Yesterday, Ashlee Vance of The New York Times grabbed my attention in an article about Cisco transitioning from boring switches and routers into "peddling e-mail software, video conferencing systems, cable TV boxes - even furniture."
However, what really caught my eye in that article was the following statement by RBC Capital Markets Managing Director - Mark Sue:
 "Cisco is kind of like the Madonna of networking, it is continuously trying to reinvent itself."
Personally, I find the reinvented Madonna a boring failure. Why? Because she is mimicking younger generation artists and no longer has her "own unique personal style." I like my Elvis "karate kicking" his way across the stage in a jumpsuit, and if he were alive today, hopefully he would have transitioned into yet another totally unique persona. |
 Catching my attention on Network World, Cisco Subnet blogger Ken Presti recorded two podcasts on the following new directions being taken by Cisco:
and At the end of the collaboration podcast, Ken Presti cautioned Cisco against taking their eye off the ball in the networking space – something that can easily happen when companies expand into new areas. |
Perhaps Cisco's motivation to focus on new directions can be partly explained by last week's 2008 Cisco proxy statement, which revealed that over 90% of Cisco executive compensation was performance-based.
There are 3 main components of this performance-based compensation:
1. Company Performance Factor (CPF)
2. Customer Satisfaction Factor (CSF)
3. Individual Performance Factor (IPF)
The 2008 Cisco company performance factor (CPF) revenue target was $39.745 billion, or 13.8% growth, however revenue only grew to $39.540 billion, below target at 13.2%.
Exceptionally, Chambers grew income to $11.652 billion, which at 12.9% was above the CPF target of $11.461 billion, or 11% growth.
Unfortunately, yours truly believes pressure from Cisco's company performance factor (CPF) is pig-headedly forcing John Chambers into "the grass is greener somewhere else mentality," which is focusing Cisco away from its successful product mix.
It is my opinion that by juggling so many balls in the air, Cisco is creating huge execution risks that will simultaneously cause Cisco's stock price to lag as investors become more and more confused about Cisco's business.
Perhaps it's time for Cisco to spinoff its boring business units, giving investors the choice of which business direction to take!
Do you believe Cisco will successfully keep its eye on the ball while reinventing itself?
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Cisco's 2008 proxy statement revealed this week a couple of interesting snippets:
During 2008 the number of Cisco shares owned by CEO John Chambers declined by 3,473,334 shares to 23,178,966. Simultaneously, a 27% drop in Cisco's stock price year-over-year dealt Chambers a whopping paper loss of $208,378,904.00
Cisco Stock Ownership
CSCO (Cisco) Stock Chart
Additionally, the filing revealed that Chambers received total compensation of $11,159,987 in fiscal 2008, a $175K increase from last year even though the Cisco stock price is off by 27%.
However, it was Wim Elfrink - executive VP of worldwide operations and business development who earned the highest salary at $859,605 - but perhaps that was because he was paid in Euros rather than U.S. dollars. Cisco used the exchange rate of $1.1.57070 per Euro that was in effect on the last day of Cisco’s '08 fiscal year.
Cisco Compensation Table
Other highlights from the statement provide insight into a potential options overhang.
In September 2007, Motley Fool contended that by mopping up potential dilution to support Cisco's stock price (Cisco's massive options overhang), Cisco stock buybacks do little more than transfer money from Cisco stockholders to Cisco's executive team.
At that time, Cisco spokesperson Lang Tibbils responded to the Motley Fool article saying that: "Cisco's policy is to grant options to all 60,000-plus employees, the entire company benefits from the buyback program not just executives."
This from Cisco's 2008 proxy statement:
The following table provides information as of July 26, 2008 with respect to the shares of Cisco common stock that may be issued under existing equity compensation plans.
According to Cisco's 10-K filing, as of September 5, 2008 Cisco had 5,883,028,141 shares of common stock outstanding, a potential options-related dilution (overhang) of 20%.
