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Consolidated Complaint for Violation of the Federal Securities Law
Source: Milberg Weiss Date: 05/15/02 Time: 9:43 AM
MILBERG WEISS BERSHAD HYNES & LERACH LLP WILLIAM S. LERACH (68581) DARREN J. ROBBINS (168593) SPENCER A. BURKHOLZ (147029) DANIEL S. DROSMAN (200643) 401 B Street, Suite 1700 San Diego, CA 92101 Telephone: 619/231-1058 619/231-7423 (fax)
LEVIN, PAPANTONIO, THOMAS, MITCHELL, ECHSNER & PROCTOR, P.A. FREDRIC G. LEVIN (pro hac vice) J. MICHAEL PAPANTONIO (pro hac vice) TIMOTHY M. O'BRIEN (pro hac vice) 316 South Baylen Street, Suite 600 Pensacola, FL 32501 Telephone: 850/435-7000 850/436-6084 (fax)
Co-Lead Counsel for Plaintiffs
UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF CALIFORNIA
SAN JOSE DIVISION
PLUMBERS & PIPEFITTERS NATIONAL ) Master File No. C-01-20418-JW ) PENSION FUND, et al., On Behalf of ) CLASS ACTION Themselves and All Others Similarly ) Situated, ) CONSOLIDATED COMPLAINT ) FOR VIOLATION OF THE
http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 2 of 223 FOR VIOLATION OF THE Plaintiffs, ) FEDERAL SECURITIES LAWS vs. ) ) CISCO SYSTEMS, INC., JOHN T. ) CHAMBERS, LARRY R. CARTER, GARY ) ) J. DAICHENDT, JUDITH L. ESTRIN, ) CARL REDFIELD, MICHELANGELO ) VOLPI, CAROL A. BARTZ, STEVEN M. ) WEST, EDWARD R. KOZEL, ROBERT L. ) ) PUETTE, DONALD J. LISTWIN, ) DONALD T. VALENTINE, and ) PRICEWATERHOUSECOOPERS LLP, ) ) Defendants. ) ______) ) In re CISCO SYSTEMS, INC. ) SECURITIES LITIGATION ) ______) ) DEMAND FOR JURY TRIAL This Document Relates To:
ALL ACTIONS. ______
SUMMARY OF THE ACTION
1. This is a securities class action on behalf of all purchasers of the common stock of Cisco Systems, Inc. ("Cisco" or the "Company") between 8/10/99 and 2/6/01 (the "Class Period"), arising out of defendants' manipulative conduct, fraudulent course of business and false statements regarding Cisco's business - including its orders and demand for its products, the reasons for and the impact of the growth in its inventories, the quality of and accounting for its "vendor financing" program, the development and sales of its new Monterey fiber optic switch, the capability of its Cerent product, its success in penetrating the customer service software market, its success in penetrating the telecommunications service provider market with new fiber optic products, the success and continuation of Cisco's acquisition program, and Cisco's forecasted growth and its F01-F02(1) revenues, net income and earnings per share ("EPS"), as well as Cisco's actual reported financial results throughout the Class Period.
2. For years, Cisco achieved rapid growth by selling data transmission equipment (routers) to corporate customers and government agencies to network their computer systems and to provide access and data communications via the Internet. However, by 99, these markets were maturing and so to try to sustain its rapid growth, Cisco began to try to sell data and voice transmission equipment to telecommunications service providers, including both large established telephone carriers, as well as new Competitive Local Exchange Carriers ("CLECs"). Also, beginning in 93 Cisco had begun an acquisition binge to try to obtain new technology and new products to stimulate Cisco's revenue and EPS growth, using Cisco stock as the currency to pay for these acquisitions. By 98-99, Cisco's ability http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 3 of 223
to obtain top flight engineering talent, cutting edge technology and new products to boost its revenues and EPS had become dependent upon its ability to continue to make large numbers of acquisitions. Cisco's pace of acquisitions accelerated rapidly during 99-00, with Cisco acquiring 18 companies in 99 and 23 companies in 00. Between 93 and 00, Cisco acquired 71 companies - 95% of which were for Cisco stock. During the Class Period, Cisco's ability to continue to make these types of acquisitions, which were vital to its continued business success and EPS growth, was dependent on Cisco's stock price increasing.
3. By 99, Cisco was also operating in an environment of intense competition to hire and retain talented, technically competent employees. This was due to a critical shortage of such people in Silicon Valley, in part because new dot.com and Internet-related companies were offering these types of employees very lucrative stock option-based compensation programs. Cisco's compensation system for its employees was predominantly based on stock options to buy Cisco stock, with employees regularly receiving option grants at Cisco's then market price, varying in size by the recipient's position in the corporate hierarchy. By 00, Cisco had over 530 million employee stock options outstanding. Cisco's stock options, which were critical to enabling Cisco to retain existing employees and attract new employees, became more valuable only if Cisco's stock increased in price.
4. By 99, because of Cisco's need to continue to constantly make acquisitions using its stock and its dependence on stock options to compensate its executives and attract and retain high-quality employees, Cisco's top executives were under tremendous pressure to push Cisco's stock price ever higher. Because Cisco's business and growth strategy had become so dependent upon its stock price, Cisco's stock price was a fixation among its top executives, who monitored the trading of the stock on a daily - even hourly - basis!
5. Due to Cisco's rapid growth, by 98 its sales had reached an annual level of over $8 billion. Due to Cisco's increasing size, analysts and investors became concerned over Cisco's ability to continue to achieve the strong 30%-50% annual revenue growth it had been reporting. Moreover, because Cisco controlled some 45% of the enterprise market, its ability to grow at the same rate as in the past was doubtful. As a result of these concerns, Cisco's stock, which had been a very strong performer, increasing from approximately $8 in early 98 to more than $30 in early 99, stagnated during 99, trading at $29-3/8(2) on 2/1/99 and $29-3/8 on 8/10/99 - the start of the Class Period - meaning Cisco's stock - a supposedly unique growth stock - had shown no net price gain in over six months! This stock price stagnation was a major concern to Cisco's top executives. Worse yet, they feared that if analysts and investors perceived that Cisco's revenue and EPS growth rates were slowing, they would be unwilling to pay the type of huge premium that Cisco's stock had historically enjoyed and this would result in a sharp decline in Cisco's stock price. They knew that any such decline in Cisco's stock would be a disaster for Cisco and its top executives, as it would curtail (if not eliminate) Cisco's ability to continue to make the large numbers of acquisitions upon which Cisco's business plan and financial growth had become dependent. Such a price decline would also reduce (if not eliminate) the value of the stock options held by Cisco's executives, management and other employees, resulting in a huge loss of wealth for Cisco's executives and even an exodus of valued employees, who would be lured elsewhere by more lucrative stock option programs of smaller, still rapidly growing companies that had stocks which would more likely appreciate in price.
6. So, in order to make it appear that Cisco was maintaining its phenomenal growth, Cisco consistently "beat the Street" - reporting quarterly revenue growth that exceeded forecasted levels and, beginning in 87, quarterly EPS that were $.01 better than consensus forecast every quarter, creating a Cisco "cult" following among analysts and investors. The importance of Cisco http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 4 of 223
consistently beating the Street's EPS consensus forecast by $.01 each quarter was highlighted by Cisco in a 5/00 Fortune magazine article:
Wall Street ... has fallen hopelessly in love with Cisco. But managing Wall Street is also a textbook operation. "The company reports like clockwork," says George Kelly, a Morgan Stanley Dean Witter analyst who has had a buy on the company since it went public. Says Larry Carter: "We focus on communicating and being consistent. There is nothing Wall Street likes more than that." That attitude helps explain why of the 33 analysts covering Cisco, 12 have buys and 21 have strong buys.... And it helps explain why Carter was able to point out to a group of institutional investors at a Merrill Lynch conference this year - right after the company's tenth anniversary as a public company - that Cisco had just logged its 40th quarter in a row of record revenues and profits, without ever missing expectations. Music to Wall Street's ears.
7. When reporting its 4thQ F99 and F99 results after the close of trading on 8/10/99 - the beginning of the Class Period - and then, throughout the Class Period, Cisco continued its pattern of beating consensus forecasted EPS by one cent each quarter - defying skeptics, critics and bears on Wall Street. During virtually the entire Class Period, Cisco assured analysts and investors that it was enjoying strong demand for all its products in all geographic regions, while consistently reporting a book-to-bill ratio above one, supposedly concrete evidence that new orders for its products were exceeding shipments, demonstrating that Cisco was continuing to enjoy strong demand for its products, which would allow Cisco to continue its exceptional revenue, net income and EPS growth for the next several years. In fact, so strong was demand for Cisco's product that in late 00, Cisco actually increased its forecasted growth rate and its F01 and F02 revenues, net income and EPS.
8. During the Class Period, Cisco also assured investors that it was now successfully penetrating the huge telecommunications service provider ("SP") market, a/k/a, the carrier market via fiber optic transmission products - a transition away from Cisco's historic dependence on the corporate and government agency markets (the "Enterprise market"), which was absolutely essential for Cisco to be able to continue to show the kind of strong revenue, net income and EPS growth it had reported in the past. This success was exemplified by Cisco's representation that its new "top of the line" Monterey optical switch product was being successfully developed for commercial release and orders for the Monterey switch were being received, and Cisco's representations about its Cerent product which could supposedly handle 3.8 million calls and which would help contribute to continued strong revenue, net income and EPS growth for Cisco in F01-F02.
9. In fact, Cisco had tried to get into the SP market in 97 and 98, but was unable to make much headway into this market as competitors, including Ascend (later part of Lucent), offered much more aggressive financing to SP companies. When the Cisco SP group proposed Cisco offer more aggressive financing to break into the telephony/SP market, Cisco's CFO rejected the idea as too risky. However, by late 98, so that Cisco could succeed in the SP market, Cisco decided to offer much more aggressive financing. Customers were then demanding $1 of working capital financing for every $1 of equipment financing. Cisco ultimately agreed to finance under these terms and was thus able to increase its revenues from, and its market share of, the SP market - however, it was only due to aggressive financing that Cisco was able to do so.
