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Cisco VP Gets Cool Reception

Light Reading
News Analysis
Light Reading
2/25/2003

NEW YORK – A Cisco Systems Inc. (Nasdaq: CSCO) financial guru today left the impression that Cisco investors shouldn't be expecting a cash dividend -- and that they may want to temper their outlook for the coming months.

Dennis Powell, senior vice president of corporate finance, did not provide any new financial information on the company here at the Merrill Lynch & Co. Inc. Global Communications Investor Conference. But after his presentation, some members of the audience walked away with a less rosy outlook for Cisco in the coming quarters.

“Gross margins are at their peak,” noted Tal Liani, an analyst with Merrill Lynch, covering Cisco. “There is limited upside.”

During his talk, Powell highlighted the company’s performance over the past few quarters. While revenues have been flat to down, gross margins have improved, reaching about 70 percent for the year. The company has also controlled costs associated with headcount and inventory. On a pro forma basis, the last three quarters have been the best the company has seen in its history, said Powell. And, he continued, in terms of GAAP, Cisco’s second fiscal quarter (ended January) recorded the highest earnings the company has seen in its history (see Cisco Profits Up, Outlook Down).

But a dark cloud looms over Cisco as it searches for a bottom to the spending slump. Although he didn’t come right out and say it, Powell suggested that gross margins will likely not continue to improve. Cisco's rising gross margins, in fact, have risen some eybrows among those analysts who suspect that 70 percent is unusually high and not sustainable.

“In a weak spending environment, a hit in the gross margins will have a huge impact on the company,” said Liani. “The risk is that Cisco’s technology will become more commoditized and margins will fall.”

As a result the company will be looking to expand its business in new product areas -- including, security, storage area networking, voice over IP, and wireless. But Liani is skeptical that the new areas will be enough to sustain any meaningful growth in Cisco’s business.

“These markets are really small,” he said. “We ran the numbers and even if these areas grow 25 percent, that is only about 3 percent growth for Cisco.”

Powell said the company will also try to squeeze out more market share in its traditional markets: switching and routing. The company currently has about 68 percent and 80 percent market share, respectively, in each of these sectors.

Powell indicated that the company would not be cutting costs even if the quarter starts to look weak. Rather, he insisted, the company would continue to control headcount through natural attrition -- he said the company has been able to reduce its headcount by 5 percent on a yearly basis through this method. He noted, however, that Cisco would continue to offer substantial compensation and stock option plans to retain employees.

After the formal presentation, Powell fielded a series of questions from investors asking whether Cisco would be returning any of the cash the company generates every quarter to investors by way of a dividend.

Cisco has been aggressive about buying back its stock, spending about $4.4 billion on the buy-backs so far, according to Powell. But some investors would like to see this extra cash coming back to them in the form of dividends.

While Powell said the company is considering all options right now, it seems unlikely that it will offer dividends anytime soon, mainly because of tax issues. Cisco has managed to keep its cash balance stable, ending the previous quarter with $21.2 billion in cash and no debt.

“We believe the cash on the balance sheet has been a competitive advantage,” said Powell. “That is the reason we have been able to take market share from competitors, because we are viewed as a sustainable company.”

But he also admitted that it’s possible to have too much of a good thing and that the company is considering using some cash to make acquisitions and/or expand its customer financing program.

Liani said he did not expect Cisco to make any major moves anytime soon. In terms of acquisitions, the company will likely stick to its current strategy by focusing on early startups with fewer than 100 employees that are located near Cisco’s San Jose, Calif., headquarters.

— Marguerite Reardon, Senior Editor, Light Reading

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DoTheMath
DoTheMath
12/5/2012 | 12:34:21 AM
re: Cisco VP Gets Cool Reception
Quote> Cisco's rising gross margins, in fact, have risen some eybrows among those analysts who suspect that 70 percent is unusually high and not sustainable.

"In a weak spending environment, a hit in the gross margins will have a huge impact on the company,G«• said Liani. G«£The risk is that CiscoG«÷s technology will become more commoditized and margins will fall."
-----------------------------------------------

Many people on this board have wondered if Cisco's gross margins are due to written-off inventory making its way into product, though I kind of doubt it. If it were so, and Cisco has not reported it, that would be borderline unethical. Especially because they are claiming highest pro-forma profits and GAAP profits in their history. This would be a material fact in that regard.

In any case, 70% gross margins are unsustainable. Cisco has benefited from high prices it charges customers while squeezing suppliers for every last penny. Two things are bound to happen: customers wise up, and suppliers consolidate, leaving gross margin to go nowhere but down. Growing their business could still leave profits stagnant.





xip42
xip42
12/5/2012 | 12:34:15 AM
re: Cisco VP Gets Cool Reception
Very interesting point about written-off inventory. I assume they don't throw the parts out, so they are still around for building into a product. I'm guessing write-off may not be the correct term. There are several accounting tricks involved here.

Let's say i purchased a part for $1000 a year ago, but now i can purchase that same part for $500. If i have a bunch of inventory i have not used, but purchased at $1000, it's really only worth $500 at this point. So i can write down the value of that inventory. I don't know if write-off is correct since that has a conotation of a complete loss. I don't have a complete loss, just a reduction in value.

Adding to this is the fact that FASB allows LIFO and FIFO methods for accounting for inventory. Maybe they use LIFO right now since the last parts into inventory are the cheapest, hence provide the greatest gross margin. But it can catch up with you.

All this is much more complicated than i've indicated, but it's perfectly legal and acceptable.

Mike
DoTheMath
DoTheMath
12/5/2012 | 12:34:14 AM
re: Cisco VP Gets Cool Reception
xip42>Adding to this is the fact that FASB allows LIFO and FIFO methods for accounting for inventory. Maybe they use LIFO right now since the last parts into inventory are the cheapest, hence provide the greatest gross margin. But it can catch up with you.

