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Never, that is, until this week, when Cisco saw its first bona fide stock slide ever. Since its Friday, May 5, close of $67.75, the stock has lost 13% of its value. It closed at $58.50 on May 10. Is it serious? That depends. The reasons cited for the slump have varied from a poorly argued cover story in Barron's last weekend to an offhand comment by CEO John Chambers during a conference call on May 9. If either of these proves to be the primary downforce, there's not much to worry about. But since markets aren't exempt from the law of gravity, keep your eye on the overall drop in the tech sector. Cisco may be the shiniest apple of all tech stocks, but it's still a tech stock. BAD ACCOUNTING? The bloodletting started with Barron's. The cover story -- complete with an illustration of a house of cards -- called Cisco's whole acquisition strategy into question. Writer Thomas G. Donlan's thesis was that Cisco's recent acquisition spree (so far this year, it has bought 10 companies, including the $5.7 billion purchase of ArrowPoint Communications [ARPT] announced last Friday) is based on risky accounting that cannot possibly fulfill investors' hopes. The article zeroes in on Cisco's use of the "pooling of interest" accounting method for its acquisitions, in which Cisco doesn't have to charge the costs of a merger against its earnings. If it used the "purchase" accounting method, which does force acquirers to charge acquisition costs against the bottom line, Cisco would have no earnings for the foreseeable future, the story asserts. Donlan also attacks Cisco's high valuation, namely its May 5 price-earnings ratio of 132 for estimated fiscal year 2000 earnings. By the market's close on May 10, that p-e figure was down to 114, driven mostly by the Barron's article's impact. SILLY LOOPHOLE. Like most financial journalists, I feel a twinge of professional envy whenever another publication features a market-moving story. But the fact is, the Barron's article didn't contain much that was new. And I disagree strongly with Donlan's argument. For one thing, accounting methods are in the end just accounting methods. As long as everyone understands the method being used, the choice matters little, if at all. Of course, pooling-of-interest accounting is a silly loophole that's bound to be closed by the Financial Accounting Standards Board in the next few years. But that will have no material impact on Cisco's business. The company might have to slow its acquisition pace, but past acquisitions won't be affected at all. Besides, Cisco buys other companies with its own stock, which has been established as a precious commodity by the market. As long as that stock continues to rise, the company can use it to buy promising young startups. Cisco investors understand and accept this, along with the high p-e ratio. AMORAL MARKET. As far as the p-e ratio goes, again I have a problem with the Barron's argument. Barron's is the leading voice of the "moralist" camp of investing: It believes that there's a correct valuation of stocks. So when stocks become too cheap or too expensive, then something is wrong with the picture. Not so. The stock market is amoral. There is no high moral ground when it comes to p-e ratios. If the market decides that Cisco is worth a p-e of 190, then that's the correct p-e. If the market says its p-e should be 5, then that's correct. Of course, if perceptions change about Cisco, then the stock's value could change -- and stories in Barron's could play a role in creating those perceptions. But moral correctness does not a long-term valuation make. It just doesn't work that way. Then there was Chamber's comment during the May 9 conference call. After reporting yet another stupendous quarter of earnings and revenue growth that fell in line with analysts' expectations, Chambers mentioned that his company is suffering from "supply shortages" that could affect revenue and earnings projections for the next quarter. NO DOWNGRADES. Determining the difference between pessimism-to-make-the-lawyers-happy and a true change in the guidance that a CEO gives to the market is a difficult art. But don't forget that for the analysts who follow Cisco, their living depends on correctly determining that difference. And not a single analyst downgraded the stock after the conference call. Three of them even upgraded it. So it's surprising that the stock went down anyway. Most analysts who cover Cisco still expect it to make $0.14 in earnings per share next quarter. Chances are that the company will reach that mark. Chambers would have been more specific in his negative comments if he was worried, which would have led analysts to lower their estimates for the next quarter. Besides, Cisco -- unlike competitors such as Lucent (LU) and 3Com (COMS) -- isn't a manufacturer. Although it makes a very small amount of its products, the vast majority are made by contract manufacturers. Chambers clearly said his company was confronting supply shortages, not the contractors that make most of its products. One component that he mentioned, memory chips, is in the midst of a well-publicized scarcity, so that can't be described as news. "This company is so strong in supply-chain management, if anyone knows how to deal with a shortage, it's Cisco," says First Union Securities Inc. analyst Steve Koffler, who rates Cisco a strong buy. So what's going on? Step back and look at the big picture. The stock's 13% slide makes sense when you consider the revaluation of technology stocks overall. Cisco isn't changing, and its growth story isn't changing. Investors' views of how much a tech stock is worth are changing. If some important news signified a negative change in Cisco's story -- and the Barron's article doesn't contain any -- it could truly hurt the stock. But if what we're witnessing is just an alteration in investors' perceptions of the tech sector, then Cisco's drop is just a slight wobble in the orbit of what remains one of Silicon Valley's brightest stars. Jaffe writes about the markets for Business Week Online What do you think about Cisco's valuation? Let us know at our Ask Sam Jaffe Interactive Forum EDITED BY DOUGLAS HARBRECHT |