The proxy statement closed with a requirement by the Cisco board of directors that CEO John Chambers use a private airplane for business travel "because his responsibilities on behalf of Cisco entail substantial national and international travel," according to the filing.
In conclusion the proxy statement duly noted:
Mr. Chambers will be reimbursed for expenses incurred in the operation of his private plane when used solely for Cisco business provided such expenses do not exceed the market rate charged for equivalent commercial charter travel.
To date, there have been no reimbursements made to Mr. Chambers under this policy.
Perhaps the success of Cisco Telepresence has kept Cisco stockholders (at least up till now) from reimbursing John Chambers for the business use of his private plane!
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 As Wall Street goes to Hell in a handbasket, we took note last week in the blog story: |
"That total financial customers represent only 3-4% of Cisco revenues"
Also, earlier this summer created the headline:
Tough times help Cisco gain market share
With that in mind, it is my belief that Cisco will continue to excute well during this ongoing IT spending slowdown, allowing Cisco to actually increase its market share dominance.
 However in the opinion of yours truly, United States Treasury Secretary - Henry Paulson is leading a shameless corporate welfare bailout called the Paulson Plan.
Incredulously, Paulson is trying to get Congress to legislate that American taxpayers buy $700 billion of toxic assets (illiquid mortgage backed securities). |
While the embarrassing legacy of the eight-year Bush adminstration reaches an unfathomable new low (in the opinion of yours truly), yesterday RBC Capital Markets Analyst Tom Curlin provided the following economic perspective on enterprise systems and hardware:
 We continue to assume year-over-year deceleration in U.S. IT spending in 2008, and we now assume this process will culminate in a contraction phase.
Housing prices are at the epicenter of the current economic slow down, but history tells us housing prices do not bottom before volumes bottom. Yet housing starts continue to decline, inventory to sales metrics in housing remain high, and the rental equivalent value of homes remains elevated. |
Meanwhile, credit spreads remain extremely high as banks attempt to de-leverage against a degrading mortgage asset base, and the degradation is spreading to other parts of their loan portfolio. Until the asset degradation stops, which does not happen until housing values bottom, credit spreads will remain at elevated levels.
 |
Credit Crunch
The U.S. yield curve (view chart) has steepened considerably in recent months, and growth in the U.S. monetary base (view chart) has stabilized. However, the credit markets continue to tighten and the flow of credit to consumers and corporations is contracting (view chart). The Treasury department, the SEC, and the Federal Reserve recently announced unprecedented measures designed to stabilize the credit markets, including a proposed vehicle for recycling bad debts from bank balance sheets. Unfortunately, this vehicle will be funded through the issuance of U.S. treasuries, which is likely to drive up longer term interest rates, thereby increasing the cost of home mortgages and placing further pressure on housing values, unless foreign central banks elect to print currency and buy U.S. treasuries to stabilize rates. |
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Consumer Malaise
Growth in real average hourly earnings before taxes (view chart) is contracting as inflation pressures persist and employment growth approaches a contraction phase (view chart). The consumer tax burden appears to be peaking in concert with the earnings pressures (view chart). Unfortunately, consumer debt issuance continues to contract as the housing bubble bursts (view chart). An aggregation of each of these factors to approximate consumer cash flow (view chart) correlates highly with consumer spending and is signaling a recession. |
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Corporate Caution
Industrial production is contracting in response to the consumer spending pressures (view chart). Corporate profit margins remain elevated but also are contracting (view chart), leading to a decline in corporate profit growth (view chart). Meanwhile, corporate credit issuance has entered a contraction phase (view chart). An aggregation of these factors to approximate corporate cash flows (view chart) is contracting, consistent with degrading employment and capital spending metrics (view chart). |
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IT Spending Correlation
In the face of a degrading capital spending environment, IT spending is decelerating but resilient (view chart). We assume further deceleration culminating in a contraction. Growth in new orders for computer and electronic equipment remains subdued (view chart), but the book-to-bill ratio is stable. Inventory growth is elevated, suggesting an inventory correction is forthcoming (view chart). Finally, at the component level, the growth in bookings and billings for semiconductors continues to decelerate, and the SEMI book-to-bill ratio remains subdued (view chart) . |
The Fed’s interest rate policy remains accommodative even as inflation metrics have rebounded. The recent pull back in commodity prices provides some cover for this approach.
