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Ouch!

Cisco’s been reeling since this came out yesterday. It’s a brutal slamming of Cisco’s print-your-own-money acquisition strategy. There’s a Silicon Valley saying that if Cisco’s stock ever drops below %20 they’ll be killing each other trying to get out of the parking lots along Tasman Drive.

I have personal experience with the “House of Cards”, and for me the place was so miserable that even the prospect of lifelong wealth didn’t at all encourage me to stay. Imagine what happens when the stock collapses?

Cisco hasn’t done a good job of integrating recent acquisitions. The TDM guys just don’t get along with the IP guys, the switching guys hate the routing guys, and the business units are all trying to eat each others’ lunch. Also, 80% of Cisco’s revenues still come from less than 20% of its product line — curiously the same stuff they’ve been selling for the last 6 years.

Is Cisco a good investment? Who knows anymore. But it’s clear that the blush is gone and now they’re going to have to prove to the Street that they can make some of these new acquisitions stick, and retain their employees.

-Ian.

>From: “McColl, Matthew”
>To: “Ian Bell (E-mail)”
>Subject: FW: DJN BARRON’S: Cisco’s Bids: Its Growth By Acquisition Will Po
> se P roblems
>Date: Mon, 8 May 2000 19:06:42 -0600
>X-Mailer: Internet Mail Service (5.5.2650.21)
>
>
>Have you seen this article? What are your thoughts?
>
>
> DJN BARRON’S: Cisco’s Bids: Its Growth By Acquisition Will Pose
> Problems
>
>Symbol: CSCO
>Industry: CMT TEL
>Subject: BRN DJN DJWI ANL CAC FNC PRO STK WEI
>Market Sector: MMR TEC TPX
>Geographic Region: CA NME PRM US USW
>Product/Service: DAR DTE
>
> By Thomas G. Donlan
> Is it possible not to love Cisco Systems? The most successful company in
>the hottest sector of the Internet economy, it provides routers, switches and
>thousands of other products that power the communications revolution. The
>San Jose-based company enjoys revenue growth of more than 50% every year. At
>the peak of its share price, it boasted the greatest market value in the
>history of Wall Street — nearly a half-trillion dollars, almost all of
>that wealth created in the past five years. At the moment Cisco is second
>only to
>General Electric in market value.
> How does Cisco do it? It is a great engineering company, brilliantly
>managed and technologically astute. But for the full story of Cisco’s
>success,
>it’s
>important to realize that Cisco is a great financial-engineering company as
>well, and therein lies a host of dangers.Growth is at the center of both
>engineering stories.
>More than any other successful high-tech company, Cisco has grown by
>acquiring
>other companies.
>How it chooses those companies defines its corporate strategy. How it
>integrates
>them into the
>Cisco empire defines its corporate politics. How it retains the people
>acquired
>with the companies
>defines its corporate culture.
>Cisco is a modern house of cards, in which the cards are Cisco stock and
>the companies acquired for Cisco stock. Indeed, Cisco stock has all the
>trading
>power that a boy in the 1950s would have had if he could print his own
>Mickey Mantle rookie cards. Beyond routers, switches, software and services,
>that’s
>what Cisco does for a living: It prints its own trading cards.
> After a recent split, there were about 7.0 billion Cisco shares
>outstanding,last week worth more than $67 3/4 each.
> At 67, Cisco shares sell for 190 times the company’s 35-cent-a-share
>earnings in the fiscal year that ended July 31, 1999. The price is 130 times
>Street estimates of 52 cents a share for this fiscal year, and 100 times the
>estimate of 67 cents for fiscal 2001.
> Cisco earnings, by the way, are remarkably predictable: The company has
>beaten the Street estimate by a penny per share for eight consecutive
>quarters. Cisco attributes its accuracy to its high-tech accounting system,
>not to any legerdemain. Its next quarterly report is scheduled for release
>on Tuesday.
> Such enormous P/E ratios make for powerful trading cards, and Cisco has
>used its stock to make acquisitions valued at more than $30 billion.
> Though questions have arisen about both the price and the earnings side of
>Cisco’s P/E ratio, the prices Cisco pays for other companies validate the
>prices of its previous takeovers and its own still-sky-high price, despite a
>recent tumble. The latest example is Cisco’s acquisition of the “intelligent
>Web switching” company ArrowPoint Communications, announced on Friday. Cisco
