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.

Credit Notes Payable for $38,160

Debit Interest Expense for $540

Credit Cash for $2,160

Debit Interest Expense for $2,160