Question

Analysis of Changes in Profitability and Growth: Cisco Systems, Inc. 1 By any stretch of the imagination, Cisco System s (CSCO) has been a strong growth company. A darling of the Internet boom of the late 1990s, it was one of the few technology companies tied to the Internet and telecommunications that prospered during that era. Its products - networking and communications equipment such as router and sw itching devices - built the infrastructure of the Internet. While most Internet and telecommunications firms str uggled and failed, their supplier, Cisco, capitalized on the new technology. At one poi nt in 2000, its market capitalization was over half a trillion dollars, the largest market capitaliza tion of any firm ever. Its stock price increased from $10 in 1995 to $80 in 2000, supported by sales growth from $2.0 billion in 1995 to $18.9 billion 2000. In early 2000, Cisco’s P/E stood at 130 so investors saw plenty of room for more earnings growth. However, with the subsequent collapse of the technology bubble and the demise of telecommunications firm such as WorldCom, Qwes t, and AT&T, the anticipated growth failed to materialize. Indeed, in 2001 Cisco wrote down inventory by an astonish ing $2.3 billion (under the lower-of-cost-or-market rule), to reflect the dr op in demand for its products and the emergence of second-hand telecom equipment market. Exhibit 1 presents Cisco’s income statements fo r the fiscal years 2000-2002 and balance sheets for 1999-2002. The exhibit also includes the cash flow from operations a nd cash investing sections of the cash flow statements. The 2000 sales of $18 .9 billion were up from $12.2 billion in 1999 and $8.5 billion in 1998, a tremendous gr owth record. But subsequent sales growth was not as impressive, as you can see, and led to declini ng earnings. Indeed, Cisc o posted a loss for 2001. Lower earnings on increasing shareholders’ equity clea rly implies that residual income is declining. By the end of 2002, Cisco’s shares traded at $15, well down from the 2000 high of $80. Other information, most of the from the 10-K f ootnotes, that was useful in reformulating the financial statements is presented below. Note th at the cash flow statements from Exhibit 1 are particularly useful for identifying core income becau se some of the items in the reconciliation of net income to cash flow from operati ng activities involve unusual items.
Questions: 1. What adjustments are necessary to reformulate the income statements and balance sheets to properly separate financ ing from operations? 2. What adjustments are necessary to separate core operations from othe r sources of income? What items are identified as core in the Balance Sheet? 3. Calculate Core RNOA and decompose the ratio for Cisco for 2002 and 2001.
1. Long-term investments are comprised of the following: 2002 2001 2000 1999 Equity investments 567 1,529 6,225 877 Debt investments 8,233 8,817 7,463 6,155 8,800 10,346 13,688 7,032 All short-term investments ar e debt investments. Restri cted investments are debt investments. 2. $50 million of cash and equivalents is regarded as operating cash. 3. “Interest and other income” in the income statements is composed as follows. 2002 2001 2000 Interest income 895 967 577 Gain (loss) on investments (1,104) 163 531 (209) 1,130 1,108 The gain on investments applies mainly to debt and equity investments, but does include some derivative gains and losses and other small items. 4. The change in accumulated other comprehensiv e loss for all years was due almost entirely to unrealized gains and lo sses on debt investments. 5. Cisco’s income tax rate (combined federal and state) is 36.8 percent.

