Reading Between the Lines To Spot the Next Cisco

by: William Trent, CFA

Often, a company seeing weakness will cut back on its own purchases. When we previewed earnings for Cisco Systems (NASDAQ:CSCO) we said “A major supplier, Altera, (NASDAQ:ALTR) looked weak. That makes us nervous.” With Cisco now down nearly 10% in the two days since announcing earnings, we thought it an appropriate opportunity to demonstrate supply chain analysis in action.

We do so by turning to recent comments from management at Cisco as well as some of Cisco's suppliers.

Paul Silverstein - Credit Suisse

John, if I missed you in the prepared remarks, I apologize. But can you give us some more insight in terms of what you are seeing in the US enterprise market? Whether there are any signs of a pick up in that market sector?

John Chambers

Sure, Paul. The market, it stayed pretty flat in terms of mid-single digits for the quarter. And that to me was actually good that it didn't spillover into commercial. In fact commercial went up. And I am seeing from the customers, most people feel that they are coming in for a soft landing. They are being conservative on their budgets, which is little bit of surprise.

(Excerpt from full CSCO conference call transcript)

How much of a surprise was it? Or, at least, should it have been? Altera reported earnings on April 23, and said:

Tim Luke - Lehman Brothers

Just on the networking side, it sounds like Cisco is moving back towards the lean inventory. I was under the impression that of the program that they started a while ago, and maybe you could give us some sense of how long that you think that will take to work through in terms of having an impact in your orders, and then when you would expect to see that move upwards again, having been worked through?

John P. Daane

Tim, I will start with the networking side. As you probably are familiar with us, we tend, or we really do not want to talk about specific customers, so I am going to stay generic here. We have seen customers move to sort of a lean model over time where they are moving to a VMI program, if you will, vendor management inventory essentially or a program where they are having ultimately the contract manufacturer hold their inventory for them, in which case you are basically removing one of the buffer spots in the chain where there used to be inventory before.

Typically, if you think about it, customers only keep a small amount of inventory, so you would expect at any particular time that there may be an impact of about a quarter, so a month to three months, and then you should see a return to the normal buying pattern.

This is specific to one customer this quarter. That’s a major customer in the networking space. I would note that we have had this effect over the last several years from other large customers, particularly in the communications area, that have also been doing this.

(Excerpt from full ALTR conference call transcript)

So we know for a fact that Cisco was reducing orders - either to trim inventory (the official story) or to reflect slower orders. Yet Cisco's major competitor Juniper (NYSE:JNPR) was seeing blowout sales when it reported (also on April 23.)

And now moving to the enterprise business. We continue to make progress in this marketplace with approximately one third of our business coming from enterprises, where we today served over 20,000 enterprise customers worldwide. Our enterprise business in total grew 25% in Q1 as compared to the same period a year ago.

(Excerpt from full JNPR conference call transcript)

Based on Juniper's results, even keeping shifting toward a leaner inventory presumably would be overwhelmed by such strong growth. The official story starts sounding less plausible.

So how can one figure out which companies are exposed to others as either customers or suppliers if you don't already know? We went to Edgar full text search and typed in [Cisco NEAR10 "major customer"]. It gave us 32 results, including PMC Sierra (NASDAQ:PMCS) and Avanex (AVNX). While PMC Sierra's transcript wasn't available, we were able to get one for Avanex, which reported on May 3.

John Harmon - Needham & Company

And congratulation on getting the divestiture done. Just a couple of questions. One just the obvious question. Given what one of your competitors said last night, have you felt the effect of these supply chain shortenings, and secondly the Lucent-Alcatel merger, what effect has that had on your business?

Jo Major

I will help people understand if they didn't read the other scripts. Both last quarter and this quarter, there has been some discussion of the fact that companies like Nortel and Cisco have publicly announced manufacturing initiatives along the line of lean.

And lean is simply a look at how you can remove inventory from your system. So you look to your suppliers to provide shorter lead times and again that's a real fundamental attribute of the new amplifiers suite, it’s a really fundamental attribute of the idea of bringing tunable dispersion compensation out to manage inventory.

But the lean initiatives had met in some areas. You’ve seen some pull backs on purchasing, because they would have had 15 weeks of inventory and they want to move that down to 5.

(Excerpt from full AVNX conference call transcript)

From 15 weeks to 5? That sounds preposterous. If Cisco was able to operate on 5 weeks of inventory instead of 15, why didn't it make the switch years ago? Comments like these are why investors need to think about what is being said rather than take it at face value.

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