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The Cisco Hustle

First off, I want to stop the rumors that I had anything to do with the wording in this week's release of the Beige Book from the Fed. They used words like: "slow growth", "sluggish", "below expectations", "weak demand", "loosening labor markets" and "pronounced reductions in consumer borrowing". The fact that I have been writing the above for months is mere coincidence. Or it may be due to the fact that even the Fed has to recognize the problems.

This bell weather report was u-u-g-ly. Sounds like they think there is a recession going on. We will look at that and more in a moment, as this week had a lot of important news.

But first, I HAVE to comment on an interview done by CNBC with John Chambers, the CEO of Cisco. From my chair, it was one of the more outrageous hustles I have seen in years. My less than sainted Dad, God rest his Texas soul, would have been muttering words about horse droppings, or something to that effect. Chambers sounded like some Vancouver gold stock promoter, only a lot smoother and with better clothes.

First, let me state unequivocally that Cisco is a great company with great products. In ten years it will still be a great company. They have assembled a leadership team that is strong and has depth. They have a huge $18 billion cash hoard with which to buy other promising companies and technologies. I wish them nothing but the best, as their products have made my life better. I am a big fan of Cisco the company.

But as an investment advisor, it is their stock price I am concerned with. And in my opinion, the future of that price is not so great. I said so last year, and after seeing this week's report and listening to Chambers, I will say so again.

First, during the "analysts conference call" Chambers was reportedly somewhat subdued and said that investors should now think of his earlier projection of 30% to 50% annual revenue growth when Cisco's market recovers as a "stretch goal." Only time will tell, Chambers added, whether the actual growth rate would be 15% to 30%, or 30% to 50%.

Later, talking to the general public, he was not so subdued. When pressed, he clearly, at least to my ears, re-confirmed that Cisco's continued goal was 30%-50% growth. That was hard for me to swallow. Chambers knows that such a growth rate for more than a quarter or two for a company his size is not possible. Can't be done. Zero chance.

It is the Law of Large Numbers in full action.

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I couldn't understand why he would put up such an impossible target. There is no way that anything but future disappointment could come from such statements.

But then a few minutes later came the moment of understanding. Chambers acknowledged that they would be giving new option packages to their employees as an incentive.

The question I ask is, "Options at what price?" Employee options cost shareholders in the form of dilution. I assume most of the option packages at Cisco are for prices at much higher levels than the current stock price. Since much of the pay for employees is in the form of options, the potential for any profit from the current options are nil. So presumably they are adjusting the option price down to keep their employees happy.

But before we discuss the interesting topic, let's look at the actual numbers for Cisco.

Quick, tell me how much profit Cisco made last year. No fair peeking. Clue: they made 2 cents per share last quarter, which was down 85% from last year, so what was their profit in the preceding three quarters?

Answer: they did not make a profit. They actually lost 14 cents per share for the last fiscal year.

Revenues were not up 30-50% last quarter: they were down 25%. "Pro forma" income was down 85%. Even the 2 cents income last quarter wasn't from operating profits. Operating profits are those from the actual operations of the business. The company earned $199 million from interest on its considerable cash hoard. Operating profits were a rounding error $28 million on $4.3 billion in revenue. The "pro forma" profits were $163 million, so they managed to lose $60 million or so in write-downs, etc. In essence, they cooked the books to come in at 2 cents, which met with "expectations."

Chambers told analysts to expect a further 5% decline in revenue for the next quarter, so there's a good chance that Cisco will actually show an operating loss next quarter.

Prior to this report, analysts were expecting Cisco to make 28 cents per share next year. Now it seems like the expected number will be more like 18 cents. Part of that drop in estimates comes from the realization that 40% of Cisco's business comes from sales of switches. That business is down 40% in just the last two quarters. It is in free fall, and while there are signs the business may be stabilizing, there are no signs of 30%-50% annual growth.

The future is murky. "We are seeing some signs of the U.S. stabilizing, but we are cautious about the overall economics and think Europe and Asia Pacific may get worse before they get better," Chambers said. The company refused to give any guidance for the next 12 months. The real fact is they have no idea when things will turn around in their business.

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That was said on the analysts' call. On TV we tell little old ladies we are still targeting 30%-50%. Translation: keep us in your IRAs and pension plans. Don't sell our stock.

Side bet on fiscal 2002 profits: that number will be closer to 10 cents than 18 cents. But even at 18 cents, that is a P/E ratio of 100 at today's $18 share price!

