Putting Cisco in Perspective

Seeing as James J. Cramer doesn't plan to dignify the current Barron's cover story on Cisco Systems (CSCO Quote) with a response, I thought I'd supply a little perspective on that piece, which is rocking the markets today -- especially mighty Cisco.

At the same time, students of Cisco will want to be aware of an equally important Cisco piece, the diametrically opposed cover story in Fortune magazine featuring a very tight close-up on the face of Cisco CEO John Chambers.

There's essentially nothing new in the Barron's piece, which doesn't make it wrong. Barron's makes two main arguments: That Cisco can't ever grow into its valuation and that changes in accounting practices will slow Cisco's acquisition engine.

The first point has been debated for months, if not years, and people believe it's a good bet that Cisco can never grow into its valuation. Back on April 17, when Cisco traded for 57 per share, I wrote a column showing that the company was worth 158 times trailing earnings and 111 times current-year forecasts. And yet, despite those eye-popping valuations, Cisco is one of those stocks that everyone seems to need -- at any price. The stock pushed up over 71 since then, before falling back to the 62-to-63 range today. When a company that is growing earnings in the 40%-to-50% range trades for triple its profits, it's overvalued. It's that simple.

Fortune -- in a beautifully written, if puffy homage by the talented Andy Serwer -- essentially swats this out of the park by saying of Cisco, "Don't worry, be happy." Because Cisco is so good at what it does, investors will continue to reward it with a multiple that's a huge premium to its growth rate.

Who's right? We just don't know. Barron's landed the tougher punch today. Understand that both stories are what journalists call "curtain raisers." They're priming the pump for Cisco's release of quarterly earnings this Tuesday. This gets the debate going and gives analysts and interviewers talking points for CEO Chambers. But they don't resolve the issue. Investors do, and they do it over a matter of months and years, not minutes or days.

The other important assertion in Barron's is that Cisco is building a house of cards with its myriad of acquisitions that rely on the pooling-of-interests method of accounting, which eliminates goodwill and therefore minimizes damage to future earnings. There is, however, a big difference between a traditional "roll-up," where companies acquire oodles of other companies to make their revenues grow, and what Cisco does.

Cisco acquires companies with big revenue potential and then helps them meet that potential by integrating the new companies into their marketing and sales juggernaut. It's true that that game can't continue without a valuable currency to use for acquisitions, but Cisco's impressive revenue growth is more akin to "organic," or internal, growth than it is to typical roll-up behavior. Who deserves the credit for a unit that had $10 million in revenue last year, contributing $100 million this year? I'd say the current team deserves more than its fair share.

Then there's the issue of what happens if pooling accounting goes away -- as the accounting profession has proposed -- and Cisco starts printing losses because of big goodwill charges. Fortune explains away this issue by noting that Cisco is lobbying hard in Washington to see that pooling remains, so everything's OK there. Hmmm, that doesn't exactly convince me. More to the point, I'd argue that even if Cisco were to start printing "losses," while maintaining operating pace, investors might be willing to overlook the "losses" stemming from charges.

For example, JDS Uniphase (JDSU Quote) wasn't able to use pooling-method accounting for the merger that created the current version of the company because JDS Fitel, based in Canada, required the use of Canadian accounting rules. So that company accounted for its merger as a purchase and reported net losses of $241 million, or 32 cents per share, for the quarter ended March 31. That figure includes "merger-related intangibles amortization charges," and it isn't what Wall Street watches. Investors note that JDS Uniphase, an indirect competitor to Cisco, has "pro-forma" first-quarter earnings of $86 million, or 11 cents per share. At its current share price of around 90, JDS Uniphase trades for about 237 times analysts' estimates for its "earnings" in the fiscal year that ends in June. Is this too much? You be the judge.

Another example of this accounting gymnastics is so-called cheap stock, the term of art for noncash expenses related to option grants to executives at below fair-market value. Silicon Valley companies used to fight the Securities and Exchange Commission tooth and nail on this because the charges for cheap stock were killing earnings. Then they realized that investors were willing to look through the noncash charges and focus on operations. Now, nobody fights the cheap-stock charges anymore, they just record them -- and investors ignore them.

The point is that Cisco's favorable accounting treatment might be eliminated and the market still wouldn't care. But there's no doubt the company can't grow into its valuation in the time that's been allotted to it. All that is unresolved -- not by Barron's, Fortune or anyone else -- is how long investors are willing to accept huge premiums and indulgent accounting. As long as they are, it won't matter how "right" the analysis of valuation and accounting is.