Cisco Met Expectations? That's Hogwash

I've read the headlines. "Cisco Hits Forecasts," said the Los Angeles Times. "Cisco's 4th Quarter Measures Up," reported The Industry Standard. "Hitting Targets, Cisco Sees More Tough Times," noted The Wall Street Journal. The party line was remarkably consistent the morning after Cisco(CSCO Quote) announced quarterly earnings on Aug. 7: What a relief! As bad as the numbers were, the company at least managed to meet Wall Street expectations for the quarter.

To which I say, "Baloney." If you look at the numbers that count and keep your eye on the numbers that we've traditionally used to value Cisco's stock, then this was a worse-than-expected quarter. The deeper you look, in fact, the worse the implications of this quarter's numbers turn out to be for the rest of 2001 and the first half of 2002. And a detailed look also shows that Cisco's most recent quarter signals at least two more quarters of very tough times for Cisco's suppliers.

The Numbers

Here's what the company announced in its late afternoon press release over BusinessWire: "Pro forma net income was $163 million or $0.02 per share for the fourth quarter of fiscal 2001, compared with pro forma net income of $1.20 billion or $0.16 per share for the fourth quarter of fiscal 2000, decreases of 86% and 87%, respectively." Analyst estimates for the quarter had ranged from a high of 4 cents a share to a low of a loss of 2 cents a share. The consensus, according to both Zacks and First Call, was 2 cents a share. (Analysts have always used pro forma income numbers for Cisco because the company is always writing off something from one of its many acquisitions or another.)

Technically, Cisco met expectations. But I think it's important to see where that 2 cents a share in earnings came from. Not from operations, that's for sure. Cisco's operations -- its business -- generated a paltry $28 million in operating income. That's equivalent to just four-tenths of a cent per share. The bulk of Cisco's profit actually came from the bank. The company earned $199 million, or 3 cents a share, in interest payments on its cash balances.

When most of a company's earnings result from an activity that's ancillary to a company's main business, analysts raise a red flag and start to talk about the quality of earnings. The theory is that earnings that come from a company's normal business operations are of a higher quality (they're more predictable and more reproducible) than earnings that come from chance events or extracurricular corporate activities. At the moment, Cisco is certainly vulnerable to this quality of earnings criticism, because future earnings per share seem at the mercy of market interest rates.

Cisco wouldn't have a quality of earnings problem if it didn't have a quantity of revenue issue. Revenue for the quarter, at $4.298 billion, barely reached the low end of Wall Street projections that ranged from $4.255 billion to $4.5 billion. Even with layoffs and other cost-cutting efforts, Cisco hasn't been able to reduce its cost structure fast enough to keep margins from falling through the floor. Operating profit margins came to just 0.7% this quarter -- an amazing number considering Cisco's operating profit margin was 25.5% in the quarter that ended in October 2000. With the company telling analysts to expect a further 5% decline in revenue for the next quarter, there's a good chance that Cisco will actually show an operating loss in that period. (Interest income might again be enough to give Cisco a small profit next quarter.)

The past problems of this quarter translate into future problems with the stock, too. If revenue isn't going to grow markedly for the next three or maybe four quarters, as the company seemed to indicate in its post-earnings report conference call, then margins aren't likely to improve, either. Extrapolating today's margins and today's revenue into the company's next fiscal year, analysts hardly let Cisco CEO John Chambers stop talking before they began to cut estimates for the fiscal year that ends in July 2002.

Not all of the 30-some analysts who follow the stock have weighed in yet, but the consensus seems headed from 28 cents a share before the report, according to Zacks, to something like 18 cents. Cisco struck many investors as expensive before, despite the stock's huge decline from $80 a share in March 2000, because at $18 it still traded at 64 times projected fiscal 2002 earnings. But estimate cuts have made shares much more expensive in just the last day: At $18 a share, Cisco now trades at about 100 times projected 2002 earnings.

Analyzing Future Business

Now, of course, analysts have been known to get their projections wrong, so let's look at what Cisco told us about its future business in this quarterly report. Routers, which represent about 40% of Cisco's revenue, were by far the best-performing segment of Cisco's business. Revenue here fell a little less than 2% from the prior quarter (and 26% from the same quarter in 2000). It looks like Cisco's strong product line is holding its own in this segment and that, as CEO Chambers reported, Cisco's corporate customers have stopped canceling orders and are back to buying equipment.

How can a 2% decline be good news? Well, compare the indication that Cisco's router business has stopped its nosedive with the evidence that Cisco's switching business is still in free fall. Revenue in that segment fell 26% from the previous quarter and is now down 40% in just two quarters. Because switching makes up another 40% or so of Cisco's business, those kinds of numbers are indeed grim. And while a book-to-bill ratio that climbed slightly over 1 in the quarter -- showing that Cisco is now taking in new orders somewhat faster than it fills old ones -- is good news, it is not enough to signal a big increase in revenue any time soon in the switch or router segments. And Cisco's other businesses, optical and access, simply aren't big enough to carry the growth-burden at the company.

Certainly slow growth at Cisco isn't good news for Cisco's suppliers, which include chipmakers such as Broadcom(BRCM Quote), PMC-Sierra(PMCS Quote) and Vitesse Semiconductor(VTSS Quote) and optical component makers such as JDS Uniphase(JDSU Quote) and Corning(GLW Quote). But investors in those shares could find a glimmer of hope in news that Cisco's inventory fell in the quarter. Lower inventory means that Cisco will have to start ordering new parts from these suppliers sooner rather than later. Total inventory fell to a still-high $1.7 billion in the July quarter from $1.9 billion in the April quarter.

But even that piece of relatively good news is not quite as good as it seems if you look more closely at Cisco's inventory levels. Remember last quarter, when Cisco took a huge charge to write off $2.2 billion in inventory? At that point, analysts and many investors wondered if Cisco would eventually wind up using any of that pile of "worthless" raw materials and components in future products.

Well, now we know. Cisco reported that it has disposed of about $570 million of that $2.2 in "worthless" inventory. Of that, it scrapped $105 million in inventory, sold memory chips worth $89 million for $9 million and canceled commitments to buy $329 million in components after paying $200 million to suppliers. In addition, Cisco used $49 million in "worthless" chips in its own products.

That leaves about $1.7 billion of that inventory charge still to be disposed of through a combination of scrapping and consumption. The fact that Cisco will actually wind up using part of this "worthless" inventory means that the company has a bigger backlog of raw materials and components to work through than the official inventory level of $1.7 billion indicates.

If you put these inventory numbers together to come up with a figure for total inventory and then take into consideration Cisco's goal of reducing the number of days of inventory it keeps on its shelves, I think you can estimate when Cisco will start ordering at normal rates from suppliers. To me, it looks like that could happen after two more quarters of inventory reduction at the July rate. So I'd look for Cisco to begin buying from suppliers for current production at normal rates in the early part of 2002.

Exactly how good that would be for suppliers depends on what "normal" rates of ordering for Cisco will be. Cisco didn't give us much help on that in its most recent quarterly conference call, however. Cisco CEO Chambers said that investors should now think of his earlier projection of 30% to 50% annual revenue growth when Cisco's market recovers as a "stretch goal." Only time will tell, Chambers added, whether the actual growth rate would be 15% to 30%, or 30% to 50%.

Thanks a lot, but I think we knew that.