I N T E R E S T

Vol. 18, No. 17b

GRANTS
R A T E
Two Wall Street, New York, New York 10005 www.grantspub.com

O B S E R V E R
SEPTEMBER 15, 2000

Ciscos systems
Cisco Systems is not only the worldwide leader in networking for the Internetthe proverbial No. 1 seller of picks and shovels to the miners on Internet Mountainbut also a force for imagination and innovation in accounting. Generally accepted accounting principles it seems to regard as pedestrian and inexpressive. To tell its story in its own voice, a voice it knows Wall Street always longs to hear, Cisco has evolved its own reporting conventions. With a fiscal year that ended July 31, Cisco is even now putting the final touches on the year-2000 10-K report (expected to be out this week). Robert Tracy, of this staff, has made a study of Ciscos finances. It is a deep and complex subject, but not in the least obscure. Among U.S.-domiciled companies ranked by stock market capitalization, Cisco, as of last week, was second only to General Electric. For the disinterested analyst, the greatest mystery about Cisco is the connection (or the lack of one) between its financial results and its market cap. Any visitor from Planet Left Brain, not knowing the brilliant Cisco growth story, would be unable to reconcile one set of facts with the other. Thus, for instance, over the past half-decade, the stock price has climbedbut return on equity has plunged, paced by declines in operating margins and net margins. It would be asking a great deal of Wall Street to attempt a critical analysis of the financial performance of the corporation that, as much as any other, has lifted up the Nasdaq Stock Market by its bootstraps. Enter, therefore, colleague Tracy. The first order of business is to set the stage for the imminent major publishing event. Tracy has enumerated some of the dark spots that the 10-K might illuminate: Shareholders equity was bumped up by $6.4 billion, or 32%, from the third fiscal quarter to the fourth. We know that working capital was up $2 billion, investments were up $3.3 billion and other assets were up $1.1 billion. How did these assets get bumped up when net income was only $760 million? The cash-flow statement, it is to be hoped, will provide some guidance. Why are operating margins continuing to decline? Why is the other income line becoming an ever-larger component of the bottom line and, hence, masking a deterioration in operating margins? What are the other assets, and why have other assets on the balance sheet risen so much? Specifically, how much is attributed to minority investments in non-publicly traded companies?

40%

Five years of deteriorating Cisco margins

percentage change in margins for fiscal years ended July

40%

35

35

30

30

25

25

20

20

15

15

10

10

1996

1997

1998
net margin

1999

2000

operating margin source: The Bloomberg

article-GRANTS/SEPTEMBER 15, 2000

Ciscos ROE takes a header 35%

30

return on equity for fiscal years ended July

35%

30

25 return on equity

25 return on equity

20

20

15

15

10

10

1996

1997

1998

1999

2000

source: The Bloomberg

Whats behind the buildup in inventory (as measured by days of inventory)? Is there an increasing percentage of inventory attributed to finished goods and demonstration models? If so, what are the implications for average selling prices and operating margins going forward? Given the short life cycle associated with the product lines in the high-tech industry, is there a growing chance of some inventory write-offs? No doubt, the answers will be revealing, but Wall Street doesnt lack information; what it lacks is the motive to draw non-bullish conclusions from the information it already has in abundance. Thus, for example, the Cisco price-earnings multiple has climbed to about 160 from about 40 at fiscal year-end 1996, whereas ROE has fallen to about 10% from about 32%. Plainly, the stock market has found something to hang its hat on. One such handy object is evidently the black box called other income, which contains such items as realized gains from the sale of minority investments and return from fixed-income securities, both public and private. In the past four fiscal quarters, the percentage of pretax income attributed to these nonoperating sources has

vaulted to more than 40% from less than 15%. Possibly, this years stall in the Cisco stock price reflects that trend, among others. A dollar of nonoperating income is, or ought to be, less valuable in the stock market than a dollar of core earnings. Another word on income: While growth in net income according to GAAP has been nothing less than spectacular, growth in diluted earnings per share has been noticeably less so. Thus, in only the past yearfourth quarter

