Deferrals Bug Cisco Investors

This week Cisco Systems Inc. (Nasdaq: CSCO) reported revenue growth, but analysts and investors weren't singing the company's praises.

Since the trading day ended on February 6, Cisco's shares have dropped $1.85 (9.94%) to $16.76.

Wall Street gave the earnings announcement a lukewarm reception. One analyst, Dresdner Kleinwort Wasserstein's Ariane Mahler, recommended that her bank's clients sell their Cisco shares. In his research note, Robertson Stephens analyst Paul Johnson remarked that he thinks Cisco's valuation "represents investor expectations for growth that are unachievable given the current market conditions."

What gives?

Cisco remains a dominant company with billions in cash, but it raised eyebrows when it reported overall quarter-to-quarter revenue growth, while its revenues from products actually shrank from quarter to quarter.

The subcategory of Cisco's revenues called revenue deferrals, which aren't attributed to specific product or service categories, caused the most concern. This category reduced Cisco's revenues by more than $350 million in the first quarter but added $48 million to its revenues in the second quarter.

Table 1: Cisco's Revenue Breakdown for Fiscal 2002 ($M)

	Q1	Q2
Routers	1,607	1,584
Switches	1,980	2,016
Access	308	288
Other	484	432
Services	792	768
Revenue Adjustments	(396)	(336)
Revenue Deferrals	(352)	48
Total	4,423	4,800
Source: Company data

Put another way, if Cisco's revenue deferrals had stayed the same in Q2 as they were in Q1, Cisco would have reported a 2 percent quarterly revenue decline, not an 8 percent revenue increase.

The deferral category includes sales of contract terms requiring revenue deferral and products sold by Cisco distributors (where revenue isn't recognized until the distributor's point of sale).

"Because of how deferred revenues are derived and the source material those numbers are drawn from, the number is out of sync with what Cisco has reported previously," says Stephen Kamman at CIBC World Markets. "But the balance sheet and the income statement are in sync and there's no evidence here that Cisco's trying to be deceitful."

One thing that might have added to the revenue deferral mess is Cisco's product mix – the company likely experienced a shift from selling to more enterprise customers and fewer service providers during the second quarter. Cisco has always had to enter service provider and enterprise contracts into the same accounting system, though the two businesses differ greatly from each other in profit margins, annual spending cycles, and basic contract terms.

The upshot? Cisco doesn't appear to have done anything wrong, but it is frustrating investors all the same because:

• The revenue deferral item obscures how individual product groups performed over time;

• Cisco's upcoming third quarter is usually its weakest of the year, and product revenues have been sliding for several quarters now; and

• CEO John Chambers still hasn't definitively called a bottom for Cisco's businesses, and he hasn't given long-term revenue guidance due to lack of visibility.

But considering that Cisco has billions in cash -- and considering the overall state of the industry -- its problems still appear relatively minor.

Calls to Cisco about the revenue deferral issue had not been returned by press time.

— Phil Harvey, Senior Editor, Light Reading
http://www.lightreading.com