10. Thus, throughout the Class Period an ever increasing amount of Cisco's revenues came from "vendor-financed sales," where Cisco, via its Cisco Capital subsidiary, loaned customers the money to purchase Cisco equipment which resulted in Cisco making over $600 million of such loans by the end http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 5 of 223
of Class Period. When investors and analysts raised concerns over the increasing extent to which Cisco was financing sales of its products to customers and the creditworthiness of these customers - some of which were dot.com start-ups or new CLECs - Cisco repeatedly assured them that Cisco had in place controls and monitors to assure that its vendor financing program was prudently implemented, that virtually all of Cisco's loans were to tier-one financially secure corporations and that Cisco had incurred extremely small credit losses on this program. They also represented that Cisco's accounting for its vendor-financed sales was exceptionally conservative, as it was recognizing revenue only on vendor-financed sales to well established tier-one creditworthy companies and deferring revenue recognition on sales to smaller emerging companies - the so-called "structured" portion of its vendor financing program - until cash payments from them on their loans were actually received, thus indicating to investors that the revenue from "vendor-financed sales" was legitimate and that the vendor-financed sales program posed no or little risk to Cisco.
11. During the Class Period, Cisco's inventories of component parts, work in progress and finished goods increased from $652 million at 7/31/99 to $878 million at 5/00 to $1.2 billion at 7/29/00 to $1.9 billion at 10/28/00 to $2.5 billion at 1/27/01. When analysts and investors asked questions about this inventory build-up, Cisco executives assured them that this inventory build-up was the result of deliberate decisions and actions by Cisco to secure adequate amounts of component parts which were in critically short supply so that Cisco could build more finished goods to meet increased demand and reduce lead time on shipments to customers. Thus, defendants assured the investment community that Cisco's inventory build-up did not reflect any lessening of demand for Cisco's products or problem with its business, but, in fact, was a positive development, reflecting increasing demand, and which would enable Cisco to boost its sales and revenues and profits going forward.
12. During the latter part of the Class Period, as Cisco's stock was falling, investors and analysts became increasingly concerned over Cisco's ability to continue the rapid pace of acquisitions which Cisco needed to obtain cutting-edge technology and new products to continue its rapid growth. However, Cisco assured the investment community that it would continue, if not accelerate, its pace of acquisitions and that the decline in Cisco's stock price would not impede Cisco's acquisition program because the stocks of companies Cisco would be interested in acquiring had fallen even further - thus creating a situation that favored Cisco's acquisition program - making Cisco the acquirer of choice. And finally, late in the Class Period, when it became apparent that the U.S. economy was slowing down and this might negatively impact capital expenditures by Cisco's customers, Cisco assured analysts and investors that it had not seen any material slowdown in orders or capital expenditures by its customers and that, if an economic slowdown did materialize and Cisco's markets became tough, this would actually help Cisco, as businesses would have to spend more on technology to increase productivity and cut costs, enabling Cisco to grow in good times or bad.
13. Cisco's positive statements to the market during the Class Period included those summarized below:
8/10/99 - Cisco Reports Better-Than-Expected 4thQ F99 Revenues and EPS
• Cisco's book-to-bill was over 1, reflecting continued strong demand for Cisco's products.
• Inventories increased due to purchase of component parts which were in short supply and ramp-up of production of new products. Cisco was happy with its inventory management. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 6 of 223
• Cisco was confident in its outlook.
• Cisco was forecasting 30%-50% growth and F01 EPS of $.61-$.62.
8/26/99 - Cisco Announces Acquisition of Monterey Networks for $500 Million and Cerent Corporation for $7.4 billion
• The new Monterey optical switch provided Cisco with expertise in optical transport.
• The Cerent 454 platform would soon support speeds of OC-192.
• The Monterey product was a bit ahead of schedule to be shipped to telecom carriers in 00.
• These acquisitions would represent a $10 billion opportunity by 02.
• The Monterey product was a very reliable high-capacity optical cross-connect.
• Cisco expected big things from Monterey in terms of revenue.
• The Monterey acquisition would help Cisco over the next two years.
11/9/99 - Cisco Reports Better-than-Expected 1stQ F00 Results
• All of Cisco's engines were on afterburner - Cisco was firing on all cylinders.
• Cisco's linearity was very good; book-to-bill ratio was better than 1-to-1, reflecting continuing strong demand.
• Cisco's optical business was on fire.
• Cisco was forecasting sales to grow by 30%-50% and EPS to grow by 35%-40%.
• The Monterey acquisition was off to a good start.
• Cisco was increasing its F01 EPS forecast to $.62-$.67.
2/8/00 - Cisco Reports Better-Than-Expected 2ndQ F00 Results
• Sales momentum was stronger than ever and Cisco was tightly managing its inventories.
• Cisco's book-to-bill ratio was over 1, reflecting continued strong demand.
• First order for Monterey switch had been received.
• Cisco was forecasting 30%-50% revenue and 35%-40% EPS growth. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 7 of 223
• Cisco was increasing its F01 EPS forecast to $.64-$.65.
5/9/00 - Cisco Reports Better-Than-Forecast 3rdQ F00 Results
• Demand for all of Cisco's products was strong. Cisco's book-to-bill ratio was over 1. Cisco's growth was accelerating.
• Cisco's inventories were up by $183 million to obtain components in short supply and cut product delivery times.
• Cisco's vendor financing was well controlled and conservative, with 90% of loans to high-quality, financially secure customers.
• Cisco was more optimistic about the future than ever; forecasting 30%-50% revenue growth.
• Cisco was increasing F01 EPS forecast to $.67-$.70 and forecasting F02 EPS of $.87.
8/8/00 - Cisco Reports Better-Than-Forecast 4thQ F00 Results
• Cisco's Book-to-bill ratio was over 1, reflecting continued strong demand.
• Cisco's inventories grew by $360 million in the quarter due to the deliberate decision to purchase more component parts and build more finished goods to improve delivery times to meet strong demand.
• Cisco was extremely conservative in vendor financing. No material losses to date.
• Cisco was more optimistic than ever.
• Cisco was increasing F01 revenue forecast to $30 billion and EPS to $.74-$.75 and increasing forecasted F02 EPS to $.92-$1.00.
11/6/00 - Cisco Reports Better-Than-Forecast 1stQ F01 Results
• Q/Q revenue growth slowed due to seasonal factors, not weaker demand.
• Cisco's days sales outstanding were up due to better product availability and were no cause for concern. Collections were on track.
• Cisco's big jump in inventories to $1.96 billion was due to stockpiling to guard against component part shortages and improve product delivery times.
• Cisco's orders were strong. Cisco's book-to-bill ratio was over 1.
• Cisco was as optimistic as ever.
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• Cisco was increasing its annual revenue growth forecast to 50%-60%, or $29 billion for F01.
• Cisco was increasing F01 EPS forecast to $.74-$.81.
14. As a result of the strength of Cisco's business, Cisco's apparently incredibly strong financial performance, its accelerating profits and EPS, its successful development of new products, including its fiber optic telecom products, the success and continuation of its acquisition program and its forecasts of accelerating revenue, net income and EPS growth for the next several years, Cisco's stock was an exceptionally strong performer during the first half of the Class Period. Cisco stock skyrocketed during the Fall of 99 from $28-5/64 on 8/10/99 to its Class Period high of $82 per share on 3/27/00. As Cisco had approximately 7.3 billion shares outstanding, this huge advance in the price of Cisco's stock resulted in Cisco reaching a market capitalization of $555 billion by late 3/00 - the largest market capitalization of any company in the history of the world - larger than Microsoft, General Electric, AT&T, General Motors or Intel. Using its high-priced stock as currency, Cisco accelerated its acquisition binge during 99-00 - reaching an unprecedented pace of two acquisitions per month!
15. As the Cisco "cult" spread, Cisco was lauded as the best stock in the world to own and its CEO John Chambers was praised as one of the world's best and most successful CEOs. The "cult" of Cisco created by Cisco's top executives, and manipulated by Cisco's financial results and false statements, was seldom more evident than in a 5/00 Fortune magazine cover story on Cisco, headlined and stating:
THERE'S SOMETHING ABOUT CISCO: CISCO HAS AN EXPENSIVE STOCK AND AGILE COMPETITORS. BUT THIS COMPANY HAS BEATEN EVERY CHALLENGE IT'S FACED. HERE'S AN INSIDE LOOK AT CEO JOHN CHAMBERS AND THE CORPORATE MACHINE HE'S CREATED
* * * No matter how you cut it, you've got to own Cisco.
Millions of investors around the world - Cisco now has 3,530,662 shareholders ... might well agree .... [W]e're probably talking about the happiest group of people on earth. How happy? Well, on March 27, Cisco overtook Microsoft as the most valuable business on earth .... Yes, GE now holds the crown, but who are you going to bet on in this race? GE, growing 15% annually, or Cisco, growing more than twice as fast?
Five years ago you might have looked at Cisco and said, "Well, sure, this is a great company, but really, how big can it get? All it does is connect computers. Microsoft, on the other hand, sells the operating system for every PC in the world. That is huge." How times have changed! As the Internet Revolution sweeps through civilization, networking - connecting computers - may well be the most critical, fastest-growing facet of the world's economy. Even Microsofties have to admit that the network has become the computer. And even though Sun coined that phrase, no company stands to benefit more than Cisco.
... The point is that Cisco, with CEO John Chambers at the helm, must now be considered one of America's truly outstanding companies .... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 9 of 223
16. However, in truth, Cisco was a house of fraud, deception and deceit. Cisco was falsifying its revenues, net income and EPS throughout the Class Period through a series of accounting manipulations and tricks. For instance, during 99 and early 00, when Cisco could not manufacture enough of certain router products to ship to meet its revenue and earnings forecasts, and artificially inflate its reported revenues, net income and EPS, at the end of each quarter Cisco shipped empty shells of router hardware products (including Summa Four switches) - without their internal working parts - while recording revenue on those shipments of fake products, an artifice reminiscent of the infamous Miniscribe scheme, where instead of shipping disk drives, Miniscribe shipped boxes of bricks and recorded revenue! Moreover, Cisco was manipulating its reported revenues, net income and EPS via the "yellow line" scheme. Near or at the end of a quarter, in order to boost Cisco's reported revenue, Cisco would cause product in its warehouses or shipment centers to be moved across a "yellow line" on the floor of the warehouses, and then treat and account for those goods as sold, even though they had not been shipped to customers as required by Generally Accepted Accounting Principles ("GAAP") for revenue recognition. Yet a third trick used by Cisco to manipulate its financial results late in a quarter, when Cisco's CFO and CEO knew they had created enough revenue to generate net income sufficient to beat the consensus EPS forecast by $.01 (including the manipulations described above), was the early sales cut-off wherein Cisco "cut off" the quarter before the last day of the quarter, thus stockpiling the remaining legitimate sales of that quarter for the next quarter. Cisco would prioritize shipment dates based not on customer request dates but based on orders needed to meet estimates and orders which could be deferred until the following quarter. These artifices enabled Cisco to improperly manipulate its revenue recognition, thus artificially boosting its results - helping it to exceed forecasted EPS by $.01 during the Class Period, i.e., the 4thQ F99, 1stQ F00, 2ndQ F00, 3rdQ F00, 4thQ F00 and 1stQ F01. As Michael Porter of the Harvard Business School recently told Business Week, "[W]e will likely find that even during its so- called heyday, Cisco wasn't nearly as profitable ... as many believed."
