Cisco Kids

Cisco reported its earnings last night. Profits rose 58% over the same quarter last year. Sales rose 55%. Though the shares fell 7% on Monday — following the publication of the “Barron’s” article — the company is still worth more than $450 billion — or about $4,000 for every household in America…or about $75 for every Homo sapien on the planet.

Cisco shares trade hands at about 190 times earnings. This implies a growth rate for the company of about 190% — following the conventional analysis. This is about 3- and-a-half times the company’s actual growth rate.

It is also mathematically unsustainable. As I have mentioned before, growth rates above 25% are very difficult to maintain. The higher the rate of growth, the faster the market opportunity is exhausted. It is like my friend’s snails — multiplying at such a rate that they very quickly fill his bins to capacity. Very small companies with potency elixirs or a monopoly on African snails may justify extraordinarily high P/Es, for a while — but not big companies selling switches and routers.

Cisco’s story is well-known by now. In 1984, Sandy Lerner and Len Bosack got together to solve a problem. They needed to make the computers in Stanford University’s business school capable of talking to those in the engineering school. They built routers, cobbled together some software and solved the problem. Henceforth, Stanford’s business students could send dirty jokes to the guys in the engineering department via computer.

It was not long before other computer users were showing up at Lerner and Bosack’s door to get the communications equipment. The couple got married and set up shop in their home — manufacturing the devices themselves and using credit cards as a source of capital.

By 1990, CSCO was a player in Silicon Valley. The Lerner and Bosack team had brought in a venture capital group that took the company to the public markets — and then forced the founding couple out.

Many entrepreneurs’ companies last longer than their marriages. Lerner and Bosack divorced in the early `90s. So they have neither the company they founded nor each other.

But if the marriage did not prosper, the company certainly did. Cisco figured that it needed to offer more than just routers. So in the mid-`90s it began acquiring other companies involved in the computer communications trade.

“Over the next three years,” reports “Barron’s,” “Cisco would buy six more switching companies, including the $4 billion acquisition of StrataCom in 1996, which was then the largest purchase in the history of Silicon Valley.”

“Counting the six net-working companies, Cisco acquired one company in ’93, three companies in ’94, four companies in ’95, and seven in ’96. It picked up six more companies in ’97, nine in ’98, 18 in ’99, and has bought 10 so far this year, for a total of 58 acquisitions.”

The Cisco Kids have been on a buying binge. The idea is pretty simple. Customers don’t want routers. They want solutions to their communications problems. And since the problems have varied solutions, Cisco needs to offer a variety of products.

Cisco, in other words, is not a router company. It’s a marketing channel for computer communications. When it buys in some small company with a useful, but largely unknown, device, the product is marked with the Cisco brand and launched upon the customer base. Negligible sales can go to monster sales almost overnight.

“One target company,” reports “Barron’s,” “that had $10 million in revenues at the time of acquisition provided Cisco with technology that now generates more than $1 billion in revenues.”

Very well. But when you’re buying two new companies every month, they are not all likely to produce such spectacular results. In fact, most are likely to be duds. And a lot, it turns out, depends on how you do your accounting. Recent acquisitions were so outrageously expensive that if “simple purchase accounting” had been used, “Cisco’s reported earnings probably would have vanished,” says “Barron’s.”

What’s more, Cisco’s own appetite for acquisitions is driving up prices to preposterous levels. Last week it bought ArrowPoint for shares worth $5.7 billion. That’s a lot of money to pay for a company with a negative book value, that has never earned a penny and has sales of only about $40 million.

But what do the Cisco Kids care? It’s not real money. It’s “Cisco scrip” — the new currency provided by delusional TNT investors — they’re spending. Each share of CSCO stock is thought to be worth about $63. But an investor will earn no dividends, and the company itself earns only 38 cents per share.

Even if profits continue to increase at the current rate…Cisco will only earn $3.74 per share in five years. If the stock price were to continue apace — the company would have to be worth nearly $5 trillion.

This is not very likely. Cisco has competition. Nortel and Lucent are in the same business. But they are much cheaper. Nortel sells at a P/E of 100. Lucent’s multiple is 46. As “Barron’s” points out, if Cisco were valued at the same multiple as Lucent, you could buy a share of CSCO for $16.

