Friday Sept 15, 2:00 pm....Internet: End Game for Cisco?
biz.yahoo.com
Senior research analyst: Luciano Siracusano (09/15/00)
Investors in Magic 25 selection Cisco Systems (NADAQ: CSCO) were justifiably alarmed when the stock pierced the $60 level earlier this week, trading down to close at $58.88 on Tuesday after nearly 77 million shares traded hands, twice the average daily volume.
A lot was made of the technical import of the sell-off. Not only had Cisco's stock dipped below $60 for the first time in almost four months, the stock punctured its 200-day moving average, setting off all types of alarms for the chart gurus.
More important than the stock's action in the past week, however, has been its relative underperformance over the past six months. Despite another quarter of excellent operating results, Cisco stock continues to grovel 23% below its March highs. By comparison, the stocks of rivals Juniper Networks (NASDAQ: JNPR - news) and Nortel Networks (NYSE: NT - news) have both staked out new highs in recent weeks.
Investing purists would argue that the tail does not wag the dog, but in Cisco's case, as in the case of other high-tech Nasdaq stocks, a stalled or sagging stock price can have direct effects on a company's operating capacity. Moreover, given today's tax structure and the way in which companies like Cisco exploit it to lure and retain employees, a stalled or sagging stock price can also wreak havoc on a company's statement of cash flows, radically altering the valuation Wall Street places on an enterprise.
Although we continue to rank Cisco a Buy, we do so with our eyes wide open, vigilant that there are gray clouds gathering around the bend.
In recent weeks, different theories have floated as to why Cisco's stock has stalled. Last week it was the fear that telecommunications carriers would moderate the pace of capital spending next year.
Others have pointed to chinks in Cisco's seemingly impregnable armor, as next-generation networking companies start to nibble at Cisco's market dominance across different product categories.
Many have pointed to Cisco's high valuation, and the tremendous challenge the company faces over the next twelve months to generate revenue and share-profit growth that compares favorably with the record results of the past year.
Some have pointed to the heavy volume in the stock over the past several weeks, and the distribution of large blocks of shares by officers and company insiders.
Still others cite the need by portfolio managers to dump their tech losers from 2000. Such tax selling could also trigger sales in Cisco as funds reduce the percentage that Cisco shares comprise in their tech or overall holdings.
While I agree there is a degree of truth to all of this and concede that Cisco could well turn in another two or three quarters of truly impressive results, I also believe that Cisco's stock may well be nearing a top that extends back five years.
Cisco's spectacular ascent since 1995 has resulted from a confluence of forces that have all aligned themselves perfectly in Cisco's favor. To expect the same set of forces to continue into the future is wishful thinking. At some point, one of the four fundamental pillars that have undergirded Cisco's growth will give way.
First, just as Cisco was outwitting its competition to become the king of data networking, the Internet emerged. Geometric explosions in Internet traffic and the convergence of voice, video and data created a bonanza for Cisco's routers and switches. With its marketing and financial clout it succeeded in persuading customers of the advantages of an ``end-to-end solution.'' Today the company continues to stretch out to touch all the branches of the broadband network, from digital subscriber line (DSL), to Voice Over IP (VOIP) to fibre channel to storage.
Although Cisco still maintains dominance in nearly all the markets in which it competes, the movement to next-generation systems places a premium on best-of-breed products in each segment of the new network. This is one of the reasons why Juniper's ability to secure 24% of the core router market is so troubling. If Cisco is unable to capture a greater share of the burgeoning optical networking market, this technological vulnerability could become even more apparent.
In a world where optical networking is the real driver of future revenues and profits, it remains to be seen if Cisco can enjoy the same type of success that it experienced during the first wave of the Internet's development.
Second, the company rode the heels of a historic bull run to enter new markets using Cisco dollars -- its stock -- to buy the best talent in Silicon Valley. In several key instances, these acquisitions were done under the ``pooling of interest'' method of accounting, which shielded the company from incurring massive charges against its reported earnings.
Although the Financial Accounting Standards Board's (FASB) proposal to phase out pooling of interest has lost momentum in recent months as the lobbying effort to stop the proposal has intensified, there is no guarantee that this favorable accounting treatment will endure indefinitely. Although Cisco says it will continue to make the acquisitions it needs regardless of what standard is in effect, it remains to be seen whether the company will actually take huge hits to its net earnings that amortizing goodwill would entail.
