From: Adam Rifkin (Adam@KnowNow.com)
Date: Mon May 14 2001 - 20:53:54 PDT
[How do you lose two and a quarter billion bucks? Oh, the humanity! -- A.]
http://news.cnet.com/news/0-1004-200-5867112.html
Cisco's $2.25 billion mea culpa
By Larry Barrett
Special to CNET News.com
May 9, 2001, 4:15 p.m. PT
update Cisco Systems got greedy. And now it's paying the price.
On Tuesday, the network-equipment giant provided the grisly details behind
its astonishing $2.25 billion inventory write-off in the third quarter,
essentially admitting that it too was caught up in the Internet hype that,
at its peak, gave the company the highest market capitalization in Wall
Street history.
"The networking industry, having no experience with a downturn and never
having to deal with double or triple ordering, responded to high order
patterns with higher build rates and substantial inventory accumulation to
facilitate the projected shipping rates," said Needham & Co. analyst Tad
LaFountain. "As a result of what has transpired, network equipment
management might consider looking beyond the car in front of them as they
speed down the information superhighway."
As Cisco executives can now tell you, pileups on the road or in the
warehouse can be extremely painful.
Shares in the company were down $1.25, or 6 percent, to $19.13 by market
close.
To keep up with the frenetic pace of network-equipment orders during the
Internet's heyday in the mid- and late-1990s, Cisco placed big orders for
communications chips, optical lasers and subassembly boards from its
suppliers.
But the wicked combination of the dot-com implosion and the deteriorating
economic conditions in the United States and abroad finally caught up with
the world's largest data networking equipment maker, causing sales to
decline at an astonishing rate and leaving Cisco with billions of dollars in
equipment and materials that it couldn't sell and likely won't be able to
sell in the next 12 months.
In its earnings warning in mid-April, Cisco executives told its investors to
expect a $2.5 billion inventory charge, an all-time record for the
information technology industry. At the time, it said it would store the
excess inventory in warehouses and continue to monitor demand in the next
year in the extremely remote chance it might be able to unload it if
business conditions improved.
The magnitude of the charge and the company's reluctance to provide details
about which product lines it would jettison gave rise to much speculation
from industry and financial analysts who were wondering how a company could
misread the market by more than $2 billion, roughly the same amount it
earned in the first two quarters of the fiscal year.
The good news? Cisco's actual third-quarter inventory charge was $2.25
billion, lower than its previous forecast.
On Tuesday, Chief Financial Officer Larry Carter said the company plans to
"scrap and destroy" the majority of the inventory because most of it "can't
be sold because it was custom-built for Cisco."
Parts that aren't destroyed will be sold to recycling companies that salvage
metal components and resell them to brokers or other distributors.
Carter repeatedly stated that if demand for some of this equipment suddenly
improves, it's conceivable the company will sell some of the excess
inventory, but it will not have a favorable effect on the company's pro
forma results or gross profit margins in subsequent quarters.
"We don't anticipate that any of the inventory will be used based on our
current forecast," he said. "We will be very open about our treatment of
this inventory and disclose its status in future conference calls."
What's in the charge?
An inventory charge occurs when the market value of the finished goods or
components falls below the original cost. For example, if Cisco bought a
part for $500 and that part is now worth only $50, the company would have to
take a charge of $450 for that particular item.
The actual inventory charge for the quarter came in at $2.25 billion with
roughly 70 percent derived from its service provider business and the
remaining 30 percent from its enterprise and commercial businesses.
* Eighty percent of the charge came from raw materials and 20 percent was
from work in process.
* Work in process, which primarily consisted of subassembly boards, checked
in at $450 million.
* Of the raw materials, $300 million of the charge was related to memory
products, specifically DRAM, SRAM and flash-memory chips.
* Optical equipment, including lasers and modulators, represented $450
million.
* Electro-mechanical equipment accounted for $150 million.
* Non-memory components, including digital signal processors and other
microprocessors, checked in at $900 million.
Cisco Chief Executive John Chambers said sales in the fourth quarter will
likely be "flat to down 10 percent" from the $4.7 billion the company
recorded in the third quarter. And it exited the quarter with more than $1.9
billion in inventory on hand.
Craig Johnson, an analyst at The PITA Group, a networking research firm,
bashed Cisco and its management team earlier this quarter, saying the
company dug its own grave by believing its own hype and not preparing for a
slowdown.
"There were signs last summer from Nortel and Lucent that this market was
ready to crash," he said. "In the end, this just proves that the technology
industry is just as cyclical as any other despite what everyone kept telling
themselves in the past few years."
Accounting semantics
Though Cisco turned a pro forma profit before charges of $230 million, or 3
cents a share, in the quarter, it still posted a net loss of $2.69 billion.
Bill Becklean, an analyst at SunTrust Equitable Securities, said Cisco's
third-quarter results offer a textbook example of how Wall Street and
accounting practices have changed in the past 10 years.
"In years past, these charges would have been given much more weight," he
said. "But that's not what the Street does anymore. No one's going to stand
up and say Cisco's accounting methods are screwy. This is simply how things
are done these days."
LaFountain was even more candid, saying the Cisco write-off is just the
latest example of how companies are using pro forma accounting practices to
distract investors from the poor business decisions made by management.
"What everyone is missing here is that Cisco's inventory is not the problem,
but a symptom," he said. "A company that has been preaching to the choir
about the capacity of its management has proven it isn't perfect. Good
management doesn't wind up with a ($2.2 billion) inventory write-off."
In a research note, LaFountain said Cisco and other networking companies got
into trouble by building products based on sales forecasts. When
build-to-order becomes the norm, these inventory issues will clear. Cisco
has never seen a downturn and doubled and tripled ordered components based
on a shortage of components.
Other analysts were more forgiving.
"Cisco got nailed by a double whammy," said Seth Spalding, an analyst at
Epoch Partners. "They were ordering chips and other components that they
couldn't get enough of when the market was booming. When they finally got
what they needed, the market completely dried up."
Spalding said he was surprised investors were willing to look beyond the
huge inventory charge, adding that he valued the stock at around $10 or $11
a share.
Cisco shares closed up $1.11 to $20.36 ahead of the earnings report before
falling to $19.50 in after-hours trading Tuesday evening.
Looking ahead
Analysts agree that by taking this huge inventory charge, Cisco not only
will improve its own profit margins in future quarters, but will give its
component suppliers an indirect lift.
"Now they can start building their new equipment at higher margins, and
they'll be ordering it from the suppliers who have seen their sales collapse
in the past few quarters," Spalding said.
Morgan Stanley analyst Christopher Stix upgraded the stock from a "neutral"
rating to "outperform" ahead of the earnings report, saying he has received
more "encouraging feedback" from checks with Cisco's business customers that
point to a stabilizing business.
In a research note, he said that two new contracts with service
providers--China Telecom and Global Crossing--also indicate that the
company's core router business is picking up speed.
Nikos Theodosopoulus, an analyst at UBS Warburg, said Cisco and its
shareholders learned a painful lesson from the inventory write-off.
"Now they can reset the bar from a gross margin standpoint, meaning the
recovery in their core business will be quicker than if they hadn't taken
the charge," he said. "On the other had, they have to live with the fact
they took a big gamble that didn't pay off."
---- Adam@KnowNow.ComI can always sleep standing up. -- REM, "The Sidewinder Sleeps Tonight"
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