17. Cisco's outside auditors, PricewaterhouseCoopers, LLP ("PWC") also participated in Cisco's misstatements, issuing unqualified reports on Cisco's financial statements for F99 and F00. In fact, PWC received copies of reports from another accounting firm brought in to test Cisco Capital's loan portfolio which reports showed that Cisco had major problems with documentation in the portfolio. PWC was willing to participate due to the $15+ million in total fees it received from Cisco each year. This lucrative engagement had almost been lost in early 00 when the SEC advised Cisco to seek a new auditor due to PWC's independence violations. This made PWC even more reticent to object to Cisco's manipulations.
18. During the Class Period, Cisco also overstated the demand for its products and its vitally important book-to-bill ratio by accepting and counting hundreds of millions of dollars of double and triple orders from customers, knowing these orders were cancellable at the customers' option and hundreds of millions of those duplicate orders would never be fulfilled. Also, by accepting hundreds of millions of dollars of vendor financed orders from uncreditworthy customers and insisting that they order and then actually purchase millions of dollars of extra, unwanted and unnecessary product as a condition of receiving vendor financing and working capital loans from Cisco Capital, Cisco further artificially boosted both its book-to-bill ratio and its revenues, net income and EPS.
19. Also during the Class Period, Cisco misrepresented the quality of its Monterey optical switch technology, as well as the state of development of the Monterey optical switch product, concealing that development of the product was far behind schedule due to persistent engineering and technical problems that Cisco could not overcome, which would, at best, result in a long delay in the http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 10 of 223
commercial release of the product, if not abandonment of the product. In fact, at the time Cisco acquired Monterey it was not commercially viable, as this $5 million switch took up a full room. The Cerent product which Cisco claimed could be upgraded to support speeds of OC-192 and handle 3.8 million calls could in fact not do so due to limitations in its architecture.
20. By Spring 00, demand for many of Cisco's products slowed due to a combination of factors - market saturation and increasing competition from companies providing superior products, technical and performance problems with key Cisco products, declining capital expenditures by Cisco's existing and potential customers and cancelled or stretched out orders for Cisco's products. In order to conceal and cover up these adverse developments, Cisco continued to artificially inflate its revenue, net income and EPS, as well as other important business metrics, such as its book-to-bill ratio, by the improper and manipulative tactics outlined above. Cisco also accelerated its vendor financing, lending increasing amounts of money to customers of dubious creditworthiness who did not meet Cisco's own internal lending standards, recognizing the resulting "sales" as revenue. In addition, Cisco continued to force many of its vendor financing customers to order millions of dollars of product which those customers did not need and did not want - further inflating Cisco's book-to-bill ratio, revenue and EPS. These customers were so uncreditworthy that, in addition to lending them 100% of the money they needed to purchase Cisco equipment, Cisco continued to secretly make large and highly dubious working capital loans to these entities to provide them with funding for their operations and enable them to make payments on their commitments to purchase or lease Cisco products, even though most of these customers were unable to create or present credible business plans, could not provide credit applications and financial statements to Cisco and did not come close to meeting Cisco's internal lending criteria in any event. With these abusive vendor financing activities, Cisco continued to artificially inflate its revenues, net income and EPS by selling larger amounts of equipment than it otherwise could have sold while, at the same time, not taking required reserves for doubtful collectibility on the loans that financed these sales to, and the operations of, these uncreditworthy companies. The combination of vendor-financed orders for excessive amounts of Cisco product to uncreditworthy customers and the acceptance of double and triple orders from customers was why Cisco's book-to-bill ratio remained about 1-to-1, even though, in truth, the actual demand and real orders for Cisco's products had, in fact, weakened. In fact, contrary to Cisco's representations that 90% of its vendor financing loans were to tier-one financially secure enterprises, during F00 over 60% of Cisco's vendor financing sales were to financially shaky companies - accounting for 10% of Cisco's reported revenues - and between 98-00 over 50% of Cisco's vendor financing contracts had been with such companies, including ICG.Com, Darwin Networks, NorthPoint DSL, Digital Broadband, HarvardNet, Versatel, Vectris, PSINet, GTS, American Peripherals, Digital Broadband, American MetroComm, Cogent Communications, Viatel, Rhythms NetConnections, Winstar, Covad, World Wide Web and Looking Glass Networks.
21. As demand for Cisco's products softened, Cisco found itself in an extremely dangerous situation. Without any public disclosure of this very risky step, Cisco committed to purchase billions of dollars worth of component parts via non-cancellable forward purchase contracts (internally called "open purchase orders"), while, at the same time, orders from Cisco's customers for Cisco products continued to be cancellable at the customers' option! Worse yet, Cisco's top executives knew that many of Cisco's customers had double and triple ordered product and would thus cancel hundreds of millions or even billions of dollars worth of orders under the best of circumstances. To cover up the increasing danger to and deteriorating condition of Cisco's business posed by this lethal combination, Cisco's top executives lied about Cisco's inventory situation. Cisco represented that the increase in inventory that occurred throughout the Class Period was the result of intentional decisions by Cisco to obtain large supplies of critical component parts which were in short supply and build more finished http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 11 of 223
goods to reduce delivery times to customers and thus meet increasing demand when, in fact, they knew demand for Cisco's products had softened, customers were cancelling or delaying orders and Cisco was, in fact, being swamped by a tsunami of billions of dollars of unneeded and unwanted component parts, while accumulating hundreds of millions of dollars of excessive and unneeded work in progress and finished goods inventory, which would result in billions of dollars of write- offs and losses!
22. In addition, during 00 Cisco continued to make false and misleading statements about the extent of its success in developing new fiber optic products for the telecom SP market, as well as its penetration of that market. Cisco's successful diversification into and penetration of this huge telecom SP market was absolutely critical to Cisco's ability to achieve the F01-F02 revenue, net income and EPS growth it was forecasting. However, to conceal the serious problems it was having in penetrating this market, Cisco lied about one of its most important new optical switching products, the 15900 wave length optical switch - Cisco's Monterey switch - its most expensive "high-end" optical interface. While Cisco represented that it was successfully developing this product, was accepting orders for the product and would be shipping the product for revenue in late F00, the truth was that this product was far behind schedule in its development and was suffering from such serious and persistent technical and quality problems that Cisco would never be able to complete the development of the product for commercial sale and would ultimately have to completely abandon it.
23. By late 00, as Cisco's stock continued to fall and industry insiders increasingly suspected Cisco's business might be in trouble, Cisco's executives knew its acquisition program was in grave danger, as Cisco found itself unable to get companies it had been pursuing to agree to be acquired for Cisco stock. Thus, contrary to Cisco's assurances that the acquisition program would continue unabated and that the decline in Cisco's stock price would not interfere with its ability to make acquisitions, by 10/00-11/00, Cisco's acquisition program was in very serious trouble as, due to the decline in the price of Cisco's stock, Cisco was finding it impossible to continue its pace of acquisitions, which Cisco's executives knew would badly damage Cisco's competitive position and hurt its revenue and EPS growth in F01-F02.
24. In late 00, Cisco's top executives knew that the fundamentals of Cisco's business had deteriorated badly. As rumors of excessive inventories, softening demand and slowing growth circulated, Cisco's stock came under increasing pressure, falling to as low as $45 on 12/4/00, just as Cisco was to hold its annual analyst conference in Santa Clara, California - a hugely important event attended by hundreds of securities analysts. Under these circumstances (which included rumors Cisco would "pre- announce" poor 1stQ F01 results and lower its forecasted growth rates), analysts were highly focused on Cisco's statements for any hint of deterioration in Cisco's business or slowing of its growth. Cisco's top executives were determined to cover up the serious deterioration of Cisco's business and thus support Cisco's stock price in an attempt to allow Cisco to continue its vitally important acquisition program, as well as preserve the value of Cisco's executives' and employees' stock options. So, Cisco's top executives lied to analysts at the 12/4-5/00 analyst conference - making an extremely upbeat and bullish presentation - telling the investment community that:
• Cisco was making no change in its forecasts; Cisco had never been more optimistic.
• An economic downturn and tough markets would be good for Cisco, as it would force companies to cut costs and upgrade computer networks, leading to increased sales for Cisco.
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• Cisco was still experiencing tremendous demand for its products.
• Cisco was going to continue, if not accelerate, its acquisition program.
• Cisco expected its inventory situation to normalize in two quarters.
• Cisco was not seeing any pricing pressure on its products.
As a result of these false and misleading reassurances, Cisco's stock rallied, reaching $55-3/4 on 12/11/00 - an increase of more than 20% in the stock price in just a few trading days.
25. But then, in mid-12/00, without any publicity, Cisco buried in an SEC filing that it had taken over $275 million in increased loan loss and inventory reserves, much larger reserves than Cisco had previously suggested would occur! When these write-offs were publicized a few days later by the financial press, investors and analysts realized that these much larger-than-expected reserves indicated that Cisco's vendor financing activities were incurring significant losses and that Cisco had accumulated excessive inventories - information quite inconsistent with Cisco's prior assurances. The markets were stunned and shocked by this information. As a result, Cisco stock collapsed from $55-1/8 on 12/12/00 to $35-5/32 on 12/21/00, losing over $150 billion in market capitalization in just six trading days on trading volume of over 650 million shares! Desperate to halt the fall of Cisco stock, Cisco executives continued to falsely assure investors and analysts that demand for the Company's products remained strong and that Cisco's revenues and EPS would continue to show the previously forecasted levels of growth during the balance of F01 and F02. Thus, despite its sharp decline, Cisco's stock continued to trade at artificially inflated levels during the balance of the Class Period.