Third, Cisco turned itself into a cash-flow machine by exploiting the current tax laws that allow American companies to make billions of dollars in profits and pay virtually no taxes to the federal government. From 1997 to 1999, as Cisco juiced pre-tax profits at a stunning pace, it actually paid less in taxes each year, both in absolute dollars and as a percentage of pre-tax profit. Although the reported tax rate on the annual income statement for fiscal 1999 is 36.8%, Cisco only paid $301 million in taxes, or roughly 9%, on its pre-tax profit of $3.3 billion.
As Gretchen Morgenson pointed out in a front-page New York Times story on June 13, 2000, companies like Microsoft (NASDAQ: MSFT - news) and Cisco are well ``on their way to owing nothing in federal income taxes on the money they have made so far this year.''
The reason for this involves the three ways Cisco benefits by using stock options to compensate, retain and attract employees and executives.
Unlike wages, the exercise of stock options by employees does not register as an expense on corporate income statements. This is a huge benefit, allowing firms to attract and hold top talent at relatively modest salaries. Rather than paying its employees more cash, companies like Cisco actually draw cash into the corporate treasury from their employees when they exercise these options.
The final kicker is the tax benefit that companies receive from the federal government when employees exercise such options. Under IRS rules, companies receive a tax deduction equal to the gain registered by employees. Stock options have become the preferred method because they are a tax-free way to raise compensation without adding to current labor costs.
Although Cisco's annual 10-K report has not as yet been filed with the Securities and Exchange Commission for the fiscal year that ended July 31, 2000, by examining its financial statements through the first nine months it's quite clear that this tax benefit is staggering. Through April, that benefit, $930 million, was almost half as large as the net income Cisco reported for that entire period. The benefit wipes out 85% of the $1.1 billion in taxes that Cisco provisioned during that period.
Put another way, if Cisco had to account for its stock-option compensation as an expense as defined under FASB Statement No. 123, the company would have reduced net income by 23.8%, or $498 million, to $1.59 billion in 1999. Instead of earning $0.31 per diluted share in fiscal 1999, Cisco would have earned $0.24 under this method -- adjusted for a subsequent 2-for-1 stock split.
The tax treatment of the options has a lot to do with Cisco's current cash position, $4.6 billion, more than twice the cash hoard the company had amassed through the corresponding period a year ago.
How long can this virtuous cycle continue?
It will continue for as long as the nation's investor class and soft money merchants can maintain the necessary political consensus that allows America's most profitable companies to elude paying taxes.
With no changes to the accounting and regulatory rules that circumscribe the world that Cisco strides on top of, this trend will continue for as long as Cisco's employees have someone to whom they can sell their newly minted stock certificates.
Fourth, Cisco's extraordinary ability to generate cash has given its wholly owned subsidiary, Cisco Systems Capital, the ability to help existing customers buy and lease equipment from Cisco and, in some cases, become the vessels through whom Cisco creates an entirely new market for its products.
In March, Cisco Capital announced it would finance an upstart Chinese Internet service provider (ISP), Diyixian.com, which plans to spend approximately $130 million over the next three years to build a next-generation IP broadband network in China. Instead of taking a direct equity interest in the venture, Cisco structured the deal as a loan, with the right to purchase equity in the company at a later stage.
Cisco Capital gives Cisco not just another arm up in making sales, but potentially, another profit center within the company. General Electric (NYSE: GE - news) is probably the best example of a major industrial company that reaped immense profits by getting into the lucrative business of providing financing for a host of products that ultimately extended far beyond what GE itself offered.
But whereas General Electric built that capability by succeeding for more than 100 years, Cisco boosted its market cap to rarified levels, formerly reserved for GE alone, in the span of a decade.
Although the disruptive technology that is the Internet has much to do with Cisco's climb, the sheer force of Cisco's ascent and the powerful cash flow it now enjoys would not have been possible without the combustible combination of a bull market, favorable tax treatment and a huge national appetite for Cisco's stock.
That combination created the high-octane fuel that propelled the company and its stock price over the past five years.
The question now is, with 7 billion common shares outstanding, and hundreds of millions more waiting to be minted, how much gas is left in Cisco's tank.
Bottom Line:
Cisco's growth, and stock price, may be peaking. While it still enjoys a dominant presence in providing end-to-end Internet infrastructure solutions, the company may be hard pressed to repeat its meteoric five-year rise.
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