Monthly Federal Funds Rate Versus Three-Month Moving Average of Year-Over-Year Change in Total PCE Deflator
Meanwhile, the U.S. yield curve has steepened considerably since the Fed’s aggressive rate cuts in 1Q08.
Government Yield Spread – 10-Year U.S. Treasury Bond Less Federal Funds
Inflation adjusted money supply growth has stabilized but at relatively subdued levels.
Total U.S. Monetary Base – Year-Over-Year Change (%)
Despite the Fed’s accommodative stance, the credit markets remain tight as the financial sector deleverages. Consequently, debt issuance in the private, nonfinancial sector is contracting.
Four-Quarter Moving Average of Real Nonfarm Nonfinancial Corporate Debt Issuance and Total Consumer Borrowing (in Billions and SAAR - i.e. Seasonally Adjusted and Annualized Rate)
The OECD (Organisation for Economic Co-operation and Development) leading indicator continues to decelerate, signaling slowing global economic growth in the coming months.
OECD (with Six Non-Member Economies) Composite Leading Indicator (CLI) Index – Monthly and Year-Over-Year Changes (%)
Growth in U.S. real hourly wages is decelerating as inflation rebounds and employment continues to decelerate.
12-Month Moving Averages of Real Personal Consumption Expenditures Versus Real Average Hourly Before-Tax Earnings – Year-Over-Year Growth Rates
The consumer tax burden may be peaking in concert with the pressure on wages and employment.
12-Month Moving Averages of Real Personal Consumption Expenditures – Year-Over-Year Growth Rate Versus Personal Income Tax Rate
Employment growth is approaching recessionary levels.
12-Month Moving Averages of Real Personal Consumption Expenditures Versus Civilian Employment Level – Year-Over-Year Growth Rates
U.S. consumer debt issuance is contracting in response to a slower housing market and tighter credit markets. Using the current trajectory, consumer deleveraging probably continues into 2009.
Year-Over-Year Dollar Change (Whole Number) in Four-Quarter Moving Average of Real Total Consumer Borrowing (Changes in Consumer Credit & Home Mortgages) Per Labor Pool Person
This approach to estimating U.S. total real consumer cash flow (wages plus new debt) tends to track consumer spending trends and is signaling a contraction. Note that the negative spread versus consumer spending has been increasing since 2006.
Four-Quarter Moving Averages of Real PCE Versus Sum of Real After Tax Wages/Salary and Year-Over-Year Dollar Change in Real Total Consumer Borrowing – Year-Over-Year Growth Rates
Industrial production is contracting in concert with the pressures on consumer spending.
Industrial Production – Monthly and Year-Over-Year Changes (%)
Corporate profit margins are contracting from record levels as consumer demand wanes while pipeline inflation remains elevated.
Quarterly Nominal Compensation and Nominal After-Tax Corporate Profits as Percentage of Nominal National Income
A degrading demand environment in concert with margin pressure is leading to declining corporate profits.
NIPA Corporate Profits from Current Production – Seasonally Adjusted Annual Rate of Change
Corporate debt issuance is contracting after peaking at the end of 2007. Note that the corporate debt market is lagging the consumer debt market, where issuance peaked in mid-2006.
Four-Quarter Moving Average of Real Nonfarm Nonfinancial Corporate Debt Issuance (in Billions and SAAR - i.e. Seasonally Adjusted and Annualized Rate)
This aggregation of corporate profits, taxes, and debt issuance provides an approximation for corporate spending power and is signaling a contraction.
Four-Quarter Moving Averages of Real Capital Spending (without residential structures) Versus Sum of Real Nonfinancial Corporate After-Tax Profits and Debt Issuance, Year-Over-Year Growth Rates
Employment and capital spending growth levels remain positive but are beginning to decelerate, consistent with the degrading corporate spending environment.