26. In mid-12/00, Chambers knew that Cisco's business was imploding due to evaporating demand and soaring inventories. He had, in fact, attended a board meeting of Digital Broadband in which it was decided that this Cisco customer, which owed Cisco $70 million, should file for bankruptcy. Thus, in mid-1/01, he began to try to "talk the stock down" by periodically disclosing cautionary or mildly negative news in the hope that this would cause Cisco's stock to decline gradually, rather than collapse suddenly when the true and disastrous state of Cisco's business became public. In mid-1/01, Chambers stated to analysts that Cisco's 2ndQ F01 had been "a little bit more challenging" than expected because of a slowdown in customers' spending, Cisco was "slowing" its hiring pace and "our visibility isn't as good as it normally is." Analysts described Chambers' comments as "incrementally more cautious." However, analysts who reported on Chambers' comments continued to forecast a 30% three-year EPS growth rate for Cisco, F01 EPS of $.79, with F01 quarterly EPS of $.19 for Cisco - with one writing, "No change in Cisco's growth rate guidance, 30%-50% annually, but visibility decreased in near term."
27. In late 1/01, Chambers briefed analysts, stating that "business in January was a little bit slow," as the "business momentum" of most of Cisco's customers "was very tough in December and equally tough in January." On 1/30/01, Bloomberg reported:
Cisco's Chambers Lowers Forecast, Avoids Sell-off, WSJ Says
... Chambers has made several public appearances in what appears to be a move to reduce expectations for the company without openly admitting as much .... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 13 of 223
During one recent appearance, Chambers signaled concern about Cisco's growth forecast ... [but] he never explicitly told analysts to reduce estimates .... Chambers said that analysts are "reading to much into" his statements ....
The tactic can be effective in a volatile market, where missing estimates by a penny can provoke a stock sell-off, the paper said. Chambers has been successful in reducing expectations, and the shares are little changed from before he began making his public remarks ....
28. On 1/31/01, Chambers was quoted in a Bloomberg report as stating:
"I don't have a hiring freeze on the company as a whole ... [and] I still see growth rates of 30 to 50 percent per year in the segment of the information technology industry where we are involved ...."
29. On 2/6/01, Cisco reported its 2ndQ F01 results, with EPS of $.18 - $.01 below forecasted levels on revenues far below forecasted levels - and Q/Q revenue growth of just 3.5% - the lowest Q/Q revenue growth in Cisco's history as a public company! Cisco also disclosed that its inventory soared by an additional $600 million in the 2ndQ - reaching over $2.5 billion - and that it was still continuing to grow! Cisco also revealed that:
• Its accounts receivable had soared - growing much faster than its sales and that it was taking a further inventory reserve.
• It had earlier imposed a hiring freeze and was now cutting back sharply on new financing commitments by Cisco Capital.
• Its 3rdQ F01 revenues would decline from 2ndQ F01 levels - which would be the first Q/Q revenue decline in Cisco's history as a public company!
As a result of these revelations, analysts slashed the F01-F02 revenue and EPS forecasts for Cisco and Cisco's stock plunged - falling from $36-3/16 to $29-7/8, a 17% drop on trading volume of 279 million shares, the second largest one-day trading volume in the history of the United States securities markets and a one-day wipe-out of over $42 billion in Cisco's market capitalization! Chambers later admitted that, prior to 12/15/00, Cisco had seen a consistent drop off in orders, that CEOs around the country had called him telling him that the negative situation was worsening and that Cisco had imposed a "practical freeze on hiring" in 12/00.
30. Analysts and investors were furious over Cisco's deception, as the following comments show:
• Bloomberg, 2/6/01:
"They missed the top line. They missed the bottom line. The guidance was horrible," said Ed Dowd, an analyst at Independence Investment Associates .... "I don't feel comfortable about anything."
• Bloomberg, 2/7/01:
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[Salomon Smith Barney analyst Alexander Henderson said] Cisco's "guidance and outlook shocked the Street ...."
• The New York Times, 2/7/01:
Cisco ... shocked the financial analysts that follow the company by saying today that it expected revenue to decline in the next quarter by as much as 5 percent.
"I've followed the company since it went public, and I've never seen a down sequential revenue quarter," said Paul Johnson, a financial analyst at Robinson Stephens. "That took me by surprise."
* * * "The numbers are worse than we had expected, that's clearly a cause for concern," said Michael Ching, a financial analyst at Merrill Lynch.
• The Wall Street Journal, 2/7/01:
The speed of the reversal in Cisco's fortunes is startling. As recently as November, Cisco urged analysts to increase their financial targets for the current fiscal year. Then, in two January speeches, Mr. Chambers said Cisco's business had slowed significantly in mid-December. Many analysts trimmed their forecasts for the remainder of the fiscal year, but few anticipated yesterday's results.
* * * The rising payroll and rising inventory prompted some analysts to question how well Cisco is reacting to the slowdown. "I was shocked by the inventory," said Nikos Theodosopoulos of UBS Warburg.
• Washington Post, 2/7/01:
Steve Kamman, an executive director at CIBC World Markets ... said the results were even worse than his lowered estimates based on warnings the company had given earlier about a tough market.
31. During the balance of 2/01 through 5/01, Cisco continued to reveal further horrible problems with its business, including:
• Sales in Asia, Europe and the U.S. were all very slow.
• Cisco was laying off some 8,000 workers - 17% of Cisco's payroll - resulting in a $300-$400 million charge.
• Cisco was completely abandoning its most expensive optical networking product - the Monterey ONS 15900 series wave length router, which it had paid $500 million for in 99. It turned out that the product had never been successfully developed for commercial use.
• Cisco was taking an astonishing $2.5 billion inventory write-off during the 3rdQ F01 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 15 of 223
- likely the largest inventory write-off in the history of the world. Even after this huge write-off, Cisco still had $1.6 billion in inventories and about $1 billion in finished goods inventory it will most likely never sell.
• Cisco also revealed $500-$800 million in write-offs of fixed assets and goodwill, the value of which had become impaired.
• Cisco was significantly scaling back its acquisition program and has acquired only a few small companies since 12/00!
• Cisco's 3rdQ F01 revenues would decline by more than 30% from its 2ndQ F01 revenue - 3rdQ F01 revenues forecast at $9 billion during the Class Period were only $4.7 billion and Cisco would suffer a huge 3rdQ F01 loss of some $2.5-$3.0 billion, which would more than wipe out all of the profits Cisco purportedly earned in F01.
32. On 5/8/01, Cisco reported 3rdQ F01 sales of only $4.7 billion and a huge $2.6 billion loss - its first loss ever as a public company - and warned that its 4thQ sales would be flat or decline by 10% from 3rdQ levels. The sharp decline in Cisco's 3rdQ and 4thQ F01 and 1stQ F02 revenues and net income as opposed to the 50%-60% growth forecast during the Class Period is show below:
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Period came out, Cisco's stock continued to plummet, falling to as low as $11.04 from its Class Period and all-time high of $82, meaning Cisco's market capitalization had fallen from $555 billion to under $100 billion - a wipe-out of some $450 billion for Cisco's public shareholders! On 4/16/01, Needham & Co. issued a report on Cisco which stated:
There may well be an investor backlash against Cisco as its imperfections are becoming starkly revealed. Only the most ardent of supporters could still accept accounting practices that systematically overstate the underlying earnings power of the company. Management's claims of exquisitely tight control are sounding increasing[ly] hollow in the face of runaway inventory accumulation. Concrete evidence to support the company's mantra of 30-50% growth is becoming increasingly difficult to muster. The use of high-priced shares to facilitate the payment of excessive levels to acquire companies with immaterial revenues appears to have come to ... [a] conclusion.
34. The unbelievable collapse of Cisco has been the subject of bitter commentary by the financial press:
(a) As Luce and Kehoe of the Financial Times wrote:
[In 12/00] [a]n upbeat Mr. Chambers told his audience he expected revenue to continue to grow at the rapid rates to which Cisco was accustomed, and gave every impression the company was on track to meet their forecasts. "I have never been more optimistic about the future of our industry as a whole, or of Cisco," Mr. Chambers told the gathering of more than 500.
As the world's foremost e-business, with the capacity to monitor revenues on an hour- by-hour basis and to provide a daily "virtual close" - the equivalent of quarterly results at the touch of a button - Cisco's optimism was taken as a sign that the high- technology market would continue to hold up despite growing uncertainties about the U.S. economy.
... The company's share price rose 14 per cent the following day to close at $52.12.
Two months later, on February 6, when it announced second-quarter earnings, the company shocked investors by missing Wall Street forecasts ... the first time in more than six years it had failed too meet or beat analysts' forecasts.
Moreover, its results for the quarter, which ended on January 27, showed that the level of inventory on its books - including finished and semi-finished goods and components - had more than doubled to $2.5bn from $1.2bn in July 2000 (the end of the company's previous fiscal year). This, in spite of the fact that the company had possibly the world's most advanced online system for supply chain management.
Analysts and investors have yet to forgive Cisco for these sins. Since the beginning of the year, its shares have fallen more by more than 60 per cent and closed this Wednesday at a two-year low of $13.69.
(b) Just a year after its 5/00 cover piece fawning all over Cisco and Chambers, Fortune carried another http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 18 of 223
cover story on Cisco entitled, "Cisco Fractures Its Own Fairy Tale," and wrote:
On the way up to a stock market value of half a trillion dollars, everything about Cisco seemed perfect. It had a perfect CEO. It could close its books in a day and make perfect financial forecasts. It was an acquisitions machine, ingesting companies and their technologies with great aplomb. It was the leader of the new economy, selling gear to new-world telecom companies that would use it to supplant old-world carriers and make their old-world suppliers irrelevant.
Over the past year, every one of those characterizations has proved to be false.
Yes, we all know the numbers by now: Besides the drop in revenues, the company is taking a massive $2.5 billion write-off for excess inventory....
... [A]s dozens of conversations with customers, past and present Cisco executives, competitors, and suppliers reveal, Cisco has made its own mess. It made some bad technology bets. It exhibited a cavalier attitude toward potential customers. It signed long-term contracts with suppliers at just the wrong time. And a few of its products just weren't very good.
Those looking for someone to blame can start with a CEO who didn't seem able to turn off the spigot of his own optimism.
* * * Cisco has scrubbed a product developed by acquiree Monterey ... that aimed to route waves of light in fiber networks.... [A]nalysts say customers rejected it. The analysts expect Cisco to axe other lackluster products too. Its acquisition of Pirelli's optical- systems business has also been a disappointment. Once the leader in a technology that increases the capacity of fiber-optic networks, the Pirelli unit has fallen far behind rivals Nortel and Ciena....
