Meet the Street: Will the Cisco Kid Ride Again?

Cisco's ( CSCO) earnings report today promises to calm investors who are anxious about accounting issues and whether there'll be a smooth recovery, says networking analyst Alex Henderson.


Alex Henderson,
Analyst,
Salomon Smith Barney
Recent Meet the Streets
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In today's Meet the Street, the Salomon Smith Barney analyst talks about what to expect from the company, and vigorously defends Cisco's use of pro forma numbers, calling Cisco's numbers "uniquely pristine."

TSC: For the record, what is your current rating on Cisco?

Henderson: Strong buy.

TSC: And your price target?

Henderson: $25, with upside.

TSC: What do you expect from today's earnings report? Will they hit their numbers?

Henderson: We think they'll report a 3% increase in revenue in the quarter. As for earnings, we're forecasting 5 cents a share, and the Street is forecasting 5 cents a share. But we think the company will report earnings of 6 cents.

TSC: What sort of guidance do you think John Chambers will offer on the company's conference call?

Henderson: We expect him to give guidance of low single-digit revenue growth quarter over quarter and make comments that gross margins should continue to expand, as well as operating profits.

TSC: In light of the intense scrutiny of accounting practices of late, do you think Cisco will continue to rely on pro forma numbers?

Henderson: Absolutely. Cisco's accounting practices are pristine. People criticizing Cisco on their accounting don't understand the company and probably don't understand their accounting very well.

TSC: Could you explain further?

Henderson: Sure. First off, there are basically three or four buckets of accounting issues that people focus on. The first one is accounting for acquisitions. Two primary points here.

First, the company has almost always done purchase acquisitions. To the extent that you're doing purchase acquisitions, you historically have gotten goodwill and the company would write off R&D. To the extent that the accounting policy boards have been moving in the direction of eliminating pooling and simultaneously saying "we don't want you to account for goodwill any more," the accounting rules have actually come into line with what Cisco is doing anyway.

Point two: The issues associated with the quality of earnings problems that have impacted a lot of companies are not accurately applied here. There are a lot of people who'll look at the $2 billion writeoff and say, "Gee, aren't they just cooking their books?" The answer to that is no, they are not. In fact, I've been an analyst for 15 years and I've probably seen more restructuring than almost anyone else on the Street, having followed Kodak ( EK) and Xerox ( XRX) for years.

We strongly believe Cisco's handling of this $2 billion charge for inventory, for instance, is uniquely pristine. They set up a separate account and they reported that account separately to shareholders in every quarter. And they did not produce any benefit to the earnings income statement from repatriating inventory or using overly written off inventory to create profits.

A lot of companies will take charges for all kinds of things when they do restructuring, and have a sort of slush fund. They'll use that to manage earnings over the next two or three years and will not tell you what happened to those buckets of cost savings. In this particular instance, Cisco set up a separate P&L and specifically called out every quarter what portion of inventories were left from the prior period, how much they have used ... here's the gain, here's the loss on each of the pieces, here's the net benefit or net cost relative to that inventory. And here it is below the line, not included in operating profits. That is a very, very conservative approach to handling that.

TSC: Are there any problems here at all?

Henderson: The only issue that I think is a question mark is the handling of stock compensation, which is a pretty widespread problem across the technology space. In my opinion, it's more questionable than anything else.

Stock compensation is compensation, so shouldn't that be expensed? Having said that, to the extent that you are, in fact, issuing shares as the portion of the compensation, it shows up as a cost with the rise of the share count. We often tell people to make sure you keep in mind the share count is rising faster that you might expect at some other companies because of the inclusion of stock compensation to employees.

I don't necessarily think that's a bad thing. I just think people need to have a better understanding of what is. But I don't think that it's a big deal one way or the other. It's a very small number compared to the stuff people are talking about, relative to the scope of the fears people have in light of the Enron ( ENRNQ) situation.

The other point I would make that, with a lot of people talking about Tyco ( TYC) today, Cisco does not acquire companies that have meaningful revenues. They acquire companies that are generally prerevenue; they then take that product using the distribution to leverage up the distribution channel. And that process is what creates value. That is not, in my opinion, a bad strategy. In fact, I think it is a good strategy and clearly a winning strategy to a company that has end-to-end solutions to their product line.

TSC: What do you say to those who criticize Cisco for allegedly overpaying for acquisitions?

Henderson: Hey look, the market had a peak a while back. People were using highly inflated stock valuations to buy highly inflated assets. If you deflate the value of the stock and the value of the asset, you end up with a net wash. They were paying for bubble valuations with bubble equity. Big deal. That's not relevant. That's like what happened two years ago.

Companies can be bought today at prices equal to what their cash-burn rate was over their operating existence. So you have to look at where we are today. Who the hell cares where things were two years ago? It's irrelevant. What is relevant is if they make an acquisition today, is it going to artificially inflate them and are they going to pay artificially inflated prices? And the answer is no. They are paying reasonable prices for companies, often below what's been invested in them, and not much more than what they've burned.

TSC: What should we be focusing on the most with respect to the earnings report?

Henderson: Last quarter there was an issue surrounding revenue adjustments. Revenue adjustments occur when you have a product sold to a customer and then the customer says, "I can't use this, I'm going to send it back to you."

These revenue adjustments spiked up to 17% of sales two or three quarters ago and then last quarter dropped to about 7% of sales. Revenue adjustment declined last quarter, creating a stir because if not for a decline in revenue adjustments, the company would have produced lower revenues.

Less returns, which is an offset to revenue, means you inflate your growth rate. While that's true, it's also a reversal of the swing that happened in the prior two quarters, and it's actually back to a normal level. The two of them are a wash over the course of the year, who cares?

What is more important is people often need to focus on the deferred revenue line, which actually is increasing at about 10% per quarter every quarter. It's gone up from 20% of a quarter's revenue to 80% of its revenue since October of last year.

That's a very important fact because it's going to continue to grow at a pretty good clip this quarter, and I wouldn't be surprised to see it up $300 million sequentially, equivalent to 7% of last quarter's revenue. If you add in the revenue growth plus the deferred revenue line, assuming revenue adjustments are flat, that actually gives you almost a 10% growth rate quarter to quarter rather than a 3% growth rate. This will be a very important discussion point tomorrow and will make people think a lot about what's going on in the marketplace.

TSC: If Cisco does well in its report, what are the implications for technology as a whole, as well as the broader market?

Henderson: This market is very jittery right now. There are a lot of fears out there. Cisco's report is going to ease those fears, helping people to feel a little bit more comfortable that the world is understandable and can actually give you a trajectory of some gradual improvement with modest improvement in visibility over time. And that eventually it will recover and there are good companies out there you should own. You should be owning this stock. This is a very good company.

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