1999 to fourth quarter 2000the average number of diluted shares outstanding has climbed to 7.43 billion from 7.06 billion, dilution in the amount of 5.2%. Whereas Ciscos top line and bottom line (as defined) are objects of almost obsessive attention by investors, few pay heed to the balance sheet, possibly because there is little debt on it. Thats not to say there are no red flags, however. Inventories are rising, and finished goods and demonstration models constitute a larger share of the total than they used to (53% at the end of the third quarter, up from 48% in last years fiscal fourth quarter). Then, too, other assets have risen sharply. Here is another red flag, we think. Under the rubric other assets is listed goodwill (a sizable portion of which is written off as in-process R&D in the years of acquisition), intangible assets and investments in non-publicly traded companies. Cisco is famous for its investments in the builders of technologies which it deems to be complementary to its own. The real concern, notes Tracy, is how much of this balance represents investments in nonpublicly traded companies whose value is reported at cost but whose real value may ultimately be zero. How much of this balance has been driven by investments with tying agreements? (Asked

35%

Ciscos increasing reliance on other income

other income as a percentage of pretax income for scal years ended July

35%

30

30

25

25

20

20

15

15

10

10

1996

1997

1998

1999

2000

source: The Bloomberg

article-GRANTS/SEPTEMBER 15, 2000

The world according to Cisco

company accounting standards vs. GAAP
year ended July 31, 1999 1st qtr. 2nd qtr. 3rd qtr. 4th qtr.
Cisco diluted EPS* GAAP diluted EPS* Difference Cisco earnings growth GAAP earnings growth Difference
* as reported, not adjusted for splits and acquisitions

year ended July 31, 2000 years ended July 31 1st qtr. 2nd qtr. 3rd qtr. 4th qtr. 1999 2000
$ 0.24 0.13 84.6% $ 0.25 0.23 8.7% $ 0.14 0.09 55.6% 55.56% 0.00 55.6 $ 0.16 0.11 45.5% 60.00% 37.50 22.5 $ 0.36 0.29 24.1% $ 0.53 0.36 47.2% 47.22% 24.14 23.1

$0.17 0.15 13.3%

$0.17 0.08 112.5%

$0.09 0.09 0.0%

$ 0.10 0.08 25.0%

41.18% 47.06% -13.33 187.50 54.5 -140.4

about vendor financing, Blair Christie, Ciscos investor relations manager, replied that the company does not and would nottake an equity stake in a company in exchange for the sale of Cisco products.) Not the least of Ciscos triumphs is its mastery of the genre of the corporate earnings announcement (a point ably made by Bill Alpert in last weekends Barrons). While the 10-Q and 10-K do disclose GAAP financial statements, Tracy notes, those are not the numbers that Cisco hypes to the press and public. Rather, Cisco ignores official GAAP standards and, instead, has developed its own accounting standards that it believes more accurately reflect the performance of Cisco (and, coincidently, add more lilt to the stock price). Earnings per Cisco standards are GAAP earnings excluding in-process

R&D, payroll tax on stock options exercised, acquisition-related costs, amortization of goodwill and intangible assets and gains realized on minority investments, Tracy continues. Quarterly announcements are always made first and foremost in Cisco standards, with the appropriate disclosures eliminating the items that those pesky GAAP accountants want. After the announcement in Cisco standards has sufficiently whipped investors into a frenzy, Cisco releases, at the bottom of the page, the old-economy (and really meaningless at this point) GAAP standards. The accompanying table highlights the difference between Cisco standards and GAAP standards. On almost every sighting, Cisco standards are more flattering to Cisco than GAAP standards, as a trainee might have pre-

dicted. (By the way, Tracy has found, the deterioration in Ciscos operating margin is evident even in the Cisco standard presentation format: to 26.15% in the fiscal year just ended from 34.2% in fiscal 1996.) One word of warning, Tracy winds up. Even when in compliance with GAAP, Cisco has been very aggressive in its GAAP reporting. Using both stock and cash, Cisco has been a prolific acquirer of other companies, sometimes accounting for the combination under the pooling method. At other times, when accounting for the acquisition as a purchase, Cisco has liberally used in-process R&D write-offs, effectively eliminating tremendous amounts of overhead from future costs. The 10-K of Americas second most valuable company ought to provide excellent, even riveting, reading.

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