In the last 12 months, Cisco revenues were $22 billion. If the company were to grow 40% per year, halfway between Chambers stated goal, the company would have revenues of approximately $88 billion in just four years. That means they have to find and build three more business the size of Cisco as it currently is in just four years! They would do what it took decades for IBM to do and IBM had inflation and a roaring technology economy to help them. Cisco has a flat to poor economy and low inflation or outright deflation in many of its international markets.

Of course, even Chambers might have to tone down his goals at some point. At 40% annual growth the company would have revenues of $1 trillion in just 11 years.

My point is that it can't be done. In the history of the world, no company of Cisco's size has even grown at even 20% for a sustained period. Trees do not grow to the sky, and neither do technology companies, even well-managed ones.

So why set up expectations that cannot be met? I can think of two reasons. The first is not nice: you are getting ready to reset your employee options. You do not want your stock to drop another 50% before you set the options, as the dilution effect would seriously affect shareholders and possibly cause shareholder rebellion.

Second, and more likely, what if Chambers goes on TV and says, "Guys, let's get real. 10%-20% target growths in the near term are about the best we can expect, and that is after the recession is over. No company our size has grown at 20% per year for ten years. While we make great products, due to intense competition, we are watching our core products become commodities and are losing our ability to control margins."?

The stock would crater. The markets would crater. Chambers would become the Grinch who stole Christmas. His board and employees would not appreciate what happened to their stock. So even if that is what everyone really thinks in the late-at-night Cisco management meetings, they (and he) can't say it.

So Chambers keeps repeating the 30%-50% mantra. And investors keep hoping that he is right. But the numbers say he won't be. Some day, the realization will hit that Cisco is just like another great technology company called IBM. They both make expensive iron and have tough competition, but good management and research keeps them on the front edge. IBM has a P/E of 22. It revenues are $88 billion. Four times the revenues, real earnings and a market cap only 40% bigger than Cisco. Am I the only one who sees a disparity?

Of course, if we are talking growing earnings at 30%-50%, that might be possible if we start at a negative 14 cents, or even 2 cents. But even then, earnings would have to grow almost 500% to bring its P/E ratio in line with IBM. How many years will it take to do that?

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Why am I so hot about Cisco? Because every week I talk to another potential or current client who bought Cisco because it was going to grow 30% forever. I have yet to talk to someone who bought Cisco at $10 many years ago and has held on all this time.

When Chambers does this type of cheerleading, he is taking money from retirement accounts, because people want to believe him, and hold on or buy more. They think he can grow profits 5 fold in just a few years. They hear him on TV and think it is a done deal because Chambers will simply order his company to do it. But he can't, and the company won't. It will grow. But not at those numbers.

One day, investors will get tired of the song. They will realize they have been had. And Cisco stock will go the way of all over-promoted stocks.

Cisco is a great stock for day-traders, but it should NOT be in a long term investment portfolio. There, I said it. I feel better already.

The Beige Book Blues

The Beige Book is the Federal Reserve report on the general state of the economy. You can read it here. It is normally pretty dry reading. I try to go through it to get a feel for the numbers and the report. But no one can re-cap the Beige Book and make it appear exciting better than my analyst hero Greg Weldon.

Rather than try to do my own version, I will once again simply pull (with his permission) some quotes from his analysis and make comments

"There is ONE CLEAR CUT COMMON thread running thru the report ... a deflationary slowdown is spreading from the industrial sector ... through to other sectors of the economy, notably, into the consumer, and real-estate areas."

I totally agree. They take pains not to use the "D" word, but it is hard not to see it. I have been writing for over two years that deflation is in our future, barring some unusual event. After reading this report, I am more convinced than ever.

As an example, US Producer Prices fell 0.9% in July. The "core" was up just 0.2%. That is the prices paid to US factories, farmers and other producers of products and services. That represents the biggest drop in 8 years.

This clearly illustrates what I have been saying for over a year: companies do not have the ability to raise prices in order to boost their profits. It is evidence like this that allows the Fed to keep increasing the money supply and lowering rates, and not have to worry about inflation. For the first seven months of this year, the PPI rose 0.5% compared with a rise of 3.8% in the period last year. This cearly shows there is little or no inflation in the "pipeline".

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More from Weldon's Beige Book analysis. These are direct quotes from the Fed report:

"Reports from most Districts point to slow growth... Retail sales generally were sluggish and frequently below expectations, despite substantial discounting on a wide range of consumer goods....Manufacturing activity in nearly all sectors and regions declined further, as producers adjust to weak domestic and foreign demand."

"Sustained weakness in manufacturing spilled over to other businesses, with many Districts indicating declines in demand for office space and trucking and shipping services.... Stiff foreign and domestic competition kept prices of most consumer goods in check."

