April 19, 2001
Paranoia. Suspicion. Confidence.
All words that describe the varied reaction to Cisco’s announcement this week that it will write off $2.5 billion in inventory (yes, that's Billion).
Competitors are paranoid that some of the excess inventory will find its way to market even if it is written off, increasing pricing pressure and eroding profit margins. Some analysts are suspicious that there is something underhanded or even illegal about the write-off, which by most accounts is the largest technology inventory write-off in history. And investors appear confident that Cisco is working some creative accounting to make its books look pretty in the end.
Whatever the case, it’s a big deal.
”This is unheard of,” says Fred Hickey, editor of High Tech Strategist, a technology newsletter based in Nashua, N.H. “This is the greatest write-off I’ve seen in my 20 years in the business. It's unprecedented.”
In short, the accounting procedure means that Cisco Systems Inc. (Nasdaq: CSCO) is declaring $2.5 billion worth of inventory -- much of it classified as “raw materials” -- as completely useless (see Cisco's Inventory Woes Mount). It will lock up the goods in a “secured" and "segregated” area, according to Cisco officials. In taking such accounting steps, Cisco is saying that these goods will not be sold. In turn, the company must amortize the cost of the goods over time, realizing no revenue from them.
But what does it really mean? Some conspiracy theorists see beyond Cisco's explanation -- essentially, that this is a sensible way to bury a bad period of business -- and think that Cisco will find a way to sell a good portion of the so-called “worthless” goods, padding profit margins and dumping goods on the market -- and wreaking pricing havoc for competitors.
”If you are not planning on using it, then why are you holding on to it?” asks Hickey. “And if you can use it, then why are you writing it down? If you sell it, you inflate your margins.”
Hickey, a vocal critic of Cisco’s accounting methodology, says Cisco is not being honest about the accounting: He suggests that the Securities and Exchange Commission should keep a watchful eye on the whole procedure, pointing out that auditors are not likely to be able to track $2.5 billion in inventory.
“Accounting controls are not Cisco’s forte,” understates Hickey.
Because of Cisco’s power and influence in the networking market, the inventory issue is being closely watched by competitors and Wall Street analysts. For example, a significant portion of Extreme Networks Inc.'s (Nasdaq: EXTR) conference call on Wednesday night was dedicated to questions about whether Extreme sees pricing pressures escalating -- and whether Cisco’s inventory might ultimately contribute to a decline in margins
Until the fate of the inventory is known, however, the write-off will dial back Cisco’s profitability.
“The big deal is the financial impact this will have on Cisco,” says Seth Spalding of Epoch Partners. “Two billion dollars of unused product just sitting in a warehouse hurts their ratios and return on assets. It changes the profitability of the company.”
As for the conspiracy theories, Spalding says that Cisco does have legal options for adjusting the inventory charges in the future.
“People are concerned that Cisco will take a reverse on the charge later on to boost margins,” says Spalding. “But they would have to publicly disclose that. But it still would make it look like they were artificially enhancing gross margins.”
Some analysts take the hypothesis a step further. Gina Sockolow of Buckingham Research Group believes that a significant portion of the $2 billion worth of inventory is returned leased equipment from service providers.
She says that she expects Cisco to take this returned equipment, repurpose it, and sell it overseas where they can bypass the channel and make a much higher margin of profit.
“What they can do is take the finished routers that were returned from leasing contracts, reprogram them, and ship them off to third-world countries. It translates into a huge high-margin business.”
What does Cisco have to say about such speculation?
"If six months down the road demand picks up then we would use it, [but] if we used any material we would write it back on," says Sandra Wheatley, a PR manager at Cisco.
-- R. Scott Raynovich, Executive Editor, and Marguerite Reardon, Senior Editor, Light Reading http://www.lightreading.com
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