All this is much more complicated than i've indicated, but it's perfectly legal and acceptable.
---------------------------------------------------

Good points. These are legal and acceptable, but do they have any obligation to disclose what is going on? If their gross margins are high due to using "worthless" (in their books) components, isn't it a material fact shareholders should be told about?

As the article indicates 70% gross margins do look suspicious! May be there is nothing to it other than the simple fact that they have tremendous market power over both their customers as well as their suppliers.
BobbyMax
BobbyMax
12/5/2012 | 12:34:06 AM
re: Cisco VP Gets Cool Reception
Cisco has many times the wall street expectations by a penny or so. This has led very steep rise of Cisco stocks. It is very difficult to say what is happening within Cisco. Only a close look at the accounting procedures for the last seven years would reveal some pattern that has been followed. I think SEC would like at Cisco from many perspectives. Cisco's profit pattern appear to be suspicous.

Cisco has been granting huge stock option to the management and selective employees. It is not clear why there is so much disparity in giving out stock options.

Coisco should not keep $19.2 Billionsit has amassed. Millions of shareholders have lost a lot of money. The shareholders should be made whole.
Light-bulb
Light-bulb
12/5/2012 | 12:33:51 AM
re: Cisco VP Gets Cool Reception
BobbyMax,
You know I completely disagree with you on this point Bobby,
Cisco SHOULD KEEP its 19.2 Billion and for good reason. Because
as a shareholder I want Cisco to sustain and grow. And if the
economy doesn't shape up anytime soon they may very well need to
use some of this savings to help get them through. I would rather
have Cisco in business over the long haul then have a divend paid out.
As to disparity in giving out stock... Bah! Cisco has rewarded
its people who show that they are willing to go above and beyond, and
individuals who do more than just their Job. Are there a few who get
left behind or unrecognized? Yes, but such is life.

Keep Groovin' Cisco!
skeptic
skeptic
12/5/2012 | 12:33:50 AM
re: Cisco VP Gets Cool Reception
You know I completely disagree with you on this point Bobby,
Cisco SHOULD KEEP its 19.2 Billion and for good reason. Because
----------------------
I think that cisco should stop doing stock
buybacks and switch to dividends. Cisco is
already wasting a considerable amount of money
on the buybacks that could be given to
shareholders in a much better way.

Stock buybacks are a waste of cisco's cash. In
the current stock market environment, no amount
of buybacks can significantly change the market
price of cisco stock. Though the tax situation
with dividends isn't great, at least the
money is real.

skeptic
skeptic
12/5/2012 | 12:33:49 AM
re: Cisco VP Gets Cool Reception
Cisco has many times the wall street expectations by a penny or so. This has led very steep rise of Cisco stocks. It is very difficult to say what is happening within Cisco. Only a close look at the accounting procedures for the last seven years would reveal some pattern that has been followed.
-------------
The pattern is that they are a monopoly and can
manipulate their orders and deliveries to
customers in ways that allow them to manage
their earnings.

This will not change until the competitive
landscape of their market changes. And they
have the margins that they do because nobody
can touch them in terms of the scope of the
portfollio of products they offer. Juniper
can challenge them in one segment, buts thats
about it. Most of their other competition is
offering inferior products with far lower
quality.

The bigger players could compete with them,
but they lack a competitive IP routing software
base thats at parity with IOS/Junos. And the
amount of work its going to take them to get
a competitive IP/MPLS software base keeps getting
larger.

Light-bulb
Light-bulb
12/5/2012 | 12:32:14 AM
re: Cisco VP Gets Cool Reception
I understand your point here skeptic... and understand your name. :) However, I want to add one point and that is this... the stock is at a song. Lets face it With 50% of the Cash on hand you can buy back 10% of the TSO. You don't consider that large? I consider that Huge! More to the point employees stay happy with the valuation of their options. Personally, I'm against a Dividend. With 7.1b TSO and a use of 50% of on hand monies how much does that give back per/share? So I suppose the shareholders see some money coming back but what would they rather have? A company that can retain their best employees by increasing the stock price? Which also benefits each shareholder, or an immediate take the cash and run philosophy? Where we run through our monies to give the sharholder $1.00/share? In addition the Tax implications alone, maybe Bush can help that though. So after its all said and done I get .70/share so my 1000 shares gets me a whopping $700... Hmm, Maybe I'll go buy some groceries for the Wife and kids I hear Costco is doing well! The bottom line here is me personally I would rather let Cisco Hold the monies completely, my faith is in the leadership of the company. Stock buyback aside I wish they wouldn't even do that to be honest, I would prefer Cisco to invest their money into startups and new technology development. (Maybe a little Lobying) Start the acquisition Train!!!
Cheers,
BobbyMax
BobbyMax
12/5/2012 | 12:32:08 AM
re: Cisco VP Gets Cool Reception
As I have indicated before, Cisco has beaten the Wall Street estimates by a cent to a nickel many times. As a rwesult it managed to boost up the stock prices beyond a reasonable limit. For a public company, this is a very dangerous game as it eliminates competition from the market place and the customwer has to pay a lot more than the product is worth.

The second thing which is most troubling is the good will asset that it has accumulated ( if I remember correctly, above $4Billion. This amount is very unreasonable and neewds to be examined by SEC with the help of subject matter experts.

Cisco has also retained and promoted to very high positions within the company. These employees come from a very small company of 20 people ( Cresendo Communication). Cresendo manufactured FDDI cards. This also does not speak very highly of the company. When the buyers of Cisco products would learn about this, it will have very serious repurcusions.
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