Acquisitions, forecasting, technology, and yes, senior management - all have failed Cisco in the past year.... Cisco's stumbles are fascinating because Chambers promoted the company as a new breed of behemoth - one that was faster, smarter, and just plain better than the competition.
(c) The 5/14/01 Forbes reported:
Cisco scrapped the Monterey part of its strategy last month, in essence walking away from a $500 million investment. It had bought Monterey before the latter's core product was finished, and in 20 months Cisco couldn't get past field trials. The effort was hurt by the exit of Monterey founders Michael Zidikian and Zareh Baghdasarian shortly after the sale.
Nor does the Pirelli deal look all that promising. Cisco won't say how much long-haul gear it has sold since buying the Italian firm in late 1999, but outsiders are dubious. "We never understood why they bought Pirelli. It was never on our shortlist of suppliers," says one big Cisco customer.
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Volpi admits that, after two years of pursuing an "end-to-end" strategy, Cisco's "initial focus" is now only on the first end served by Cerent. That's hard to glean from Cisco's perky press releases. In its February earnings report Cisco said it "was chosen to build out optical networks" for BellSouth, among other telcos. The Bell, however, says Cisco sold it old-line routers, not the new optical wares.
(d) A 1/21/02 Business Week article, entitled "Cisco: Behind the Hype," stated:
Once one of the world's fastest-growing companies, Cisco is struggling to find its footing amid a severe economic downdraft. The company is in the red. Its sales are slumping, and its market valuation has fallen by some $430 billion, to $154 billion, since March, 2000, one of the deepest losses of shareholder wealth in history. The decline puts many of Cisco's employee stock options under water and limits the company's ability to acquire new companies.
* * * There has always been a good deal of myth-making where Cisco is concerned. At the height of the Internet frenzy, it was the very embodiment of the age. When it came to Cisco, everything seemed faster, bigger, and better. Its sales and earnings growth were second to none. It sold more sophisticated gear over the Internet than any other company as it raced to fill a demand that seemed unquenchable. It could close its books in a day, thanks to its powerful information systems. For 43 quarters in a row, Cisco met or beat Wall Street's hungry expectations for higher earnings. For one brief, heady moment, it became the most valuable corporation on the planet.
Now, in the cold light of the tech downturn, some of those myths are being exploded. As academics and other experts reassess the tech era, they are raising serious questions about how well Cisco and other highfliers actually performed, even at the height of the boom. They say that a history of aggressive accounting, form massive write-downs of assets to the use of now-banned "pooling of interest" accounting for acquisitions, makes it hard to gauge how much many of these companies actually earned from ongoing operations. These bold accounting techniques became standard operating procedure at many companies during the boom. But few applied them as deftly or with greater effect than the much-emulated Cisco.
* * * It's not just the numbers that deserve greater scrutiny. Part of the Cisco myth revolved around the company's super-sophisticated information systems. Cisco was supposedly using the Internet to bind together its suppliers and contract manufacturers into a seamless whole, pointing the way to the corporation of the future. In fact, Cisco's "network organization" did little to soften the impact of the downturn - or save Cisco from the disastrous inventory buildup.
Similarly, its vaunted acquisition strategy was supposed to make the world Cisco's lab, allow it to pluck promising technology after someone else had borne the development risk. But many of the companies Cisco snapped up with its inflated stock came with steep price tags, reaching as high as $24 million per employee. Often, high-priced talent walked soon after the deals were done. Many of those companies have yet to deliver new http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 20 of 223
products or markets or contribute to Cisco's bottom line.
Indeed, there are serious questions above how successful many of the high-tech companies were during their halcyon days. Michael Porter, a Harvard Business School professor, is now completing a major research project on the era's massive distortions in financial reporting. One astounding finding: He and his colleagues can't figure out how much money Cisco really made in the 1990s. After spending billions on buying companies, Cisco routinely wrote off massive amounts of acquisition-related charges - $5.4 billion in the past five years alone - making it nearly impossible to piece together how much Cisco actually invested or how much it earned on its capital. Says Porter: "When the historians actually plow through all the data, we will likely find that even during its so-called heyday, Cisco wasn't nearly as profitable in terms of return on invested capital as many believed."
Chambers and his top executives strongly defend the company's accounting practices. "I've got an extremely conservative chief financial officer, and we have been conservative all the way through," says Chambers. "We provide a tremendous amount of information. The more information we provide, the more questions it raises."
Trouble is, even the most sophisticated forensic accountants have had difficulty burrowing through the company's less-than-transparent financial reports. Only recently, for example, the Maryland-based Center for Financial Research & Analysis reported that a 3% growth in revenues from the previous quarter occurred only because Cisco reserved less for bad debts. The center used Cisco's own numbers released in its Nov. 5 conference call. Now, the center is backing away from its report because Cisco says it has actually been putting aside more money for uncollectible receivables, not less. However, not all of its offsetting "revenue adjustments" are broken out in its filings. Concedes Chambers: "We've got to be able to articulate [our numbers] better."
* * * It's a far cry from the '90s, when the company averaged 70% annual sales growth. But that torrid pace covered up a multitude of weaknesses. Cisco was famed for systems that were supposed to give its managers unparalleled access to real-time data. But when business weakened, those systems proved to be flawed.
Just how flawed became apparent shortly before midnight on Saturday, Jan. 27, last year, as the company prepared to close out its 2001 second-quarter numbers. Analysts were expecting a profit of 19 cents per share, but a slowdown in orders and shortages of certain parts would bring this quarter down to the wire in ways that would belie Cisco's reputation as a superefficient producer in the New Economy.
That night, at the company's main San Jose warehouse, employees scrambled to load as many boxed-up machines onto trucks as possible, thus enabling them to be counted as "sold" for accounting purposes before the quarter ran out at midnight. "We had guys running with parts, trying to run them up to the trucks," recalls Larry R. Carter, chief financial officer, who monitored the action from a computer terminal in the warehouse that tallied shipments in real time. One harried staffer, in his haste, fell headlong to the concrete floor in front of Carter. Ten minutes before midnight, Chambers called Carter's cell phone from Davos, Switzerland, where he was speaking at an economic summit. "Did http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 21 of 223
we make it?" Chambers asked. After a few more minutes of watching the numbers come in, Carter had to pass along the bad news: Cisco would undershoot expectations by a penny per share, its first Wall Street miss in 11 years.
The news shaved 13% off the company's market value in one day, but there was worse to come. It turned out that Cisco's networked-manufacturing model was not nearly as accurate as Chambers had boasted. Only 40% of what Cisco sells is actually made by the company. Instead, a network of suppliers and contract manufacturers delivers an unusually large chunk of Cisco-branded merchandise direct to customers. This business model was supposed to keep fixed costs to a minimum, eliminate the need for inventory, and give management an instantaneous, real-time fix on orders, shipments, and demand.
The highly hyped systems, however, failed to account for the double and triple ordering by customers tired of long waits for shipments. So Cisco began to stockpile parts and finished products. "We made a conscious decision when our lead times were 12 to 13 weeks to build inventory, because we were leaving a sizable amount of revenues on the table every quarter," says Carter. Soon inventories were growing faster than sales. The result: When a weakening economy brought capital spending to a near halt, Chambers found himself stuck with billions of dollars of inventory he didn't expect to have. In April, he wrote off $2.2 billion of excess inventory and cut 18% of Cisco's staff, or 8,500 employees.
Despite the massive write-off, Cisco still holds surprisingly high levels of finished-goods inventory: 26 days of finished inventories in October, three days more than it had in April when it took its big bath of a write-down. It's just another question mark about demand for Cisco's products. Dennis Powell, vice-president for corporate finance, calls the change in finished-goods inventory "inconsequential" and points out that overall inventories have fallen to $1.3 billion from $2.5 billion in the past nine months.
* * * The inventory debacle was the first major miss Cisco had. Indeed, there was good reason for its obsession with meeting Wall Street's expectations each quarter. The continual earnings gains kept Cisco's stock price high, which in turn allowed the company to make acquisitions and lure talent That obsession explains the creative ways Cisco found to account for its purchases and tally its earnings. Among the $5.4 billion in acquisition- related charges it took in the past five years, for example, the lion's share - $3.8 billion - covered "in-process research and development." In some cases, these expenses nearly equaled the cost of the acquired companies. By taking these charges up front, a move that is supposed to reflect that the acquired research and development may prove worthless regardless of the sum paid for it, future earnings tend to look a lot rosier. The reason: If the technology ultimately pays off, the earnings are unencumbered by their true costs, which otherwise would have been amortized as goodwill.
* * * One of Cisco's most frequent accounting tactics comes up every quarter when the company directs shareholders to its unaudited pro forms earnings numbers as the best gauge of profitability. In the first quarter of fiscal 2001, for example, Cisco reported pro forma earnings of $1.4 billion, nearly $600 million over its net income. It arrived at that tally by excluding such ordinary and important costs as acquisition expenses and payroll http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 22 of 223
taxes on stock-option exercises. In the fourth quarter, Cisco's pro forma income of $163 million was 23 times it actual net earnings.
While liberal use of more malleable pro forma earnings is not a rarity, most high-tech stalwarts, from Microsoft (MSFT) to Oracle (ORCL), do not report such unaudited numbers. The Securities & Exchange Commission recently cautioned companies and their investors about the potentially misleading metrics, warning companies that they could face civil-fraud lawsuits. "It's like students deciding the process of how they're graded so that they can always get an A from the teacher," says Howard Schilit, who directs the Center for Financial Research & Analysis. Cisco's Carter maintains that pro forma numbers more accurately portray the company's operating results because they exclude volatile charges, such as acquisition expenses. "The more information you give investors, the better," says Carter. "It's sort of like 'What do you like, vanilla or chocolate? We're going to give you both so you can choose.'"
Even the quality of Cisco's pro forma earnings is deteriorating. Well before Cisco's write- down in April, the company was relying on nonoperating income for a growing portion of its pro forma earnings. By the January quarter of 2001, for instance, interest and other nonoperating income had increased as a percentage of Cisco's pro forma results for each of the past five quarters, rising from just 8.8% to 14.9%. In the latest quarter, more than a third of Cisco's pro forma earnings come not from operations but from interest and other income.
* * * If Chambers is worried about the tough decisions ahead, he's not letting on. "Last year was tremendously humbling. It knocked us on our tail. But if we execute right, our future is very, very bright," he says. "Cisco is clearly positioned to break away." Investors buying up Cisco stock at 95 times earnings are banking on it. But Chambers will need much more than bold accounting and long-shot bets on fledgling markets to deliver.