What’s more, the process of creative destruction, of which Cisco has been such an extraordinary beneficiary, is not likely to stop dead in its tracks the moment Cisco finally reaches a level of profitability that justifies its current price (if ever). That is the trouble with new technology, after all. There is always newer technology…and other Lerner and Bosack teams…waiting for their moments of fame and fortune. Sincerely,

Bill Bonner

Paris, France May 10, 2000

Your correspondent in Paris…still waiting for his moment of fame and fortune…

*** Another day of low volume and sinking share prices. The Dow fell 66 points. The Nasdaq fell 84.

*** I have been expecting a “moment of truth” — when suddenly everyone realizes that the New Era is a fraud and dumps Nasdaq stocks in a panic.

*** But the markets rarely provide even a microsecond of truth. Instead of going down with a bang, there have been a few nervous days of steep declines…rallies…and a whimpering, jerky falloff in prices.

*** There were 1,287 advancing stocks yesterday; 1,576 stocks declined. Fifty issues hit new highs. Seventy-two hit new lows.

*** One explanation for the low volume may be that investors are not only waiting for the next announcement…they’re also waiting to get back to break- even. The “NY Times” provides a list of the 10 most popular stocks — currently including AT&T, AOL, Bell Atlantic, Cisco, Coke, Compaq, Disney, Exxon, GE and Home Depot. Seven of these companies are down for the year.

*** “The value accountants may not only be wrong about the New Economy valuation metric as it applies to any specific stock,” James Davidson wrote in a recent issue of “Strategic Investment,” “they are wrong about the general meaning of the rich NASDAQ valuations.” Any particular stock may turn out to be a bad investment, in other words, but you’re not wrong to be in the Nasdaq as a proxy for the New Economy. The New Economy is real — even if some of the companies turn out to be duds.

*** Davidson’s logic is that you need to get in on ground floor investment opportunities — which means investing in companies whose prices cannot be justified by current earnings. This is the way you become seriously rich, he says.

*** Of course, the odds that any given speculative investment will make you seriously rich are remote. But the argument works at an emotional level. If you are not investing in these future-oriented, high tech, high-loss, companies, you are made to feel like a has-been with no hope of ever getting rich (which is probably the case).

*** I mentioned British Energy a few days ago — an example of a very inexpensive company. Now I see “Grant’s” has done a report on the stock. “Grant’s” notes, among other things, that British Energy is Britain’s top producer of nuclear energy. In fact, it generates one of every five kilowatts of electricity in Britain. But what caught my attention was this little note: the company recently bought “an American-owned nuke for $20 million, which represented a little less than one-half of 1% of the original cost of building it.”

*** There was a time, believe it or not, when nuclear energy represented the wave of the future — similar to the way the Internet represents the wave of the future today. Billions were spent building nuclear power plants — whose produce, electricity, was in no danger of going out of style. Here we are 25 years later and the nukes are almost a liability.

***** Dan Ferris tells me “it’s time to buy stocks like it’s 1982.” But he’s found some real companies, with real products…and real profits. With a 62% sales increase over last year, one company he’s recommending just had the most profitable quarter in its 114-year history. Another produces some 7 million ounces of gold a year and is trading at a mere seven times earnings. Still another is selling at just 5.5 earnings, despite a 67% increase in sales…and already up 44% since Dan recommended it.

*** In the first quarter of 2000, venture capitalists invested US$22.7 billion in over 1,500 new startups. Most (US$17.1 billion) went to Internet companies. Money for many of these companies continues to be virtually free. Despite declining share prices — down 91%, Musicmaker down 85%, 1-800-Flowers down 64%, WebMD down 84%, CD Now down 88% — and no profits to speak of, C/Net reports venture capitalists don’t plan on decreasing their investments in Net companies.

*** Where did all these people come from? All of a sudden it is like the middle of summer in Paris. People are everywhere. Tourists. Business people. Shoppers. Backpackers. They’re filling up the outdoor cafes and jamming the sidewalks. And it’s warm. Not like Baltimore, where it was in the 90s yesterday. But it must be in the upper 70s here — and gorgeous.

I usually try to read a little as I drink my coffee after lunch. But yesterday there were so many beautiful women walking by, I had to return to the office — I couldn’t get anything done in the cafe.

“You can speak of war…and of wealth’s charms… But oh to be young again and hold her in my arms”

…or something like that…

The Daily Reckoning