions better than the others (examples: Nortel purchase of Bay Networks and Lucent's purchase of Ascend Communications)? How about a simple one, Mr. Donlan�.which company has been able to demonstrate the highest and most consistent top and bottom line growth over the last 40 quarters? Doesn't this information relate to how investors value these companies?

Hopefully the best thing that will come out of Mr. Donlan's Barron's article will be a heightened investor awareness of the fallacy of blindly depending upon cover articles in the major financial press to guide investment decisions. In my view, the capability of investors, both institutional and individual, to differentiate between innovative research, insight and analysis versus superficial analysis and lazy journalism cloaked in the respectability of a major financial publication, is significantly underestimated. The real question is when the financial press will stop underestimating the intelligence and wisdom of investors?

Whether you are a believer in Cisco Systems as a good long term investment and have a growing long position or suspect that they are severely overvalued and have a major short position outstanding, I believe that investors are starting to demand higher quality and more informative financial journalism to help guide investment decisions�and not allow financial publications pass superficial research and poor financial journalism off as anything other than what it really is:

Financial Journalism, National Enquirer-style.

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