Troubles in the Tech Sector Threaten Us All

April 24, 2000

Cisco Systems is one of the world's most successful companies. You may not own it, and I don't suggest you buy it. But you should know what is happening to this company if you really want to understand what the market has in store. Cisco's story is told a thousand times over, and if this strong company is vulnerable, the lesser lights of the New Economy are that much more precarious.

Cisco has the dominant manufacturing stake in hardware that has made the Internet's explosive growth possible. But its shares are dangerously overpriced at current levels and vulnerable to collapse if boom times should end.

Seventeen years into the most powerful bull market in U.S. history, no stock has outperformed Cisco. If you had invested $1,200 in Cisco when it went public in March 1990 you would be a millionaire today. Adjusted for 10 splits that have created 288 shares for each original share, the stock has soared from $0.08 to $68.

This is no fluke. You could even argue that long-term investors should hold no stock other than Cisco in their portfolios. The company is so well aligned with the forces that have driven the U.S. economic boom since the mid-1990s it has to be a winner. Quite a few analysts say just that.

Yellow Flags on Cisco's Happy Numbers

It's ironic, then, that Cisco, a company making the hardware and software that is supposedly driving the U.S. productivity boom is so unproductive itself. Its output per worker is pathetic. Worse, its productivity has been falling, as a look at the company's latest quarterly earnings report will confirm:

 

Cisco Earnings Report Gross Per Share (in millions) 2/8/00
  Q4 YoY Q3 YoY gain gain
Net sales $4,350 $2,845 52.9%
Total operating expenses
Operating income
Interest and other income, net
Income before provision for income taxes
Provision for income taxes
Net Income
1,640
1,174
120
1,294
388
906
1,030
8274
791
906
297
609
59.2%
42.0%
51.9%
42.8%
30.6%
48.8%

Did you spot the yellow flag? Operating expenses are rising faster than any other item on the balance sheet, racking up year-over-year gains of 59.2% . In fact, these expenses are going up 41.1 % faster than operating income.

Cisco may have some of the best and brightest workers in America. But at what cost?

The answer—when you include the company's extravagant stock option giveaways—is an astounding $750,000 per employee. That would be a bargain if each of the company's employees were responsible for, say, $1.5 million of revenues. They aren't. Cisco's workers generate less than $600,000 of revenue apiece. Considering the operating expenses, that amounts to a bottom-line loss of $150,000 per employee.

Even more ominous in the recent earnings report is the seemingly innocuous line item pertaining to Cisco's taxable income. From one year to the next, Cisco's net sales grew 52.9%; however, the provision for income taxes was up 30.6%.

The employee stock options give Cisco a great deal of leeway in juggling its taxable income. Without this freedom, Cisco's tax rate might have remained unchanged. If so, its income per diluted share this last quarter would have been 24 cents -- virtually equal to the previous quarter's figure. Take the options away, and you can see that Cisco's quarterly earnings were flat for the first time in its history!

Cisco is hardly alone in this. The whole hi-tech industry lures its workers with cheaply printed stock options then uses them to sweeten the reported bottom line. The difference between Cisco and the lesser lights rest is that Cisco actually does have some earnings to report, even if their growth is not as high as advertised. A sensible person might expect astute investors to question this practice…

Mobs Are Quiet While They're Eating

But don't look for angry investors to storm the next Cisco shareholder meeting in protest, for there are no angry shareholders. How could there be in a stock whose price has more than doubled in each of the last three years. And the financial press has kept the illusion going. When the last quarterly reports came out, for example, The Wall Street Journal headline boomed the news that Cisco had topped analysts expectations by nearly tripling its net income. It did, but a closer look at the numbers reveals a problem the Journal downplayed.

This impressive boost was not due to higher earnings this year, but to huge charge-offs a year earlier. By comparison to the 8 cents per share earnings after charge-offs in last year's fourth quarter, this year's 23-cent per share earnings look fantastic. Technically this is not fraud, but calling it triple-time growth omits a significant piece of the story.