Four-Quarter Moving Averages of Civilian Employment Level & Real Capital Spending (without residential structures), Year-Over-Year Growth Rates
IT spending is strongly correlated with non-residential capital spending and is feeling the pressure of the capital spending slowdown.
Four-Quarter Moving Averages of Real Capital Spending Versus Real ITRelated Capital Spending (without residential structures) – Year-Over-Year Growth Rates
Growth in new orders for computer and electronic equipment remains subdued, though the book-to-bill ratio remains stable. However, inventory growth is elevated, which may signal an inventory correction in the coming quarters.
Computer and Electronics Equipment Data (in millions)
Growth in new orders for semiconductors remains negative on a year-over-year basis, and the SEMI (Semiconductor Equipment and Materials International) book-to-bill ratio remains below one.
SEMI – Three-Month Moving Average Book-to-Bill Ratio
Do you agree with yours truly that Cisco will increase its market share dominance during this IT spending slowdown?
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Back on August 20th the CCIE Number stood at 21809, it reached 22070 on September 17th, this increase of 261 new CCIEs divided by 28 days, works out to an average of 9.3 newly minted CCIEs per day.
| 22,070 - CCIE Number as of September 17th, 2008
1,024 - Beginning CCIE Number issued August 1993 21,046 - CCIE Numbers earned 17,840 - Total worldwide CCIE count as of September 9th, 2008 3,206 - Potential inactive status CCIE Numbers *Note: Cisco includes CCIE Numbers under suspended status as part of the worldwide CCIE count. |
This blog compared the September 9th, 2008 worldwide CCIE count to the August 1st, 2008 count, and revealed that 100% of CCIE growth occurred outside the United States.
View the nine year worldwide CCIE count as well as more CCIE water cooler gossip.
Are 9.3 new CCIEs per day enough to meet demand?
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Yesterday, Forbes revealed a new list of the 400 Richest Americans. To be listed, an individual was required to have a net worth of at least $1.3 billion.
Curiously, the following six billionaires on the list have a "tie-in" with Cisco or its competition:
Michael Krasny - net worth: $1.6 billion
Founder of CDW a Cisco Gold Partner
Forbes duly notes:
 Auto dealer's son started used computer sales operation in kitchen after his $3, 3-line ad in the Chicago Tribune to sell old IBM generated high demand. Turned $300 profit on second sale.
Founded Computer Discount Warehouse 1984; company became one of world's most profitable resellers of tech products. Retired 2001; company bought by private equity firm Madison Dearborn Partners for $7.3 billion last October. Donated more than $350 million in CDW shares to charity. |
John Morgridge - net worth: $1.6 billion
Chairman emeritus of Cisco
Forbes duly notes:
 U. of Wisconsin grad started career at Honeywell, joined networking firm Cisco as president and chief executive in 1988. Took the company public 2 years later. Increased sales from $5 million to more than $1 billion in 6 years. Stock soared dramatically during the tech bubble.
Firm briefly the world's largest; market cap was $555 billion in 2000 but dwindled to $70 billion by the end of 2002 as the bubble burst. Became chairman emeritus 2006. Fortune continues to falter; stock down 38% since last August. With wife, Tashia, has donated $50 million to alma mater, pledged to give up to $175 million. |
Richard Egan - net worth: $1.4 billion
Cofounder of Cisco competitor EMC
Forbes duly notes:
 Marine helicopter pilot worked at Lockheed Martin, Honeywell, Intel before cofounding data storage giant EMC Corp. 1979.
Took company public 1986; sold most of his shares in tech boom. Stepped down as chairman 2001. Big GOP supporter served as U.S. ambassador to Ireland during President Bush's first term. Forced to pay IRS $62 million in 2006. They claim he used an illegal tax shelter. |
Patrick McGovern - net worth: $4.1 billion
Founder of the International Data Group (owner of Network World and the Cisco Subnet)
Forbes duly notes:
 Construction worker's son feeling pinch of publishing industry slowdown. Studied biophysics at MIT while working for first U.S. computer magazine, Computers & Automation; made associate publisher by graduation.