>paid about 90 million of its Mickey Mantle cards, shares valued at about
>$5.7 billion, for a company whose market cap a week earlier was $3.67
>billion
>and
>which went public March 31 at a price that valued the company at about $1
>billion.
> Cisco has accelerated its acquisition budget every year, just as its
>revenues have shot up and its stock has done the same. The three things are
>so intertwined, in fact, that if any one of them falters, as the share price
>has been doing, the other two are likely to stumble as well.
> Typically, Cisco acquires a company developing a new technology a year or
>so before its first product goes on the market. Cisco uses the year to
>incorporate the acquired company’s product into its own product line. Then,
>instead of being the product of an unknown startup, it carries the full
>faith and credit of the leading company in the industry, one that dominates
>at
>least 15 market segments and sells 80% of the gear that runs the Internet. A
>successful takeover goes from negligible revenues as a private company in
>the year before joining Cisco to sales of several hundred million dollars
>two
>years later.
> Interestingly, Cisco’s success and market share have not attracted the
>trust-busting interest that Microsoft’s did. For one thing, Cisco sells no
>consumer products and is therefore almost invisible, politically. For
>another,where Microsoft’s Bill Gates is hyper-competitive, Cisco’s CEO John
>Chambers
>is famously ingratiating. Where Microsoft might demand that a little company
>sell out or be squashed, Cisco would keep bidding until the target falls
>happily in love.
> Cisco’s story began in 1984, when two computer specialists employed by
>Stanford University, Sandy Lerner and Len Bosack, decided to do something
>about the inability of computers at the business school to communicate
>directly with computers at the engineering school. They cobbled together
>existing network hardware called routers, modified existing software, and
>used existing Internet protocols to create a cheap, easy-to-use solution for
>their communication problem, which would become a solution for the world’s
>communication problems.
> In 1984, there were about 1,000 host computers connected to the Internet,
>and 99.9% of the world’s people did not know they had a communications
>problem. Those who did beat a path to Lerner and Bosack’s door.
> The two married and began making customized routers in their home. They
>raised capital on their credit cards and were profitable from the start,
>eventually hooking up with a venture-capital firm before, in 1990, bringing
>the company public at $18 a share. A short time later they were forced out
>by the management their backers had hired, and they divorced soon after.
> In 1993, Cisco was a one-product company, making nothing but routers. But
>that year one of Cisco’s big customers, Boeing, said it was going to build
>local area networks that would use not routers but switches, a type of
>communications computer different from anything Cisco made, and buy them
>from Crescendo Systems.
> CEO John Morgridge and John Chambers, a sales executive he was grooming
>for the top job, concluded that if the customer wanted switches, not
>routers,
>and wanted them right then, it would be necessary for Cisco to be a network
>company, not a router company. Cisco bought Crescendo for $95 million in
>stock.
> Over the next three years, Cisco would buy six more switching companies,
>including the $4.0 billion acquisition of StrataCom in 1996, which was then
>the largest purchase in the history of Silicon Valley.
> Counting the six networking companies, Cisco acquired one company in 1993,
>three companies in 1994, four companies in 1995, and seven in 1996. It
>picked
>up six more companies in 1997, nine in 1998, 18 in 1999 and has bought 10 so
>far this year, for a total of 58 acquisitions. Says Ammar Hanafi, Cisco’s
>director of business development: “Doing acquisitions is now wired into the
>DNA of the company.”
> Cisco is also a major venture-capital investor, pumping about $200 million
>into startups last year. Its portfolio of investments in companies that are
>still independent is worth about $3 billion on a cost of $400 million, he
>says.
> Beyond routers and switchers, Cisco also has acquired software and modem
>companies. It has picked up companies with software and other technology for
>IBM network equipment. Beginning in 1997, Cisco’s takeover emphasis shifted
>to the telephone network and the range of new gear for digital subscriber
>lines.