To understand how absurdly overpriced Cisco and many other stocks have become, it may be instructive to look at the concept of present discounted value. PDV is the bottom-line calculation for lenders when they set the interest rates on bonds. They usually ask two questions before doling out money: (1) How risky is the borrower? and (2) For how long will the cash be used?

Equity investors are concerned about these things too, but they expect a payoff in higher share prices, perhaps augmented by dividends. Until recently, it was assumed that the PDV of a publicly traded company's dividends would exceed, or at least equal, the risk-adjusted returns on alternative debt instruments like bonds.

Not anymore. Dividends have nearly reached the vanishing point for the market as a whole, and supposed growth engines such as Cisco don't even pay them. Cisco's share price is based entirely on expectations of continued growth in the company's revenues. It's a misplaced hope.

True, Cisco's telecommunications hardware is nearly as pervasive as the Internet itself. But its very success has drawn vast amount of investment capital -- and competition -- into the network hardware business. The result has been an explosion in bandwidth capacity that will take years absorb.

This change is analogous to the burgeoning of Pentium-based computers during the last five years. Desktop units have gotten so cheap and powerful that nearly every company in America that uses computers has sufficient processing horsepower to handle its data needs well into the next decade.

This is not speculation, by the way. Dell's shares peaked at $55 in early 1999 and have languished ever since at prices 30% to 40% below that level. Before then, Dell's revenues had been growing even faster than Cisco's. Even world-class efficiency in manufacturing and sales can't defeat a market with drowsy buyers.

Who's Got the Bandwidth? … and Who Cares?

Cisco faces a similar crunch, although it has yet to be reflected in the price of the company's shares. Why not? Simply because no one really knows how much bandwidth has been put in place, let alone how much the world needs.

Until about a decade ago, it took no special genius to see a recession brewing: All one had to do was observe the build-up of new cars on the auto lots. But how does one "count" data carrying capacity? Even for telecommunications experts, the bottom line may be beyond reckoning.

But some of Cisco's biggest customers -- Old Economy biggies including the banking behemoths and the airlines -- have been upgrading their telecommunications infrastructure for several years. Now they probably have sufficient data pipeline in place to meet their needs for years to come.

Do Wall Street's analysts know this? Arguably not. If they did, they would realize that the demand for bandwidth cannot continue to grow exponentially. Many of the world's biggest companies -- Cisco's customers -- do not require all that much carrying capacity. They transmit data files mostly. And it should be obvious that even such a huge company as United Airlines will not grow its output of data files at an exponential rate. Relative to the explosion in bandwidth, their data transmission needs are slowing.

Admittedly, Cisco also does a huge business with companies that are building the world's telecommunications infrastructure -- firms like Nortel, Lucent, Sprint, MCI WorldCom, Quest and Global Crossing. But even here the news is bad. The revenues for two of the biggest -- MCI WorldCom and Sprint -- have flattened out over the last several quarters. In fact, they have fallen below the GDP growth rate.

Beyond that, bandwidth purveyors have begun to cannibalize each other. Phone companies, TV cable companies and Internet service providers are all competing to offer the same services, albeit by using different portions of the bandwidth spectrum. And for every company that has spent $100 million creating digital subscriber lines to deliver high-speed modem service, there is a TV cable operator looking for a way to service the same businesses and households. Both are looking over their shoulders at satellite broadcasters, and at the threat of obsolescence from technologies that are still in the laboratory or the venture stage.

All things considered, shareholders should be growing increasingly queasy as Cisco hovers within spitting distance of all-time highs.

Cisco is a bellwether for the high tech sector as a whole. And that should concern you. As the stock market's strength continues to narrow, this one company's shares are increasingly having to shoulder the burden of Wall Street's dreams. When the mass of investors awaken one day to the subtle erosion in the company's prospects, Cisco stock will be trading at half its current price or lower. Its less fortunate competitors will be in even worse shape.

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