POST OF THE DAY
Cisco
May You Receivables What You Sow

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By sonofed
February 9, 2001

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As I said in a previous post, I sold off the shares I had purchased in the 50s/60s because the lower projected growth rates for Cisco (30% vs. 50%) made the numbers stop working out to my satisfaction. I kept the shares with a lower cost basis because their overall return potential was still significant.

However, I think people are incorrectly reading some short-term conditions at Cisco as symptoms of a larger problem. I want to address those here:

1) The rising receivables are not a sign that the company is stuffing product into channels or into end users and giving generous terms. That would be a problem if it occurred, but it is not the case. In fact, the dramatic rise in receivables was caused by a hockey stick quarter. Cisco shipped a phenomenal amount of gear (>$1B) in the last week of the quarter to try to clear their backlog and hit their revenue numbers. The customer for those orders still have the standard lead times to pay their bills, so the AR number went through the roof. If the AR number stays high next quarter, this will be a cause for concern, but I expect it will correct and the 8-day rise in DSOs will disappear.

2) On inventories, Cisco gave guidance that inventories would continue to rise over the next 1-2 quarters to try to mitigate the impact of supplier problems that were driving product lead times out too far to satisfy customer needs. If I heard it correctly on the con-call, most of the inventory build-up is in raw materials and WIP. It is, for the most part, not finished goods inventory. What that means to me is that the inventory levels they've taken on are to directly satisfy pent up customer demand. If you read the trade rags, Cisco's lead times for certain hot products were becoming a decision factor for some of their customers. The inventory build-up will help mitigate this as Cisco works out their supplier issues.

3) The ROE has declined, which on the surface would be a bad thing. However, much of the ROE decline has to do with significant growth in the asset base, rather than a decline in earnings. Much of the growth in asset base is ephemeral, since it is essentially caused by pricing the value of Cisco's marketable securities to reflect the market value at the time of the report. As the market declines, these securities will lose value and Cisco's ROE will climb.

4) Market share is not the issue it has been made out to be. We've been over this about 100 times on the board, so I won't go into detail, but the overall impact on Cisco's market share from the smaller players is very very small. Yes, for a while Juniper had a more capable product than Cisco. Specifically, they supported OC-192 interfaces and Cisco did not. That product shortfall on Cisco's side has been corrected. The point is that Cisco will almost never have the absolute best product in every market space they play in. The reason is that smaller niche competitors need to have a significantly better product to even get considered by customers. Even taking all of these niche players into account, Cisco is still expanding their market share in just about all their key segments. The best evidence of this is that overall enterprise spending grew at roughly 30% in the same period Cisco grew revenues 55%. Math is math, and you can't grow faster than your market unless you gain share.

The bottom line for me is that Cisco is still valued too richly for me to be confident I can hit the hurdle rate I'm looking for from my investments by adding more money to my Cisco position. However, that has little to do with the fundamental performance of Cisco as a company or its ability to continue to dominate its markets. It has more to do with the fact that the economic slowdown is slowing Cisco's growth from 60%+ to 30%-40% and Cisco's stock is still returning from the stratospheric valuations is attained at it's peak.

People who look at the $.01 earnings miss as evidence that Cisco is in decline are misguided in my opinion. Cisco grew revenues at 55% and earnings at 48% year over year. Can you think of many other companies Cisco's size that did that? If the analysts and Cisco's management were too optimistic about Cisco's potential growth given a slowing economy and set expectations too high, that's unfortunate and disappointing. Hopefully, both management and the analyst community have learned a lesson from this experience and will be more careful in the future. However, it doesn't make sense to ignore the fundamental growth Cisco was able to rack up in Q2 just because they only grew 55% and analysts expected 60%.

Attacking Cisco's fundamentals after what most companies would describe as a stellar quarterly performance just because they didn't meet optimistic projections is a little like saying the New York Giants are a lousy football team because they lost the Super Bowl.

I say look at the real numbers involved here and decide for yourselves whether this earnings miss this quarter was the result of a fundamental shift away from dominance for Cisco, or if it was a case of the company setting unrealistic goals for itself given the current economic conditions. Decide for yourselves whether a DCF analysis for Cisco, using the current growth projections, justifies an investment at today's prices or not. I think it is safe to say that nothing changed fundamentally with the company between 4:30 PM on Tuesday and 9:00 AM Wednesday morning. Even the reduced growth projections were already on the table by Monday. If an investment in Cisco made sense to you on Monday, it should make even more sense to you now that the price has dropped.

Just my thoughts...

Steve