>No longer just a network company, Cisco reconceived itself as a
>communications infrastructure company.
>
> From there, Cisco acquired more advanced Internet technology and optical
>switching technology, maintaining its dominance in Internet gear. Last
>year’s $6.9 billion acquisition of Cerent Corp. underscored its
>determination to
>have the latest and best data transmission equipment, even in the face of
>competition from newer rivals such as Juniper Networks and Foundry Networks.
> Last year and this year, Cisco has extended its acquisition emphasis
>again.
>Its latest targets are telephony over the Internet, data over cable TV
>lines,wireless data networks and, for the first time, the specialized
>computer
>chips that make all the routers, switches, networks and phone systems fast
>and
>powerful.
> For a hint of how important acquisitions are to Cisco, consider these
>numbers: In the past three fiscal years, Cisco spent $3.3 billion on
>research and development internally and recorded an additional $1.5 billion
>in
>purchased research and development.
> Unfortunately for Cisco, the success bred by its acquisitions carries with
>it the seeds of self-destruction. As the company bids higher and higher for
>its targets, it drives up the market for all telecommunications-equipment
>companies — including Cisco itself. Acquisitions come harder and higher.
> Once upon a time, takeover artists looked for companies with shares
>trading far below the value of total corporate assets. Today’s takeover
>artists
>at
>Cisco and other such companies can’t do that. They are not buying assets,
>they are not buying products. They are not buying profits and they are not
>even
>buying revenues. They are buying people and half-formed technology that the
>people may someday turn into products generating revenues, profits and
>assets.
> Cisco’s takeover specialists run a risk: They must buy the right
>companies, with the right people, developing the right products for a market
>that may
>not exist for years after the deal is done.
> How well does Cisco do with its acquisitions? Very well, it says. One
>target company that had $10 million in revenues at the time of acquisition
>provided
>Cisco with technology that now generates more than $1 billion of revenues.
>But not all acquisitions are so successful, and for most of them, it’s hard
>for
>an outsider to gauge success.
> But Cisco does make it clear how high its hurdles are. The company has
>said it expects eight out of 10 investments to be successful.
> Until recently, Cisco accounted for most of its acquisitions through
>simple purchase accounting. More recently, however, it has made several
>acquisitions for prices that are astronomical even in this era of infinite
>price-earnings
>multiples, and accounted for them by the pooling-of-interest method. If
>these companies had been acquired for those prices with purchase accounting
>and
>entries for purchased R&D, Cisco’s reported earnings probably would have
>vanished in 1999.
> Pooling distorts earnings by failing to reduce them with amortization of
>goodwill and similar adjustments. And pooling can dilute the interest of
>shareholders. If Cisco issues 100 million shares of stock (before a recent
>2-for-1 split) worth about $6.9 billion to take over Cerent, a private
>company with $10 million of sales, stockholders ought to ask if the acquired
>outfit
>will be worth giving its owners roughly 3% of Cisco. It’s hard for anyone to
>imagine anything Cerent could do for the company to justify the dilution
>inherent in Cisco’s pooling-of-interest acquisition.
> Even with Cisco’s market cap of 39 times revenues, Cerent ought to have
>$176 million of revenues to join the Cisco family on a basis that’s
>equitable to
>Cisco’s existing shareholders. And if Cisco’s price should ever fall from
>here, the disparity would be worse.
> Friday’s acquisition of ArrowPoint should leave investors asking the same
>question. Cisco is issuing about 90 million post-split shares, with a market
>value of $5.7 billion, to acquire a company that had negative book value,
>has never earned a profit and had sales running at an annual rate of $40
>million.
>Applying Cisco’s revenue ratio, ArrowPoint ought to have sales approaching
>$146 billion.
> The Financial Accounting Standards Board has proposed doing away with
>pooling-of-interest accounting. FASB says investors can be confused if two
>equally sanctioned accounting methods produce vastly different valuations.
>Last week Congress held a hearing on the proposed ban, and Cisco officials