Founded International Data Group 1964; launched trade magazine Computerworld 3 years later. Now has more than 300 magazines, trade shows, 450 Web sites. Last year sales rose 6% to $3.2 billion. Gives away stock options to employees, despite having no desire to take IDG public. Company has invested $950 million in venture capital companies in China, $150 million in India, $100 million in Vietnam, $100 million in Korea. Created McGovern Institute for brain research at alma mater. |
Martha Ingram - net worth: $2.8 billion
Owner of Cisco authorized distributor Ingram Micro
Forbes duly notes:
 Widow of Bronson Ingram took over Ingram Industries in 1995. Bronson inherited his father's oil-and-barge business 1963.
Today Nashville company is nation's largest distributor of books, magazines, print on demand. Merged book and print-on-demand divisions in June to form Ingram Lightning Group. Son David runs spinoff Ingram Entertainment: CDs, DVDs. Original barge business led by son Orrin; president, chief executive of Ingram Industries. Son John chairman for entire operation. Martha now retired; Vassar grad and performing arts buff prominent in Nashville society. |
Jerry Yang - net worth: $1.7 billion
Member of the Cisco Board of Directors and Cofounder/CEO of Yahoo!
Forbes duly notes:
 Why didn't he take the money? Yahoo chieftain saw his stock languish for years, then pop 45% after Microsoft tried to snatch company up for $44.6 billion to take on Google in search. Balked at hostile takeover attempt; shareholder activist Carl Icahn led proxy battle to replace board, oust Yang as chief executive. Settled weeks later; Icahn and 2 friends now on expanded board. Stock down 39% since original Microsoft offer.
Met partner David Filo in grad school at Stanford, turned Internet directory project into Web portal Yahoo. Left Ph.D. track 1995, took public a year later. Brought in "professionals": Tim Koogle in 1995, former Warner Bros. boss Terry Semel 2001. Agreed to ad partnership with Google in June following Microsoft debacle; Yahoo will post Google ads alongside Yahoo's search results. |
Did we miss anybody?
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Today Nortel hosted an investment community webcast to discuss expectations for its third quarter and full year 2008 financial results (Note: Nortel's stock price plunged almost 50% after today's webcast).
Yesterday, Cisco hosted its Financial Analyst Conference webcast for members of the investment community with a keynote delivered by CEO John Chambers followed by Cisco executive team overviews of the company's financial roadmap and long-term strategy.
Placing a Wall Street analyst perspective on this week's Nortel and Cisco webcasts, RBC Capital Markets Managing Director Mark Sue offers a comparative Nortel vs. Cisco investment outlook:
Future Prospects
Nortel
The situation is getting worse for Nortel and the company is being forced to strengthen its balance sheet with another round of asset sales. With softening demand and increased competition, Nortel may need to once again retool and refocus as it looks to find its position in a consolidating industry. Our price target moves to $4.
vs. Cisco
Cisco articulated a detailed message regarding its growth prospects and highlighted key new markets and adjacent opportunities which may enable the company to meet its long term growth guidance range of 12-17%. Video, Collaboration, and Virtualization were key areas of focus and may collectively represent $62B in additional addressable markets.
Initiatives and Challenges
Nortel
Nortel preannounced 3Q08 earnings and revised their 2008 outlook citing the economic downturn and significant customer pressure in Carrier, Enterprise and Metro Ethernet. Additionally, Nortel is exploring divesting its Metro Ethernet-40Gig optical business which we estimate at $1.7B in 2009. MEN was one of the faster growing segments with a projected CAGR (Compound Annual Growth Rate) of 10% and a potential $2B market size. Peer groups in optical have also suffered so Nortel's timing may not be the best. Nortel is also planning additional restructuring and cost reduction initiatives.
