Analysis:Cisco blows smoke, market inhales
10/3/2001 7:42:00 PM
WASHINGTON, Oct 03, 2001 (United Press International via COMTEX) -- The stock market was sharply higher
again Wednesday, with the Dow closing over 9,100 and Nasdaq rising almost 6 percent. It wasn't one of its more
realistic days. Leading the market, with its stock up a staggering 22 percent to $13.95, was Cisco Systems Inc.
Once again John Chambers, Cisco's chief executive officer, has spun the market a tale, and the market has
believed it.
Speaking at Goldman Sachs's Communicopia conference Wednesday morning, he told the market what it wanted to
hear, that yes, Cisco would meet its earnings forecast for the quarter to end October, of 2 cents per share, on sales
of around $4.2 billion.
Great news! On an annualized basis, Cisco is trading on only 174 times earnings, on sales down 3 percent for the
quarter. What a bargain! Of course, that may only be on a "pro forma" basis, not counting all the losses on inventory
and private equity investments that may be revealed when the figure is finally announced.
The "bargain" becomes even more extreme when you look at Cisco's annual report for the year ended July 28, which
finally made it to the Securities and Exchange Commission Sept. 24, thus enabling analysts to dig more deeply
among Cisco's rosy "pro forma" earnings spin.
In the year to July 2001, Cisco reported a net loss of $1.01 billion. If however you look at the "stockholders' equity"
statement, you will find that this does not include $3.81 billion of net unrealized losses on investments, so the
"comprehensive net loss" was actually $4.82 billion.
Of Cisco's investments, the bulk was "corporate notes and bonds" up from $3.22 billion book value in 2000 to $7.43
billion in 2001, a remarkable increase in a difficult year. Somehow, I don't think these are normal AA-rated bonds you
might buy in the market --- much too uninteresting. I think they're bonds of telecom and Internet companies, issued
primarily to Cisco to finance purchases of Cisco equipment. Of course, given the downturns in that business, there
may be some more "unrealized losses" to come. And that's not to speak of Cisco's $1.99 billion of equity
investments.
Another quirk. In the third quarter, to April 30, Cisco recorded an inventory write-off of $2.77 billion. Since inventory in
July 2001 after the write-off was 36 percent above that a year earlier, on sales up only 15 percent, this was not
before time. Nevertheless, after the write-off Cisco had $2.77 billion book value of inventory lying around, carried in
the books at zero. Naturally, over the next several quarters, this inventory can be sold, at a discount of course, and
the sales revenue is then pure profit.
Since Cisco needs only $150 million in earnings to reach its 2 cents share forecast for the quarter to October, it
must be pretty likely that a good share of this will come from inventory yard sales --- they recorded $187 million in
such sales revenue in the July quarter, after all.
Finally, stock options. In the year to July 2000, Cisco employees exercised 176 million stock options at an average
price of $5.75, and thereby relieved Cisco's outside shareholders of a cool $8.16 billion, being the difference between
the exercise price and the market price of Cisco shares at the time of exercise (which can roughly be assumed to
be the price at which new options were granted.) None of this, of course, went through the official income statement,
where Cisco's Net Income in the year to July 2000 was $2.67 billion.
OK, so the year to July 2000 was the culmination of a period in which Cisco stock had been rising at unprecedented
rates. In the following year, to July 2001, things were very different, and one could thus expect employee stock option
exercise to be much less profitable to employees, or dilutive to stockholders.
One's expectation would be right. In the year to July 2001, Cisco employees exercised options on 133 million shares,
at an average exercise price of $7.43 per share. With the new option grant price during the year being $39.93 per
share, Cisco employees' option profits, at the expense of outside shareholders, were way down, to $4.32 billion.
Only just over half!
Of course, the snag is, that even on Cisco's accounting the company did not make a profit in the year to July 2001;
instead the company registered a loss of $1.01 billion. So outside shareholders suffered $4.32 billion of ownership
dilution to management, and another $1.01 billion of actual losses, just to add insult to injury.
The truth is plain; you can do the arithmetic. Over its entire lifetime (the company was founded in 1984), more than
100 percent of Cisco's net income, even as reported, has been paid out to management. On a true value basis, not
one penny has accrued to outside shareholders; the company has been financed simply by issuing new shares to
new shareholders at ever higher and higher prices.
While the problem does not arise under generally accepted accounting principles, under the analysis above it
appears similar to a Ponzi scheme. |