Cisco Income Statements 2002 2001 2000 Sales 18,915 22,293 18,928 Cost of sales, reported 6,902 11,221 6,746 Gross margin 12,013 11,072 12,182 R&D 3,448 3,922 2,704 Sales and marketing 4,264 5,296 3,946 General and administrative 618 778 633 Restructuring charges --- 1,170 --- Amortization of good will 690 154 Amortization of intagible assets 699 365 137 In-process R&D 65 855 1,373 total operating expenses 9,094 13,076 8,947 operating income from sales, before tax 2,919 (2,004) 3,235 Investment income (209) 1,130 1,108 Income before tax 2,710 (874) 4,343 Taxes 817 140 1,675 Net income 1,893 (1,014) 2,668
Cisco Balance Sheets Assets 2002 2001 2000 1999 Current Assets: Working Cash 9,484 4,873 4,234 913 Short-term investments 3,172 2,034 1,291 1,189 Accounts Receivable 1,105 1466 2299 1250 Inventories 880 1684 1232 658 Deferred tax assets 2,030 1809 1091 580 Lease receivables 239 405 -   -   Prepaid expenses 523 564 963 171 total current assets 17,433 12,835 11,110 4,761 investments 8,800 10,346 13,688 7,032 restricted investments 1,264 1,286 1,080 Property and equipment 4,102 2,591 1,426 825 Goodwill 3,565 3,189 2,937 157 Lease receivables 39 253 527 500 Purchased intangibles 797 1,470 1,150 303 Other assets 3,059 3,290 746 235 Total assets 37,795 35,238 32,870 14,893 Liabilities Current Accounts payable 470 644 739 374 Income tax payable 579 241 233 630 Accrued compensation 1,365 1,058 1,317 679 Deferred revenue 3,892 3,214 1,386 724 Other accrued liabilities 2,496 2,553 2,653 631 Restructuring liabilities 322 386 --- --- 9,124 8,096 6,328 3,038 Minority interest 15 22 45 44 Common shareholders' equity 28,656 27,120 26,497 11,811
Cash Flow Years Ended July 27, 2002 July 28, 2001 July 29, 2000 Cash flows from operating activities: Net income (loss) $1,893.00 ($1,014.00) $2,668.00 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 1,957 2,236 863 Provision for doubtful accounts 91 268 40 Provision for inventory 149 2,775 339 Deferred income taxes ($573.00) ($924.00) ($782.00) Tax benefits from employee stock option plans 61 1,397 2,495 Adjustment to conform fiscal year ends of pooled acquisitions - - ($18.00) In-process research and development 53 739 1,279 Net (gains) losses on investments and provision for losses 1,127 43 ($92.00) Restructuring costs and other special charges - 501 - Change in operating assets and liabilities: Accounts receivable 270 569 ($1,043.00) Inventories 673 ($1,644.00) ($887.00) Prepaid expenses and other current assets ($28.00) ($25.00) ($249.00) Accounts payable ($174.00) ($105.00) 286 Income taxes payable 389 ($434.00) ($365.00) Accrued compensation 307 ($256.00) 576 Deferred revenue 678 1,629 662 Other accrued liabilities ($222.00) 251 369 Restructuring liabilities ($64.00) 386 - Net cash provided by operating activities 6,587 6,392 6,141 Cash flows from investing activities: Purchases of short-term investments ($5,473.00) ($4,594.00) ($2,473.00) Proceeds from sales and maturities of short-term investments 5,868 4,370 2,481 Purchases of investments ($15,760.00) ($18,306.00) ($14,778.00) Proceeds from sales and maturities of investments 15,317 15,579 13,240 Purchases of restricted investments ($291.00) ($941.00) ($458.00) Proceeds from sales and maturities of restricted investments 1,471 1,082 206 Acquisition of property and equipment ($2,641.00) ($2,271.00) ($1,086.00) Purchases of technology licenses - ($4.00) ($444.00) Acquisition of businesses, net of cash and cash equivalents 16 ($13.00) 24 Change in lease receivables, net 380 457 ($535.00) Purchases of investments in privately held companies ($58.00) ($1,161.00) ($130.00) Lease deposits 320 ($320.00) - Purchase of minority interest of Cisco Systems, K.K. (Japan) ($115.00) ($365.00) - Other 159 ($516.00) ($424.00) Net cash used in investing activities ($807.00) ($7,003.00) ($4,377.00) Cash flows from financing activities: Issuance of common stock 655 1,262 1,564 Repurchase of common stock ($1,854.00) - - Other 30 ($12.00) ($7.00) Net cash (used in) provided by financing activities ($1,169.00) 1,250 1,557 Net increase in cash and cash equivalents 4,611 639 3,321 Cash and cash equivalents, beginning of fiscal year 4,873 4,234 913 Cash and cash equivalents, end of fiscal year $9,484.00 $4,873.00 $4,234.00

Answer 1

Cisco's reformulated Income Statements
CORE OPERATIONS	2002	2001	2000
Sales	18,915	22,293	18,928
Cost of sales, reported	6,902	11,221	6,746
Gross margin------------------------------1	12,013	11,072	12,182
R&D	3,448	3,922	2,704
Sales and marketing	4,264	5,296	3,946
General and administrative	618	778	633
In-process R&D	65	855	1,373
Total Core opg.exp.---------------------2	8,395	10,851	8,656
Income from core operations-----3= 1-2	3,618	221	3,526
Unusual opg. Exp.
Restructuring charges	---	1,170	---
Amortization of good will		690	154
Amortization of intagible assets	699	365	137
Total unusual opg. Exp------------------4	699	2225	291
Net Opg.income -------------------5= 3-4	2,919	-2,004	3,235
Investment income---------------------6	-209	1,130	1,108
Income before tax------------------7=5+6	2710	-874	4343
Less:Taxes	817	140	1,675
Net Income after tax	1893	-1014	2668

Core items in the balance sheet(Partial)
	2002	2001	2000	1999
Operating assets --Current Assets:
Operating Cash	50	50	50	50
Accounts Receivable	1,105	1466	2299	1250
Inventories	880	1684	1232	658
Deferred tax assets	2,030	1809	1091	580
Lease receivables	239	405	-	-
Prepaid expenses	523	564	963	171
Total Operating assets--------------1	4,827	5,978	5,635	2,709
Operating liabilities: Current
Accounts payable	470	644	739	374
Income tax payable	579	241	233	630
Accrued compensation	1,365	1,058	1,317	679
Deferred revenue	3,892	3,214	1,386	724
Other accrued liabilities	2,496	2,553	2,653	631
Total Operating liabilities-------------2
Net Operating assets ----------------1-2	2,331	3,425	2,982	2,078
Net Opg.income(as above)	2919	-2004
Return on Net opg.assets=Before-tax opg.income/Opg.assets(1-taxRate)	2919/2331*(1-36.8%)=	-2004/3425=
	79.14%	-58.51%

RNOA= Profit Margin*Opg. Asset Turnover*(1-Tax Rate)
RNOA= (Opg.Inc./Sales)*(Sales/Net Opg.Assets)
Sales	18,915	22,293
Profit Margin	2919/18915=	-2004/22293=
	15.43%	-8.99%
Opg. Asset Turnover	18915/2331=	22293/3425=
	8.11	6.51
(1-Tax Rate)=(1-36.8%)	63.2%
RNOA=PM*Op.ATO*(1-Tax Rate)	15.43%*8.11*63.2%=	-8.99%*6.51=
	79.09%	-58.52%