>joined executives of other high-tech companies in opposing it. They said it
>would make it more difficult to do mergers that apply the capital of
>established firms to the technology of new companies.
> Cisco fans seem anything but confused by Cisco’s reported earnings. They
>have awarded Cisco a share price that’s about 190 times reported fiscal 1999
>earnings. Yet there are serious questions about the quality of earnings at
>Cisco and other communications-equipment vendors.
> In order to close their deals, they are giving generous financing packages
>to their customers — sometimes to customers whose ability to pay ought to
>be more closely explored. Cisco failed to return calls on the question
>before
>press time, but it acknowledged in a footnote to its most recent quarterly
>report that it is experiencing increased demand for vendor financing, and
>has taken on increased risk as a result. The company does not fully disclose
>the
>extent of its vendor financing. A close reading of footnotes in the annual
>report shows that “net investment in leases,” a form of vendor financing,
>rose from $190 million in fiscal 1998 to $500 million in fiscal 1999, but
>fell
>again to $212 million at the end of the second quarter of fiscal 2000.
>Deferred revenues, which include accounting for deliveries where collection
>is questionable as well as other less problematic items, rose to $724
>million
>in fiscal 1999 from $339 million in fiscal 1998, and were not broken out in
>the
>quarterly statement.
> The company’s P/E alone should give investors pause, even though analysts
>strain to justify it. No established company has ever traded at such a high
>multiple and failed to come a cropper in the end — especialy not an
>established company with such predictable earnings.
> If Cisco sold at the multiples of its competitors, investors would be
>shocked. If the market valued $1 of Cisco’s earnings the way it values $1 of
>Nortel’s earnings, at a multiple of 100, Cisco stock would be selling for
>$35 a share. If it could command Lucent’s multiple of 46, Cisco’s share
>price
>would be around $16.
>
> How much does a company have to earn over the next 10 years to warrant a
>multiple of 190? By the old-fashioned one-to-one rule of thumb, matching the
>growth rate with the P/E ratio, earnings would have to grow 190% a year.
> Even bullish analysts do not believe that Cisco’s profits will even double
>from fiscal 1999’s $2.5 billion, much less that they will do so every year
>for more than a decade. If they did, the analysts would have to believe that
>Cisco’s existing businesses will produce profits of $2.5 trillion in 2010.
>If they believe that, then they should consider selling every other company
>in
>their portfolios, because a company that earns $2.5 trillion in 2010 will
>have taken over half the world. Of course, a company that successful will
>probably sport a P/E ratio way above a mere 190 times earnings, and it will
>be
>able
>to take over half the world for stock.
> Another question worth asking produces a different answer: If a
>hypothetical long-term investor buying Cisco at 67 3/4 at the end of last
>week
>were
>seeking what some bullish analysts expect, about 35% a year in price
>appreciation,
>what would the stock be selling at in 2010?
> Answer: $1,300 a share. At a multiple of 190 times earnings, Cisco would
>be making around $6.80 a share, or about $47 billion. That’s hefty, but a
>far
>cry from $2.5 trillion, the kind of earnings the P/E ratio implies.
> The absurdity of such speculation points up the ultimate impossibility of
>Cisco’s acquisition binge: It can’t go on forever. It also points up Cisco’s
>utter dependence on continuing an everincreasing string of successful
>acquisitions.
> —
>SHAREHOLDER DATA
>
>Market Value $495.6 bil.
>Shares Outstanding 6.94 bil.
>Insider Net Buys
>(shrs. Latest 6 mos.) 1.16 mil.
>Average Daily Volume 44.5 mil.
>Institutional Holdings 57%
>
>DIVIDENDS
>
>Current Rate None
>Current Yield None
>
>KEY DATA
>
>Profit Margin 17.1%
>Return on Common Equity 15.5%
>Return on Total Assets 14.2%
>Revenues to Assets 70%
>Debt to Equity 0%
>Current Ratio 2.0
>Business: Communications technology
>Headquarters: San Jose, California
>Recent Stock Price: 67 1/2
> —
>SNAPSHOT
>
> 1999 1998 1997 1996
>
>EARNINGS* $0.38 0.30 0.23 0.16
>(Per share)
>
>REVENUES $12.2 8.5 6.5 4.1
>(billions)
>
>NET INCOME* $2,096 1,355 1,051 913
>(millions)
>
>BOOK VALUE $1.78 1.14 1.06 0.48
>(Per Share)
> (END) DOW JONES NEWS 05-06-00
> 01:51 AM
>End of News

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