'Virtual Close' Fails To Work for Cisco

Wall Street slaps Cisco for missing forecast as accounting process falters

Investors clobbered networking powerhouse Cisco Systems Inc. earlier this month, driving the company's stock down 16% when Cisco missed analysts' earnings forecasts by a penny for the second quarter ended Jan. 27.

It's usually the other way around.

San Jose-based Cisco typically beats Wall Street estimates by 1 cent, in part by using an accounting process that company President and CEO John Chambers calls the "virtual close." That process, according to Chambers, enables the company to keep such close tabs on its financials that it's able to close its books in a matter of hours and, when necessary, make quick course corrections to enhance earnings.

So why didn't it work this time?

Chambers said that while the virtual close lets Cisco look at the financial state of the company on a daily basis, it doesn't allow it "to predict the future." That's particularly true, he said, when dealing with macroeconomic trends, such as the current rapid slowdown in the overall economy.

"We started to see some initial softness [in product sales] the second week in December, which continued throughout much of January," Chambers said, adding that sequential growth of 4% from the first quarter to the second quarter was somewhat troubling too.

"The challenge [in growth] was primarily in the U.S. alternative service provider market," Chambers said.

Alternative service providers include companies such as emerging competitive local exchange carriers that compete with the regional Bell operating companies.

Ironically, the service provider segment is where Chambers said he believes Cisco will realize most of its planned 30% to 50% annual growth rate. And it's that very focus that may adversely affect Cisco's historical ability to change direction on a moment's notice.

Jim Slaby, an analyst at Giga Information Group Inc. in Cambridge, Mass., said the time required to close a big sale on network equipment to service providers may be as long as 18 months. That's three times longer than a typical sale to a corporate user, he said.

Moreover, selling to service providers isn't as predictable as selling to business users, because there's a lot more competition in the service provider segment, according to Slaby.

Cisco is well entrenched in the enterprise space, he added. But compared with Brampton, Ontario-based Nortel Networks Corp. and Murray Hill, N.J.-based Lucent Technologies Inc., Cisco is still a newcomer to the service provider market. Slaby also noted that dozens of start-ups are clamoring for a piece of that pie.

Although Cisco's earnings may have been off a penny per share from Wall Street expectations, the networking company certainly isn't struggling.

Cisco reported Feb. 6 that net sales for the quarter were up by 55% at $6.75 billion, compared with the $4.36 billion reported for the same period last year. And pro forma net income was $1.33 billion for the quarter, up 48% from the same period last year.

Chambers said the company could see a couple of soft quarters in the future. But as long as recessionary pressures in the U.S. don't migrate to Europe and the Asia-Pacific region, he said, Cisco should continue to enjoy a 30% to 50% annual rate of growth during the next five years.

Wall Street reaction isn't necessarily rational, said Michael Speyer, an analyst at the The Yankee Group in Boston.

Cisco is subject to economic slowdowns just like any other company, he said. "And even a slight deviation from expectation is more than the market can stand," said Speyer.

Copyright © 2001 IDG Communications, Inc.

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