35. Moreover, Cisco's acquisition program was not the unalloyed success represented:
(a) The 5/1/01 Business 2.0 reported:
Michael Zadikian, a former Cisco executive ... is also critical of the Cisco acquisition strategy, maintaining that products from so many acquired firms don't work well together because they weren't built to do so. The approach puts the onus on customers to make the products work. "There are interface compatibility problems, software mismatches and integrating these businesses is still a problem," he says. "From the outside looking in it seems Cisco integrates well. Inside, it looks horrendous. The pieces don't fit together."
(b) The 5/1/01 Business 2.0 also reported that, referring to Cisco's acquisition program, the man in charge of it stated:
"We've made more mistakes than anyone else," says Cisco's M&A guru Ammar Hanafi.
(c) A 1/21/02 Business Week article highlighted the failed acquisition strategy:
It was an all-to-typical deal for Cisco Systems Inc. Monterey Networks Inc., an optical- http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 23 of 223
routing startup in which Cisco held a minority stake, was a quarry with no revenue, no products, and no customers - just millions in losses it had racked up since its founding in 1997. Despite those deficits, Cisco plunked down a half-billion dollars in stock to buy the rest of the company in 1999.
But within days of closing the deal, all three of Monterey's founders, including its engineering guru and chief systems architect, walked out the door, taking with them millions of dollars in gains from the sale. "I came to the realization I wasn't going to have any meaningful impact on the product by staying," says H. Michael Zadikian, a Monterey founder. Eighteen months later, Cisco shut down the business altogether, sacking the rest of the management team and taking a $108 million write-off.
That dismal tale hardly jibes with Cisco's widespread reputation as an acquisitions whiz. Not since the conglomerate era has a company relied so heavily on its ability to identify, acquire, and integrate other companies for growth ....
* * * Chambers often maintained that his acquisition strategy was aimed at acquiring brainpower more than products. But an analysis of the 18 acquisitions Cisco made in 1999 shows that Monterey was no fluke. Many of the most valuable employees, the highly driven founders and chief executives of these acquired companies, have since bolted, taking with them a good deal of the expertise and experience for which Cisco paid top dollar.
The two founders of StratumOne Communications Inc., a maker of optical semiconductors purchased for $435 million, left Cisco. The chief exec of GeoTel Communications Corp., a call-routing outfit acquired for $2 billion, walked out after nine months. So did the CEOs or founders of Sentient Networks, MaxComm Technologies, WebLine Communications, Tasmania Network Systems, Aironet Wireless Communications, V-Bits, and Worldwide Data Systems - all high-priced acquisitions in 1999. Some simply felt Cisco had become too big and too slow. "People who crave risk don't do so well at Cisco," says Narad Networks CEO Dev Gupta, who sold Dagaz and MaxComm Technologies Inc. to Cisco in 1997 and 1999, respectively. "Cisco focuses much more on immediate customer needs, less on high-wire technology development that customers may want two or three year out."
* * * Difficulty holding on to top talent was not the only flaw in the Cisco acquisition machine. Cisco often paid outrageous sums for these unprofitable startups - a total of $15 billion in 1999 alone. Even some of the deals that Cisco considers successful look pretty dreadful using simple math. Its 1999 acquisition of Cerent Corp., a maker of optical-networking gear, is a good example. Cisco paid $6.9 billion for the company, or $24 million for each of Cerent's 285 employees, even though the company had never earned a penny of profit and had an accumulated deficit of $60 million. Even if earnings bounce back to 2000 levels of roughly $335 million, it would take Cisco about 20 years to recoup the purchase price.
Of course, deals such as Cerent found their rationale in Wall Street math. If investors were willing to pay 100 times earnings for Cisco's stock in 1999, then a Cerent profit of, http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 24 of 223
say, $300 million could effectively increase the market cap of Cisco by some $30 billion. Call it bubble economics. Besides, many of these deals were done for highly inflated Cisco stock instead of cash. Even so, that wampum could have been used to buy other assets that could have delivered greater returns.
Only in the months since the bubble burst has it become evident just how muddled Cisco's mergers-and-acquisitions strategy became. In its haste to do deals, Cisco often purchased companies it didn't need or couldn't use. In some cases, the buying spree led to overlapping, duplicative technologies, political infighting, and just plain wasted resources, as Monterey shows. "M&A works to some extent, but at Cisco, it got out of hand," says Iqbal Husain, a former engineering executive at Cisco.
After losing many of the leaders of these businesses, product delays and other mishaps were not uncommon. When Cisco closed down Monterey, for example, the company still hadn't put a product out for testing, which alone would take as long as a full year. "By the time the product was there to test, the market wasn't," says Joseph Bass, former CEO of Monterey.
36. Purchasers of Cisco's stock during the Class Period paid artificially inflated prices for the stock and have suffered billions of dollars of damage. However, Cisco's insiders named as defendants did not do nearly so poorly. During the Class Period, the Cisco insiders named as defendants sold over 11.5 million shares of their Cisco stock at artificially inflated prices as high as $80.24 per share, pocketing $604 million in illegal insider trading proceeds - one of the largest insider bail-outs in history! The graphic below shows the insider stock sales of the Individual Defendants in the aggregate from 9/4/98 through 2/6/01 and demonstrates that the Individual Defendants' stock sales during the Class Period, when they knew Cisco's stock was artificially inflated, greatly exceeded their Cisco stock sales in the eight months prior to the Class Period:
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37. The Cisco insiders named as defendants sold the following amounts of stock during the Class Period:
% of Shares Defendant Shares Sold Owned Sold Proceeds
Bartz 60,400 21.8% $ 2,545,262 Carter 2,134,400 48.3% $ 83,523,632 Chambers 2,300,000 9.7% $151,512,500 Daichendt 2,216,866 46.4% $109,623,108 Estrin 1,058,626 50.8% $ 65,777,167 Kozel 993,690 46.4% $ 54,980,565 Listwin 56,248 1.4% $ 1,794,592 Puette 190,000 82.6% $ 14,124,500 Redfield 1,110,000 29.3% $ 61,715,700 Valentine 940,000 19.0% $ 29,344,400 Volpi 390,000 21.2% $ 23,325,600 West 100,000 35.7% $ 6,571,350 TOTAL: 11,550,230 22% $604,838,376
38. The following graphic shows the events of the Class Period, defendants' false statements, the performance of Cisco's stock, defendants' insider trading, how Cisco's stock outperformed an index of the stocks of similar companies during the Class Period and how Cisco's stock collapsed as information concerning the true state of its business entered the market:
[chart unavailable]
JURISDICTION AND VENUE
39. The claims asserted herein arise under §§10(b), 20(a) and 20A of the Securities Exchange Act of 1934 ("1934 Act"), 15 U.S.C. §§78j(b), 78t(a) and 78t-1, and Rule 10b-5. Jurisdiction is conferred by §27 of the 1934 Act, 15 U.S.C. §78aa.
40. Venue is proper here pursuant to §27 of the 1934 Act. Acts and transactions giving rise to the violations of law complained of occurred here.
THE PARTIES
41. Lead Plaintiffs Plumbers & Pipefitters National Pension Fund, Central States, Southeast and Southwest Area Pension Fund, Carpenters Pension Fund of Illinois, Alexander Nehring and John J. Petrera, Jr. purchased shares of Cisco common stock during the Class Period and were damaged thereby. Additional plaintiff members of the Class that have standing under §20A of the 1934 Act are set forth in the Appendix A attached hereto.
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industry. Cisco has approximately 7.3 billion shares of common stock outstanding, which shares trade in an efficient market on the NASDAQ National Market System.
43. (a) Defendant John T. Chambers ("Chambers") was, during the Class Period, President, Chief Executive Officer, and a director of the Company. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Chambers sold 2.3 million shares of Cisco stock at an artificially inflated price of $65-7/8 per share, for proceeds of more than $151.5 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
(b) Defendant Larry R. Carter ("Carter") was, during the Class Period, Senior Vice President-Finance and Administration, Chief Financial Officer, Secretary and a director of the Company. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Carter sold 2,134,400 shares of Cisco stock at artificially inflated prices as high as $64 per share, for proceeds of more than $83.5 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
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(c) Defendant Gary J. Daichendt ("Daichendt") was, during the Class Period, Executive Vice President-Worldwide Operations of the Company. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Daichendt sold 2,216,866 shares of Cisco stock at artificially inflated prices as high as $66-1/2 per share, for proceeds of more than $109.6 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
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(d) Defendant Carl Redfield ("Redfield") was, during the Class Period, Senior Vice President- Worldwide Operations of the Company. Redfield had responsibility for holding back shipments in quarters in which Cisco had met its numbers and would determine whether to move items across the "yellow line" to be counted in one quarter's sales or to be held for the next quarter. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Redfield sold 1,110,000 shares of Cisco stock at artificially inflated prices as high as $64.81 per share, for proceeds of more than $61.7 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
(e) Defendant Donald J. Listwin ("Listwin") was, until 8/00, Executive Vice President-Service Provider and Consumer Lines of Business of the Company. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Listwin sold 56,248 shares of Cisco stock at artificially inflated prices as high as $31.91 per share, for proceeds of more than $1.7 million. While Listwin's pre-Class Period sales exceeded his Class Period sales, Listwin also benefitted from his investments in companies related to Cisco, described herein.
(f) Defendant Donald T. Valentine ("Valentine") was, during the Class Period, Vice Chairman and a member of the Board of Directors of Cisco. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Valentine sold 940,000 shares of Cisco stock at artificially inflated prices as high as $31.25 per share, for proceeds of more than $29.3 million. Valentine oversaw Cisco's acquisition program, while at the same time being a general partner of Sequoia Capital, which owned shares in many of the companies Cisco acquired, placing Valentine on both sides of many of Cisco's acquisitions.
