Are Dark Clouds Gathering Over Cisco?

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From: Ian Andrew Bell (
Date: Fri Sep 15 2000 - 18:24:53 PDT

Sorry all... video content on that first URL. But there's a growing
feeling in the media that Cisco may have realized their peak. IMHO,
analysts and reporters sitting on CNBC predicting poor stock performance
tends to be a self-fulfilling prophecy.

There are also a lot of signs from within Cisco that this is the case: ie.
the departure of Don Listwin (and probably more key execs that we haven't
heard about); fewer acquisitions; and stemmed growth plans.

Cisco is now far behind in Optical Networking (the flavor of the month),
having made the wrong strategic moves in this space. History will likely
record that a key error was in not acquiring Juniper prior to the IPO
(which, by all accounts, they had a shot at doing).

Everything significant about Cisco is driven by continued growth in the
stock price: employee retention, realization of value after acquisition,
and the power to form major alliances.

If that curve is gone then there will be chaos as employees (notoriously
underpaid and overworked, even by Silicon Valley standards) drive over each
other to leave the parking lot.

Moreover, whereas Cisco has typically recovered the cost of smaller
acquisitions through the attendant rise in stock value following the
announcement, the absence of this spiking activity will significantly
inhibit Cisco's ability to maintain its deal-making production line. Note
that Cisco's acquisition binge has slowed this year in line with its stock

Not good signs. Perhaps Cisco truly is the IBM of the '90s.



End Game for Cisco?
Senior research analyst: Luciano Siracusano

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) and Nortel Networks (NYSE: NT) 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
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

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

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) 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),, 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) 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


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