POST OF THE DAY
Cisco Systems
The Incredible Shrinking Cisco

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By babyfrog
August 12, 2003

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

So, now that the dust has settled around Cisco's most recent earnings report, I thought I'd take this opportunity to mention a few of the 'highlights' that were glossed over by those who were more interested in making a good impression than revealing the true facts... I'm sorry it took so long to get to this, but my family was in town visiting, and we're in crunch time in planning our wedding, so my Fool time has been dramatically reduced.

My top level analysis is that Cisco shrunk once again, and it shows no sign of growth in the near term future. I will back this claim up with data, provided primarily by Cisco itself.

Unless otherwise specified, the data used in this presentation was sourced from http://newsroom.cisco.com/dlls/fin_080503.html :
(all values in millions)
STATEMENT OF OPERATIONS
Net sales
Q4 2002: 4829
Q4 2003: 4702
Net change: -2.6%
Hmmm... Sales were down, once again, on a year over year basis. The company, once again, showed its ability to sell fewer products one year than it did the previous year, in spite of making acquisitions - acquisitions that should have at least allowed it to add to its revenue numbers. One has to wonder what the decrease in sales would have looked like if Cisco hadn't been out buying its revenues through acquisitions.

R&D Expenses
Q4 2002: 797
Q4 2003: 736
Net Change: -7.7%
One of the few expenses I don't like seeing reduced, Research and Development represents the future of the company's internal growth. Especially for a company with a well saturated market that relies so heavily on corporate capital spending where the 'next generation' product needs to be significantly better than the 'previous generation' product to encourage replacemet, a continued reduction in R&D expenses does not bode well for the long term growth rate of the company.

Sales and Marketing Expenses:
Q4 2002: 1028
Q4 2003: 1022
Net change: -0.6%
Uh oh. Sales and marketing costs dropped a lower percentage than revenues did. That means that sales and marketing as a percentage of revenues rose, which is an indicator that Cisco had to work harder to sell each dollar's worth of product in this quarter in 2003 than it did in the same quarter in 2002. This is not a good sign.

General and Administrative Expenses:
Q4 2002: 152
Q4 2003: 187
Net change: +23%
I hate to be cynical, but this smacks of poor management. Why on Earth are 'administrative expenses' going through the roof during a time when the company's sales are trending downwards? Who is getting the large raises for the privilege of mismanaging the company to ever decreasing sizes? Why were general expenses going up in a time when the government was actively fighting deflation?

On the stock dilution front:
Q4 2002 BASIC: 7292
Q4 2002 DILUTED: 7410
Q4 2002 diluted - basic spread: 118
Q4 2003 BASIC: 7001
Q4 2003 DILUTED: 7136
Q4 2003 diluted - basic spread: 135
Well, that's a mixed blessing, I guess. On the bright side of things, the total number of shares outstanding decreased by 3.99%, but on the dark side of things, the anticipated dilution accelerated from 2002 to 2003. If the stock recovers, it's going to cost the company more to keep from diluting shareholders' ownership percentages. This smacks of increased stock options grants - once again rewarding management for shrinking the company.

BALANCE SHEET
Cash and Equivalents:
2002: 9484
2003: 3925
Net Decrease: 5559, or 58.6% decrease
Uh oh. Cash dropped. A lot. Where did the cash go? Well some of it went to pay for the share repurchase program to pay for Cisco's massive options grants - a transfer of wealth from shareholders to management, for doing the excellent job of shrinking the company. As for the rest, well some went to the "investments" category, as showcased below:

Investments:
2002: 8800
2003: 12167
Net Increase: 3367, or 38.3%
Most of those investments were in the form of bonds - a dubious investment choice in a period of extremely low interest rates (remember - this period ENDED in July, 2003). The big thing to notice, however, is that the increase in investments (3367) is less than the decrease in cash (5559), indicating that the difference (2192) went elsewhere - likely to fund the stock repurchase program that allows the company's management to freely award itself stock options.

Total Assets:
2002: 37795
2003: 37107
Net change: -1.8%
Hmmm, the company appears smaller.

Accounts payable:
2002: 470
2003: 594
Net change: 26.4%
What? Sales are down and 'margins' are theoretically up, which means that costs of goods sold should be down. Why are accounts payable up so much? Is Cisco squeezing its suppliers? If so, why? Doesn't it realize that when the industry recovers, its current bully tactics are not going to endear it to its suppliers? The thing about squeezed suppliers is that they have long memories and the ability to reward alternative customer, once those other customers have regained their ability to compete...

