InformationWeek

e've just had our first big bomb of the second quarter: Cisco Systems (CSCO--Nasdaq) warned that its upcoming earnings report would fall well short of expectations. What's all the fuss, you ask. After all, Cisco's stock is already down from $82 to its most recent low of $13 before settling in around $17. That's a decline of almost 80% already. Isn't the bad news discounted?

First, the worst offense was the 30% sequential decline in revenue projected for fiscal 2001's third quarter, which ends in April (Cisco's fiscal year ends in July). This will bring revenue in the upcoming quarter to about $4.7 billion, down from $6.7 billion in the second quarter. The company also disclosed a potentially flat fourth quarter, with the possibility of a further 10% decline sequentially be-tween the fiscal third and fourth quarters.

Let's assume revenue stays flat. That implies revenue for fiscal 2001 will run about $22.7 billion. Though this is 20% higher than last year's total of $18.9 billion, it's substantially below the company's target of 30% to 50% that's been the industry's recent growth rate--and a target that president and CEO John Chambers feels comfortable endorsing for the future. I'm having trouble getting to those growth rates even over a longer time frame, especially considering the enormous revenue base that Cisco represents today. Even Chambers admits that revenue from carriers is potentially large but very "lumpy" (in the $50 million to $300 million-plus level per deal), where one late payment could skew a quarter's earnings. Forget earnings consistency; let's just say this remains a very cyclical business.

Second, Cisco expects to take a $2.5 billion inventory charge in the fiscal third quarter. Excuse me? Wasn't that the same level as the total inventory on its balance sheet at the end of its latest fiscal quarter? Let's do the math--there's lots of numbers, but stay with me and we'll have some questions to ask about Cisco's inventory risks. Since gross margins for the quarter were expected to be in the low-to mid-50s, the cost of goods sold during the quarter was around $2.5 billion ($4.7 million in fiscal third-quarter revenue multiplied by 52% gross margin). At the end of the fiscal third quarter, Cisco is projecting inventory of about $1.6 billion. The cost of goods sold by the company during the quarter was $2.5 billion; when we add the ending inventory of about $1.6 billion, we get $4.1 billion. Now, subtract the beginning inventory of $2.5 billion to get $1.6 billion net new manufactured goods during the quarter. That means Cisco wrote off about 156% of the total net goods it manufactured during the quarter.

But how can this be, when Cisco had only three months of inventory on the books to begin with? Could there be more return of products allowed than originally disclosed in historical contracts with the carriers? I have nothing on which to base these theories other than the fact that writing off a whole quarter's inventory seems a bit much to just shrug off. It's very disturbing. My only consolation is that Redback Networks Inc. (RBAKıNasdaq) was worse. It wrote off $24 million of inventory and had only $17 million at the end of its most recent quarter.

The third item from Cisco is becoming a favorite of mine--consolidation of "excess facilities." Due to restructuring and layoffs, an amazing number of technology companies have slowed or halted new building plans. Cisco will have excess facilities charges of $300 to $500 million--yes, those one-time charges again. Using Redback as a recent comparison, the company had a one-time excess facility charge of $23 million on quarterly revenue generation of only $90 million.

I could go on. Alas, Cisco and many related companies would like us to just forget all these one-time charges. Tell that to investors as their shareholder equity declines further.

Remember that the write-off in assets and inventory effectively means that the capital written off will earn zero for the rest of a company's business future. That's not exactly a great return on shareholder's equity.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.