"The most pronounced reductions were in consumer borrowing....With both borrowers and lenders pulling back in response to economic uncertainty.... Layoffs in many high-tech manufacturing and service firms, boosted the number of highly skilled workers applying for jobs through temporary employment agencies."

"Reports of reduced work hours, lost overtime, forced furloughs, planned shut downs, and layoffs, were pervasive.... Districts indicated continued weak demand for business services, including advertising, computing, data processing, and temporary employment agencies, resulting in employment reductions.... No signs of price inflation were noted. Office space and employees grew more abundant."

Notes from other stories and then quick comments:

US wholesale prices fell 0.9%, and they fell four times faster than inventories. Businesses are aggressively price cutting and inventories are hurting.

Auto demand is holding up, but the steep price cuts and cheap financing can't be good for profits. Moreover, a tidal wave of used lease cars are coming onto the market over the next year. I recently bought my first used car in almost two decades because the price for a luxury car with only 25,000 miles and a full 3-year warranty was over 40% lower than a new car. The logic will hit more than one person looking for their next automobile. The auto industry is braced to lose more than $18 billion on these used cars as they now have to figure out how to reduce their used car inventory while maintaining new car sales.

US consumer borrowing fell by $1.6 billion. I have talked to several bankers who have mentioned weak loan demand. The borrowing decline was the biggest since 1992.

This goes along with the reports of very sluggish retail sales.

Visibility: The Recession Comes Into Focus

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Last year about this time I warned that a recession should start in the third quarter of this year, based upon negative yield curve spreads. Once again, we will be able to say that the negative yield curve has never failed to predict a recession.

Earlier this year, many analysts talked about a second half recovery. I kept talking about recession in the second half, saying they were wrong. But upon reflection, I now realize they must have meant the second half of 2002.

I printed the words from the Beige Book without much commentary. There doesn't need to be much. The news is bad. This is the beginning of the recession. Unfortunately, we should have at least one more quarter of bad earnings and negative reports. Will investors continue to be optimistic in the face of continued lay-offs? I expect next month's job report to be worse, as independent analysis like the Challenger Report is showing an increased number of lay-offs.

The dollar is finally showing signs of weakness. I know, from your letters, many of you hold Euro and Swiss accounts. I think you will be very happy you did by the end of the year.

I could do a whole e-letter on the foreign situation. It would sound worse than the Beige Book. Japan is especially showing they are clearly in a deflationary recession. No matter how much the Japanese equivalent of the Federal Reserve tries to inflate, banks cannot find borrowers and deflation is the order of the day.

The Prime Minister of Japan actually said, in what is one of the more outrageous things I have heard a politician say, that what was needed for the economy to grow was a little inflation. Better the appearance of growth than no growth, I guess, if you want to keep voters happy.

The Fed talks about weak international demand. Cisco says they are worried about Europe and Asia. This is precisely what I have been writing about for quite some time. We have now arrived.

Now we wait, looking for The Bottom. None of the Three Amigo indicators has given us any sign we are near The Bottom. But it will come, and hopefully our patience will be rewarded as we courageously get back into the stock market.

The Bond Train is Leaving

I keep repeating one theme: long term rates should go down in a recession. As it becomes clear to investors that this recession is going to be more than a one-month problem, I think we could see rates begin to drop, and perhaps rapidly. Long term rates dropping is one of the things that will spur the economy, as it is good for housing and business.

The long term bond train has not left the station, but the conductor is calling, "All aboard." In conjunction with Don Peters, whom we represent, for the last few months, we have been slowly putting new bond timing clients into long term zero coupon bonds. We are no longer doing it gradually. New clients are going 100% immediately into long term zero coupon US Treasury bonds. Peters is in the top 1% of bond managers for the last 25 years. If you have any questions or would like information about our program, you can call Wayne Anderson or myself at 800-829-7273 or email us your address and phone number.

That's Enough For Today

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Time to hit the send button. I do want to say that I appreciate being able to come into your home or office every week. I look forward to writing to you, and feel as if I have many friends on the other side of this computer. If you enjoy reading this half as much as I do writing it, then we are both happy campers.

This has been a very busy week. I am still trying to get a new fund ready to go, and there is just a lot of work in making sure everything is done right. My daughter has been working late nights with me, getting material ready. She is trying to get finished before next weekend so she can go to Puerto Vallarta with my wife for a few days. I get to stay and finish the job, of course. I even get to do the sermon at her church, which will be a switch for the small congregation. But maybe I can work in a little golf this weekend.

And you should do something fun as well. After all, it is summer, and life is too short to work too hard, at least all the time.

Your looking forward to finishing the paperwork analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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