Shareholder's Equity:
2002: 28656
2003: 28029
Net change: -2.2%
Yup. The company is smaller. 2.2% smaller. Hmmm... Smaller shareholder's equity. Equity down a larger percentage than assets. Larger stock dilution... I'm really not liking what I'm seeing here. These are not signs of a growing company.

STATEMENT OF CASH FLOWS
(Note: 12 month data from the press release quoted above. 3 month data calculated from a combination of the press release and the previous filings via http://www.freeedgar.com )
12 month Net Cash Flow from Operations 2002: 6587
12 month Net Cash Flow from Operations 2003: 5240
Net change: -20.4%
This is ugly. Very, very ugly. A 20% drop in cash flow from operations, combined with a higher reported earnings certainly raises my eyebrows. Let's look at the 4th quarter alone:
12 month 2002: 6587
First 9 month 2002: 4978
Therefore: Last 3 month 2002: 1609

12 month 2003: 5240
First 9 month 2003: 3691
Therefore: Last 3 month 2003: 1549
Net change, last three month 2002 to last three month 2003: -3.7%
Hmmm. The cash flow problems seem to be less in the last three months of 2003 than they were in the first nine months, but cash flow from operations was still down, year over year, in the most recent quarter. I don't like decreasing cash flows. I especially don't like decreasing cash flows when coupled with increased reported earnings. It smacks of "management is trying to hide something". Accounting maneuvers to boost earnings in periods of declining cash flow tend to either bite the company in future period via a large 'one time charge', feed on themselves (ala PharMor and Enron) to the point where they become out and out fraud, or cause internal cannibalization (ala Coca Cola a while back) to the point where 'one time charges' and asset sell offs to make numbers become the rule, rather than the exception. Once in a while, a company can 'grow through' such cash flow/earnings divergent periods, but I wouldn't ever bet on it. I have no reason to believe that Cisco is doing anything illegal, but the path they're on scares me quite a bit, because there is a high likelihood of an adverse outcome.

===

I know that people like to say that the stock market looks to the future, not the past, so any problems the financial statements may have uncovered are not necessarily prophetic of the future. Granted, but Cisco's guidance for Q1 2004 is not pretty, either. According to http://www.nwfusion.com/news/2003/0805ciscoearn.html , Cisco expects revenues to be up 2% to 4% sequentially in Q1, 2004, or a 2%-4% rise over Q4, 2003.

In reality, that is not nearly as good news as it sounds. According to the Fool's quote service ( http://quote.fool.com/Snapshot/financials.asp?currticker=csco&symbols=csco ), Cisco had $4845 (million) in revenues in Q1 2003. From what I quoted before, Cisco had $4702 (million) in revenues in Q4 2003. A 2% 'sequential rise' in revenues will bring Cisco to $4796.04 (million), a 3% 'sequential rise' in revenues will bring Cisco to $4843.06 (million), and a 4% 'sequential rise' in revenues will bring Cisco to $4890.08 (million).

At best, if Cisco meets the TOP END of its revenue projections, its revenues will increase by 0.93%, year over year. If Cisco hits squarely in the middle of its revenue projections, its revenues will DECREASE slightly, year over year. If Cisco hits the low end of its revenue projections, its revenues will decrease by a shade over 1%, year over year. It can honestly be said that Cisco's projection for Q1 2004 is for flat revenues, year over year. Which, of course, is not at all obvious from the presentation from management.

===

I don't like what I see. The recently reported data looks ugly, other than the 'per share earnings' number. The projections call for no real growth in the upcoming quarter... It's one thing to have a bad quarter or a bad year. It happens. It's something totally different to have a bad year and window-dress it so that it looks much better than it actually was, and then represent an essentially static going-forward picture as 'growth.' There's an old saying about putting Lipstick on a Pig...

I have no position in Cisco. I have no trust in John Chambers and his management team. There's too much continued divergence between cash flow and profits, too much emphasis on fictitious 'growth', and too much recent history of corporate shrinkage in spite of acquisitions. I refuse to short sell the stock because Chambers is a modern day P.T. Barnum style showman, and the company has a long history of keeping its stock elevated, in spite of data to the contrary. I refuse to invest in a company trading at 35 times earnings when no growth is evident or being projected - there are simply too many faster growth companies (with higher yields) that are trading at lower multiples. And the 'speculative' part of my portfolio is already occupied, so there's no place there for Cisco.

Just my opinion, based on Cisco's reported data.

-Chuck


Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.