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(g) Defendant Edward R. Kozel ("Kozel") was, during the Class Period, Senior Vice President of the Company until 1/00 when he took a leave of absence from the Company. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Kozel sold 993,690 shares of Cisco stock at artificially inflated prices as high as $64.74 per share, for proceeds of more than $54.9 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
(h) Defendant Michaelangelo Volpi ("Volpi") was, during the Class Period, Senior Vice President, Chief Strategy Officer of the Company. Volpi was responsible for identifying Cisco's numerous acquisition targets and for performing what minimal due diligence Cisco performed on these acquisitions. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Volpi sold 390,000 shares of Cisco stock at artificially inflated prices as high as $64.50 per share, for proceeds of more than $23.3 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
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(i) Defendant Judith L. Estrin ("Estrin") was, during the Class Period, Chief Technology Officer of the Company until her resignation in 4/00. Estrin left Cisco and sold her stock because she was aware of the ongoing fraud complained of herein and wanted to try to "get away." In fact, just prior to the beginning of the Class Period, in 5/99, Estrin had given a presentation to 150 people at Cisco (including Chambers, Carter and Redfield) in which she discussed the threat that Microsoft posed to Cisco in which Microsoft could eventually turn Cisco into a hardware only company as Microsoft competed in the enterprise software market. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Estrin sold 1.05 million shares of Cisco stock at artificially inflated prices as high as $65.89 per share, for proceeds of more than $65.7 million. This defendant's insider stock sales were dramatically out of line with her insider stock sales in the eight months prior to the Class Period:
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(j) Defendant Carol A. Bartz ("Bartz") was, during the Class Period, a director of the Company and a member of the Board's Acquisition and Special Acquisition Committees. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Bartz sold 60,400 shares of Cisco stock at artificially inflated prices as high as $64.13 per share, for proceeds of more than $2.5 million. This defendant's insider stock sales were dramatically out of line with her insider stock sales in the eight months prior to the Class Period:
(k) Defendant Steven M. West ("West") was, during the Class Period, a director of the Company and a member of the Board's Audit Committee. During the Class Period, while in possession of material, non-public and adverse information about Cisco, West sold 100,000 shares of Cisco stock at artificially inflated prices as high as $65.78 per share, for proceeds of more than $11.9 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
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(l) Defendant Robert L. Puette ("Puette") was, during the Class Period, a director of the Company and a member of the Board's Acquisitions and Audit Committees. During the Class Period, while in possession of material, non-public and adverse information about Cisco, Puette sold 190,000 shares of Cisco stock at artificially inflated prices as high as $80.24 per share, for proceeds of more than $14.1 million. This defendant's insider stock sales were dramatically out of line with his insider stock sales in the eight months prior to the Class Period:
44. The parties listed in ¶43(a)-(l) are referred to as the "Individual Defendants." they are liable for the false statements pleaded herein at ¶¶93, 109, 119, 141, 144-145, 167, 173, 196, 207 and 237, and http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 33 of 223
Cisco's false financial statements as those statements were each "group-published" information for which they were collectively responsible. Chambers, by reason of his stock ownership and position of control and authority with Cisco, was a controlling person of Cisco. In particular, Chambers was able to and did control the contents, preparation and release of various quarterly and annual financial reports and statements, prospecti, SEC filings, press releases and presentations to securities analysts pertaining to the Company. As a result, Chambers is responsible for the accuracy of the public reports and releases detailed herein and is, therefore, liable for the representations contained therein. Cisco controlled each of the Individual Defendants. These controlling persons are liable under §20(a) of the 1934 Act.
45. Defendant PricewaterhouseCoopers ("PWC") is an international accounting and consulting firm. PWC was engaged by Cisco to provide "independent" auditing, accounting and management consulting services, tax services, examination and review of filings with the SEC, audits and/or reviews of financial statements which were included in Cisco's SEC filings, including audited and unaudited information, and annual reports. As a result of the myriad of services it rendered to Cisco, PWC personnel were present at Cisco corporate offices and operations continuously during 99-01 and had continual access to and knowledge of Cisco's private and confidential corporate information and business information. PWC received millions of dollars in audit and consulting fees during the Class Period, including $18 million in F01 alone. PWC's role in the fraud alleged herein is described in ¶¶329-353.
SCIENTER, SCHEME AND FRAUDULENT COURSE OF BUSINESS
46. Cisco and the Individual Defendants made false and misleading statements, engaged in a scheme to defraud, pursued a course of business that operated as a fraud and deceit on purchasers of Cisco common stock and sold their Cisco shares while in possession of material negative non-public information regarding Cisco, without disclosing same.
Cisco's Senior Executives
47. The top executives of Cisco run the Company as "hands-on" managers, dealing with important issues facing Cisco's business, i.e., demand for its products, product sales, orders, supply and inventory, as well as the design, testing and final pre-shipment validation of its new products, the manufacturing effectiveness and efficiencies of its products, and the quality of those products. Cisco maintained a system of internal controls that was organized and directed on a day-to-day basis under the supervision of Chambers, Cisco's CEO, and several executive and senior and ordinary vice presidents.
(a) Chambers was Chief Executive Officer and a director of the Company.
(b) Carter was Senior Vice President-Finance and Administration, Chief Financial Officer, Secretary and director of the Company.
(c) Daichendt was Executive Vice-President Worldwide Operations of the Company.
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(e) Kozel was Senior Vice President of the Company.
(f) Redfield was Senior Vice President-Worldwide Operations of the Company, and oversaw the shipment of products at year end, manipulating the shipments to meet Wall Street expectations.
(g) Volpi was Senior Vice President, Chief Strategy Officer of the Company, and was responsible for Cisco's failed acquisition strategy.
(h) Estrin was Chief Technology Officer of the Company.
48. Cisco's senior executives were motivated to inflate Cisco's financial results because the majority of their compensation (bonus) was based on Cisco's revenue and profit results. The following table from Cisco's 9/00 Proxy shows the significance of reaching certain bonus payments to their compensation:
SUMMARY COMPENSATION TABLE
Name and Position Year Base Salary ($) Bonus ($) Options (#) John T. Chambers, 2000 323,319 1,000,000 4,000,000 President, CEO, Director 1999 305,915 637,184 5,000,000 1998 285,622 604,895 5,400,000 Donald J. Listwin, 2000 455,702 902,174 1,000,000 Executive VP 1999 397,399 637,280 1,200,000 1998 332,267 598,407 1,650,000 Gary J. Daichendt, 2000 454,591 902,174 1,000,000 Executive VP 1999 368,490 591,053 1,200,000 1998 322,132 547,697 1,200,000 Larry R. Carter, 2000 386,262 861,750 850,000 Senior VP, CFO, 1999 367,063 612,131 640,000 Secretary, Director 1998 326,439 555,152 1,350,000 Carl Redfield, 2000 342,228 763,773 750,000 Senior VP 1999 321,897 549,396 600,000 1998 267,559 454,909 900,000 Mario Mazzola, 2000 412,520 850,958 500,000 Senior VP 1999 374,640 576,882 640,000 1998 327,353 556,839 1,200,000
In addition, the value of options granted to Cisco senior executives was directly tied to Cisco's stock price.
49. Each of the Senior Officers, by virtue of their high-level positions with Cisco, directly participated in the management of Cisco, was directly involved in the day-to-day operations of Cisco at the highest levels and was privy to confidential proprietary information concerning Cisco and its business, operations, products, growth, financial statements and financial condition and was aware of or http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 35 of 223
deliberately disregarded that the false and misleading statements were being made by and regarding the Company. Because of their managerial positions with Cisco, each of the Senior Officers had access to the adverse undisclosed information about Cisco's business, products, financial condition and prospects and knew (or deliberately disregarded) that these adverse facts rendered the positive representations made during the Class Period materially false and misleading.
Financial Monitoring and Controls
50. Cisco's Senior Officers closely monitored the performance of Cisco's business via financial reports which Cisco's Finance Department (under Carter) generated on an hourly, daily, weekly and monthly basis. There were "order reports" and "backlog reports" that summarized orders by dollar volume and product type, as well as unit "shipment" reports. The Finance Department also distributed monthly financial reports comparing Cisco's actual financial results to projected results. Thus, defendants knew the status of orders for and sales of every Cisco product so that they knew where Cisco stood in terms of the sale of and demand for its products, as well as Cisco's actual financial results compared to budget. Thus, Cisco's top officers were constantly aware of the current order rates for its products, as well as sales into and out of its distribution channel and its own direct sales. In fact, Cisco's computerized financial monitoring and reporting system is so sophisticated and refined that Cisco can "close its books" on a corporate-wide basis instantly, the so-called "real time" or "virtual" close. Cisco's internal forecasting system was Siebel System's Astro - which extended 12-15 months into future. Each Monday, every sales department reviewed weekly/monthly/quarterly results vs. forecasts. At 9:00 a.m. on Monday mornings the regional sales managers would hold a conference call to discuss booked sales and new opportunities. At 3:00 p.m. the vice presidents of sales would have a conference call in with corporate, including Rick Justice, with the key developments in sales. Justice would then report this information to Chambers, Listwin and Carter who all had offices next to one another.
51. Cisco has an extremely sophisticated system of internal financial and accounting controls which operate under the supervision of Cisco's CFO Carter. The financial reporting system is so efficient that Cisco, in essence, is able to close its books instantly and is in a position to determine its quarterly revenues, profits and EPS to date instantly, at any time during the quarter, subject to non-recurring charges and adjustments. In fact, Cisco's top executives received monthly financial statements for Cisco within a day or two after the close of a month that provided detailed financial information about revenues, profits and EPS on a company-wide basis and detailed sales data for each of Cisco's products in each of the geographic regions where Cisco operates, as well as for its own direct sales. Also, Cisco's top executives received daily reports on product sales, prices and component part, work in progress and finished goods inventories that allowed them to monitor the demand for each of Cisco's products in all of its markets and all of its distribution channels.
52. Cisco's unique ability to monitor its key business metrics on an instant basis was often commented upon in the press and often stressed by Cisco to analysts as giving Cisco's top executives instant knowledge of all of Cisco's key operational metrics and unique visibility into Cisco's future business operations. In the 10/12/99 USA Today, an article about Cisco's "virtual close" appeared, stating:
CISCO CHIEF: VIRTUAL CLOSE TO HIT BIG INTRANET ALLOWS UP-TO- MINUTE LOOK AT BOOKS * * * When USA TODAY reporters Del Jones and Beth Belton caught up to Chambers in Washington, he said there is a big trend brewing. It's called the "virtual close." Huh? Let Chambers explain. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 36 of 223
Q: What is a virtual close?
A: It's the ability to close the financial books with a one-hour notice. By connecting an entire company via intranet, even one with operations in dozens of countries, what was once done quarterly can now be done anytime. It's an electronic infrastructure that almost instantly shares all information.
Q: What's the value of that?
A: The ability to close so quickly lets you spot problems and opportunities at any time. It allows you to see what's going on in every aspect of your business .... Normally, executives might not see things until after the quarter has ended or two or three weeks later.
