Ripples Spread From Cisco Write-Off

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

flanker 12/4/2012 | 8:32:11 PM
re: Ripples Spread From Cisco Write-Off Cisco has the option under US GAAP accounting
to write off inventory if it has no market value.

Cisco can easily make that case, their equipment does not have a long depreciable life. If Cisco wants to refurbish/give away/sell another day this inventory that is their right.

I doubt they will ever make back the 2 billion, so it is right to write it off. And yes, they will reverse the write off, it does pad profits going forward. It is a reserve account.

Furthermore, the rules about setting up "reserves" (fake losses) like this are looser in Japan and Europe, so nobody should really be complaining, except Cisco shareholders who will see a lot of extraordinary income going forward.

rafaelg 12/4/2012 | 8:32:12 PM
re: Ripples Spread From Cisco Write-Off "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.

Am I missing something?
gardner 12/4/2012 | 8:32:19 PM
re: Ripples Spread From Cisco Write-Off >Wait a second. This is a business not a charity. Cisco has every right to do what they can do to.

I don't know what Cisco is planning but I do think red1969a ought to realize that charity or not one has to follow the accounting regulations required by a public company or face a hiatus in a federal tennis camp. And that is a good thing for all of us. Playing fast and loose with the numbers undermines a free market.

I don't know these people learned their economics but it seems as if there are a lot of people today that think that anything can be justified as long as you make a profit doing it. Accounting rules exist to make capitalism possible. Yes! Possible! Without them you have the sort of gangster capitalism practiced in Russia today. I don't think anyone wants to live in that kind of economic environment. And what is more such unbridled gangsterism masquerading as capitalism is more likely to trigger a general inability to distinguish between an honest profit and profiteering. This, I'm afraid brings an inevitable trend toward more socialism not less.
rafaelg 12/4/2012 | 8:32:22 PM
re: Ripples Spread From Cisco Write-Off Wow!!!
That's smart... put all the stuff in a closet, write it off and then bring it back as you need it. And if you don't, give it away!

...and we just watch.

This is a wonderful country! I may do that with my furniture...

red1969a 12/4/2012 | 8:32:22 PM
re: Ripples Spread From Cisco Write-Off Wait a second. This is a business not a charity. Cisco has every right to do what they can do to.
pocketrocket 12/4/2012 | 8:32:30 PM
re: Ripples Spread From Cisco Write-Off Cisco has many advantages to taking one great big
lump-sum write-off, especially given that they
are _keeping_ the "scrapped inventory".

First of all, the stock market rewards those who
engage in "Take a Bath Accounting". The market
would rather see one terrible quarter followed
by 7 pretty good quarters then to see eight
quarters of mediocore earnings. There is no
reason for this, but it is true.

Second, this material, which is on the books
at zero, could be used as ammo in case of a
major price war.

Third, its mere presence may act to deter
a major price war.

Yah, this is more evidence that the folks
running Cisco are very, very smart.
Scott Raynovich 12/4/2012 | 8:32:32 PM
re: Ripples Spread From Cisco Write-Off mu-law:

How do you envision this operating?

StartUpGuy1 12/4/2012 | 8:32:32 PM
re: Ripples Spread From Cisco Write-Off Scott,

Look at the "buy one, get on free" deals

mu-law 12/4/2012 | 8:32:33 PM
re: Ripples Spread From Cisco Write-Off This is a supply of "giveaways" to be used as sales incentives. No revenue, no problem.

This is quite an arsenal, and I would be concerned if I were an adversary. Wait... I am! Oh crap...
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