Near term, metrics remain challenging, particularly in the financial verticals. But to put it in context, total financial customers represent only 3-4% of Cisco's revenues. And considering Cisco's skills of forecasting and projecting its business, we believe the extra conservatism of just 8% YoY (Year Over Year) growth for the near term may have been factored in a deteriorating enterprise environment. On the margin, Cisco may be seeing incrementally positive trends with some domestic and international carriers.
Revenue Expectations
Nortel
For 3Q08, Nortel sees revenues of $2.3B versus the street at $2.7B. Gross margin is expected to be ~39% due to delivery delays and product mix. Operating expense is expected to be $60M lower than 2Q08 or about $950M. For CY2008, Nortel expects sales to decline 2-4% YoY versus previous guidance of low single-digit growth. Gross margins are expected to be at 42% for the year and Management Operating Margin is expected to improve 125-175bps YoY versus prior expectations of a 300bp improvement. Deferred revenue in 4Q08 goes from $350M to $320M.
vs. Cisco
Cisco entered the quarter with a book to bill greater than 1.0 and backlog of $4.8B, and with geographic and segment balance offsetting weak sectors, we believe Cisco remains well placed to meet its near term financial metrics. Consensus for the current October quarter is $10.33B (just +8% YoY). Nonetheless, if the macro deteriorates further and remains broad based, Cisco will be impacted. Cisco declined to call a time frame for a recovery but we do point out that the consensus for the following January quarter calls for reasonable 8.5% YoY growth.
Strategic Considerations
Nortel
Cash burn during 3Q08 will be about $500M. While earnings are a significant factor, there are about $220M in "one-off" charges including a $70M payment to Flextronics, a $50M LG Electronics earnout, an $80M impact from having an additional payroll period during the quarter and some small acquisitions. End of year cash balance is expected to be between $2.6B and $2.9B.
vs. Cisco
Cisco's core markets of switching and routing (54%) are maturing and may grow just 8-9% over time. Yet, add to this baseline growth emerging markets, adjacent markets and services, and it might be enough to nudge the needle higher to 12-17% overall. Several new products will also help nudge the needle and Cisco emphasized the new 1000V for virtualization, mid range Telepresence systems, and web collaboration.
Investor Forecast
Nortel
Nortel shares are currently trading at 0.3x 2009E EV/Sales (Enterprise-Value-To-Sales). Over the last three years, Nortel shares have traded between 0.3x and 1.7x EV/Sales, with an average of 1.0x. On a P/E basis, the shares are trading at 7x our new CY09E EPS of $0.50. Visibility towards our estimates which do not factor in the planned divestiture remains low and another strategy rethink may be necessary for Nortel.
Nortel Stock Chart:
vs. Cisco
Cisco's financial model remains healthy with gross margins near 65%, operating margins of 29.5% and strong cash generation. Cisco has $8B left in its share repurchase authorization. Organizational tweaks and a broader use of the development council is also helping Cisco to address market growth opportunities faster. And despite the muted environment, Cisco may be executing better than its peers. And with shares trading at 13x our CY09 earnings, we view Cisco as a strong relative defensive name.
Cisco Stock Chart:
Related stories:
Nortel sees Q3 revenue down, will sell metro Ethernet unit
Cisco: TelePresence will do for Cisco what iPhone did for Apple
Is investor confidence potentially an accurate measurement of future customer acceptance in the marketplace?
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Luckily, Michael Patterson - President and CEO of Plixer International sent us the following photos from the down under Cisco Networkers 2008 event being held this week in Brisbane, Australia.
Fluke Networks Booth - Cisco Networkers 2008 Australia
Dimension Data Booth - Cisco Networkers 2008 Australia
NetScout Booth - Cisco Networkers 2008 Australia
Plixer International Booth - Cisco Networkers 2008 Australia
Statseeker Booth - Cisco Networkers 2008 Australia
Cisco Booth - Cisco Networkers 2008 Australia
Cisco Booth - Cisco Networkers 2008 Australia
