Cisco may gain from old inventory

When Cisco Systems reports its second-quarter results on Wednesday, one thing to watch for is whether it will boost the bottom line by bringing inventory back from the dead. In November, Cisco reported first-quarter results that topped estimates, but the networking giant disclosed that an "excess inventory benefit" helped pare its net loss under generally accepted accounting principles (GAAP). Cisco reported a net loss of $268m in the first quarter, but it could have been twice as ugly if the company hadn't gained $290m from selling or using inventory that it had previously written off for dead. Cisco excluded the inventory benefit from its pro forma earnings. Pro forma earnings are closely followed by Wall Street and form the basis of most analyst estimates. The company did nothing improper, and its results have been certified without qualification by PricewaterhouseCoopers. But in taking the inventory benefit, Cisco flip-flopped from its previous stance, which was that it wouldn't use inventory that was written off. This quarter, a similar accounting move could draw scrutiny by investors who demanded accounting clarity after Enron's implosion. Here's what happened: Last May, Cisco Systems took a $2.25bn inventory charge in its fiscal third quarter. The charge was designed to clear out liabilities, and Cisco told analysts that the company had no intention of later taking the products out of inventory and using them to boost net income. During its third-quarter conference call, chief financial officer Larry Carter said Cisco's outlook didn't account for inventory benefits in the future. Carter said chances of the inventory being reused in the future were slim, and he noted that the company planned to "scrap and destroy" most of it. However, Cisco did rummage through the $2bn scrap heap and found some parts worth using. The company's garage sale was noted by few analysts, many of whom have been telling investors to focus on the future. Nevertheless, a few Cisco analysts are carefully watching to see whether the networking giant once again boosts its quarterly results by using gear previously declared obsolete. "I'm sure they're going to leverage it until it's gone," said Craig Johnson, an analyst with the PITA Group. "From a pure business perspective it makes sense. Some of the inventory was custom, but there are DRAM chips and all this other stuff that can still be used." Cisco did not respond to calls inquiring about the inventory benefit. In regulatory filings, Cisco disclosed that it auctioned off $4m in inventory, used $234m in products or research and development and settled $52m in purchase agreements. Analysts said the inventory benefit goes straight to the bottom line and boosts margins. Since the inventory has been written off already, it's essentially free. While Cisco's inventory benefit from the first quarter went largely unnoticed, a repeat performance is likely to get more attention. Merrill Lynch analyst Samuel Wilson said he expects the company's inventory benefit will be "less than $100m" in the second quarter. Many analysts say Wall Street is suffering from a severe case of "Enron-itis," where companies with aggressive accounting get unwanted -- and some say unwarranted -- attention. Given the accounting problems and subsequent bankruptcy of energy trader Enron, once the seventh-largest company in the United States, investors are increasingly skittish about any earnings statement that uses pro forma accounting. Pro forma accounting was popularised by dot-com companies, which regularly reported earnings results that excluded items such as stock options and income taxes. Because there are no rules governing pro forma results, companies often exclude a host of items usually considered expenses under GAAP. Wall Street analysts say pro forma results give investors a better look at the operations of a company, but critics note that it causes ambiguity and say GAAP is more reliable. "There is not a body of literature governing pro forma," said Robert Swieringa, Dean of Cornell University's Johnson Graduate School of Management. "GAAP is a set of rules and guides used to measure assets and liabilities." Swieringa said the pendulum is swinging back to GAAP accounting now that the Enron meltdown has made Wall Street skittish. "When things are going well, little attention is paid to the details," he said. "People are now looking at the footnotes." Indeed, shares of Electronic Data Systems, WorldCom and other companies have been whacked by investors over accounting worries. Recent turbulence in the stock market has largely been attributed to accounting concerns. And fund managers are looking closely at companies such as Cisco that have made many acquisitions to gauge whether there are any accounting time bombs. Lawrence York, fund manager for the WWW Internet Fund and a Cisco shareholder, said his analysts have been poring over Cisco's accounting, not necessarily because he distrusts the company, but because there may be something that may spook big mutual fund companies. "We're in a period where people are reacting in ways that are more emotional than analytical," York said. "Mutual funds that have any questions about a company's accounting are erring on the safe side and selling." York said he believes Cisco's accounting is above the board and said he may add to his position if there's a sell-off. "It comes down to integrity, the accounting system and trust in management," York said. "I could be wrong, but I look at Cisco as a company that's credible." To its credit, Cisco has been open about its inventory benefits, clearly noting that in its earnings releases and pro forma tables it has gained from its write-off last May. According to Lawrence D. Brown, an accounting professor at Georgia State University, Cisco's disclosure about the reused inventory should be commended. "The good news is that the company is detailing it in their earnings," Brown said. "What happens with a lot of 'big bath' charges is that the write-offs are reversed later and show up in operations without any disclosure. "There are two ways to look at Cisco's inventory charge," he said. "Either the company took the big charge hoping to boost earnings later, or it honestly felt the charge was at fair value at the time." Many analysts in the Cisco camp contend that any accounting worries are unwarranted and argue that pro forma accounting, which excludes charges and items such as inventory benefits, is the best way to evaluate the company. For instance, Morgan Stanley analyst Christopher Stix blasted a BusinessWeek report on Cisco last month for raising concerns about the company's accounting. In a research note, Stix said worries about Cisco's accounting are unwarranted. "If there is any criticism to be made of Cisco's accounting in its annual report or October 2001 10-Q, it should be that they are being too conservative, not too aggressive," Stix said. "Conservatism today inevitably leads to reversals in the future." Stix, who didn't return calls, argued that Cisco took the inventory benefit only because it was too conservative with its write-off last May. "To take the charge, they had to believe or at least argue that they anticipated not using the inventory," Stix wrote. York said Cisco's use of previously written off inventory may mean that demand is picking up, echoing a theme of Wall Street analysts. In regulatory filings, Cisco didn't reveal what it actually sold or used, but analyst surmise there must be demand to take it off the shelf. Nikos Theodosopoulos, an analyst at UBS Warburg, said Cisco's enterprise business looks stable, but the company is still suffering from weak demand from its telecommunications customers. However, Theodosopoulos noted that Cisco has been aggressive on pricing and offered a zero percent interest financing promotion for the US consumer market, which makes up a small portion of its overall revenue. Analysts said Cisco is likely to remain cautious about its outlook for future quarters, which implies to some that it may be hard to justify the company's current stock price. "There's no rate of business they can report right now to justify the stock price," said Tad LaFountain, an analyst at Needham & Co., noting that investors are betting on a big turnaround in business down the line. At current estimates, Cisco has an estimated price-to-earnings ratio of 95 for 2002. Despite those worries, many analysts consider Cisco the best bet in a bad lot of struggling networking equipment makers. The company has $4.5bn in cash and analysts still consider Cisco a Wall Street darling, albeit one that's struggling right now. "Cisco is one of those few companies that Wall Street doesn't really question," said PITA Group's Johnson, noting that the company's penchant for acquisitions may make it immune from criticism from analysts backed by investment banks. "When you look at all the former highfliers being targeted, I find it curious that Cisco is omitted from the sweep." Whether that trend continues may depend on Cisco's financial results.

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