53. A 5/00 Fortune magazine article about Cisco reported on Cisco's "instant close" capability:
One meta-example can be found in the home of Listwin, Chambers' right-hand man, and his wife, Lorene Arey, who is Cisco's head of PR, in the hills west of Palo Alto. (Listwin and Arey are sort of Cisco's golden couple.) In their den after dinner, Listwin ... boots up his Dell Dimension and logs into the Cisco network. Right away the data that pop up onto his screen are nothing short of stunning. It's info that anyone running a business would kill to have. Listwin clicks through to the day's worldwide sales figures, which can be instantly sorted by region, product, or customer. (The ten biggest customers that day include Wal-Mart, General Dynamics, Ingram Micro, and other resellers.) Then there's net revenue, net income, margins, orders, and expenses. "I look at these numbers first thing every morning," says Listwin.... "The information now on our network is invaluable." The data at Listwin's fingertips are obviously extremely sensitive, so only Cisco's top half-dozen or so execs are privy to it....
Aha! Now you begin to understand why Cisco has such a legendary grasp of its numbers. How it can "guide" analysts down to the last penny as to what it will report for the quarter. "John and Larry Carter [Cisco's CFO] run such a tight ship, it's almost unbelievable," says Ray Bell, who used to work at Cisco and is now CEO of networking startup SmartPipes.
Carter, who at 56 is one of the few graybeards around Cisco, was the guy who pushed for instant online numbers. He even launched an effort to take the data one step further. He wanted to close Cisco's books in a day. One day!?! For most companies this takes weeks (which is why the SEC gives them 90 days after each quarter to report). After nearly a year of cajoling, Carter finally tested the process on Jan. 10. Not wanting too wait for the end of his second quarter to see if Y2K had mucked up his financials, Carter decided to do a mock close of Cisco's books that day. And it worked!
54. Other comments on Cisco's unique financial controls and financial reporting system include:
• [T]he company's accounting is already automated to such an extent that Cisco can close its books on any given day within a few hours.
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• Larry Carter highlighted the financial innovation within Cisco, namely the virtual close. The company is using its advanced IS systems to drive financial performance. For example, management has the ability to track revenue, discounts, and product margins on an hourly basis.
• Larry Carter, CFO, on enhancing and managing growth
After 6 years, Mr. Carter['s] ... achievements in bringing financial information to line executives and bringing senior management data in hours, weeks is legendary. Today, Cisco is a case model reviewed by leading companies around the globe.
* * * So, what Mr. Carter presented was how the role of finance has changed from collecting financial data to having a system for continuous monitoring and analysis of critical information. The Cisco Executive Information System can drill down to day, geography, line of business, product sales channel, or customer/partner all the way down to specific account managers.
• [Chambers said] [v]ery often at the end of a quarter [we] might have realized that we had a problem in one of our product lines, that we didn't meet our margin expectations on it. Well, today the first line manager can see who has responsibility for that product, either in engineering or in manufacturing [and] that the second week into the quarter our margins aren't in line with what we expected. They can explode that information down because of our use of Web-based architecture to understand exactly [what happened].... Well, those decisions used to come to the CFO and CEO two to three weeks after every quarter was closed. That now is done by the first line manager any time they want to look into it. That's what empowerment is all about. That's what the Internet is about.
• Larry Carter, Senior Vice President and Chief Financial Officer ... highlighted that information is key to differentiation. The continuous monitoring and analysis of critical information by management at Cisco is key to effectively running the business.
Vendor Financing
55. In 98, the growth in Cisco's enterprise business was increasingly difficult to maintain because Cisco controlled such a large portion of the market and its sales were so high that it was almost impossible to generate 30%-50% increases. Cisco's success in the SP market had been increasing as Cisco had begun to offer vendor financing. Carter had initially opposed offering vendor financing saying it wasn't a business they wanted to get into due to the risks involved. Cisco instead had partnered with other companies to offer financing. The success from this was limited because when Cisco met with a customer who wanted financing, the Cisco sales representative would have to bring an employee of both Cisco Capital and its financing partner. By comparison, competitor Ascend would just send a sales representative with a term sheet and authority to grant financing. As it became more evident that Cisco would be unsuccessful in the SP market if it did not offer vendor financing, Cisco began to offer generous financing. The need to do so became even more urgent when Lucent acquired Ascend in 99. With Ascend's aggressive sales force and Lucent's ability to offer financing, defendants knew Cisco would have to offer generous financing to be able to gain any traction in the SP market. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 38 of 223
56. Thus, by 99, Cisco was in an increasingly intense competitive battle with Lucent Technology and Nortel Networks to sell networking and telecommunications equipment. An internal 10/99 Business Summary indicated that money was drying up in the high yield bond market for many of Cisco's CLEC customers who were deciding on whether to buy from Cisco or from competitors based on Cisco's willingness to not only provide financing for equipment but also for working capital (called "soft dollars"). An internal Cisco Business Summary indicated that a couple of the customers demanded $1 of working capital for every $1 of equipment financing. It was clear to Cisco's executives that such customers wanted Cisco's financing more than the equipment, but Cisco was willing to provide the financing so that it could report sales growth in the SP space.
57. As Cisco's vendor financing program escalated during 99-00, the amount of loans Cisco had committed to make skyrocketed to over $2.5 billion, while the amount of loans actually funded reached over $600 million. As Cisco's vendor financing exposure escalated, analysts and investors began to question Company officials, especially Chambers and Carter, about the vendor financing program, focusing on the quality of the credits being extended, as it was well known that among the companies seeking to buy product from Nortel Networks, Lucent and Cisco under their vendor financing programs were a substantial number of smaller dot.com companies and newly formed CLECs which were not proven or successful companies with strong financial positions. This created a risk of significant credit losses about which investors and analysts were concerned.
58. A further risk created by Cisco's aggressive use of financing to coerce customers into buying Cisco's products was Cisco's undisclosed guarantees of loans by third-party lenders to Cisco customers. When certain third-party lenders would agree to finance Cisco customers, they would require Cisco to guarantee all or a portion of the financing. These third-party lenders included Deutsche Bank, Sunrise Capital, GE Capital and Silicon Valley Bank. Contrary to the requirements of GAAP, as set forth in FASB Statement of Financial Accounting Standard ("SFAS") No. 5, Cisco did not disclose these guarantees, which are a contingent liability to the Company.
59. When investors and analysts raised concerns over the increasing extent to which Cisco was financing the sales of its products to customers and the creditworthiness of these customers - some of which were dot.com start-ups or new CLECs - Cisco repeatedly assured them that Cisco had in place controls and monitors to assure that its vendor financing program was being prudently implemented, that virtually all of Cisco's loans were to tier-one financially secure corporations and that Cisco had incurred extremely small credit losses on this program - less than 1% of the loans outstanding! They also represented that Cisco's accounting for its vendor-financed sales was exceptionally conservative, as it was recognizing revenue only on vendor-financed sales to well established tier-one creditworthy companies and deferring revenue recognition on sales to smaller emerging companies, the "structured" portion of its vendor financing program, until cash payments from them on their loans were actually received.
60. Cisco also overstated the demand for its products and Cisco's vitally important book-to-bill ratio by accepting hundreds of millions of dollars of double and triple orders from customers, knowing these orders were cancellable at the customers' option. Also, by accepting hundreds of millions of dollars of vendor-financed orders from uncreditworthy customers and insisting that they order and actually purchase millions of dollars of extra, unwanted and unnecessary product as a condition of receiving vendor financing and working capital loans from Cisco Capital, Cisco further artificially boosted its book-to-bill ratio, as well as its revenues, net income and EPS - helping it beat consensus EPS forecasts quarter after quarter by $.01. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 39 of 223
61. One way Cisco manipulated its revenue recognition was to insert a distributor in between Cisco and a customer who could not pay. For example, a Texas customer was not able to get financing for more than $100,000 from other sources, but Cisco was offering millions of dollars in financing. Because the customer did not have the ability to pay Cisco for product shipped to it, Cisco would not be able to recognize revenue until the customer was able to pay for it. To get around this requirement, Cisco arranged for the customer to buy the Cisco equipment from a reseller (in this case, Sprint) who would purchase it from Cisco. The customer would use funds provided by Cisco Capital or Sunrise Capital (a Cisco affiliate) to pay Sprint. Sprint would then pay Cisco. Because the product had "sold through" (from Sprint to the customer) and Cisco had been paid, Cisco would recognize revenue. In fact, this set up was a sham, as in effect Cisco had sold to a customer which could not pay. This was a wide-spread practice throughout Cisco and led to the $2 billion problem with unrecoverable vendor financing.
62. By Spring 00, demand for many of Cisco's products began to slow. In order to conceal and cover up these adverse developments, Cisco continued to artificially inflate its revenue, net income and EPS, as well as other important business metrics, such as its book-to-bill ratio, by a variety of improper and manipulative tactics. Cisco also accelerated its vendor financing, lending increasing amounts of money on extraordinarily generous terms to customers of dubious creditworthiness who did not meet Cisco's own internal lending criteria, recognizing the resulting "sales" as revenue. In addition, Cisco continued to force many of its vendor financing customers to order millions of dollars of product which those customers did not need and did not want - further inflating Cisco's book-to-bill ratio, revenue and EPS. Some of these customers were so uncreditworthy that, in addition to lending them 100% of the money they needed to purchase Cisco equipment, Cisco continued to secretly make large and highly dubious working capital loans to these entities to provide them with funding for their ongoing business operations (25% in addition to the 100% loan to finance the purchases of Cisco product), even though these customers were unable to create or present credible business plans and did not come close to meeting Cisco's own internal lending criteria.
63. With these techniques, Cisco continued to artificially inflate its revenues, net income and EPS by selling larger amounts of equipment than it otherwise could have sold while, at the same time, not taking required reserves for doubtful collectibility on the loans that financed these sales to and operations of these uncreditworthy companies. And, contrary to Cisco's representations that 90% of its vendor financing loans were to tier-one financially secure enterprises, during F00, 60% of Cisco's vendor financing sales were to financially shaky companies - accounting for 10% of Cisco's reported revenues - and between 98-00, 50+% of Cisco's vendor financing contracts had been with such companies!
Inventories of Work in Progress, Finished Goods and Component Parts
64. Cisco's inventories of work in progress, finished goods and component parts are three of the most vital parts of the operational aspects of Cisco's business. The accumulation of excessive work in progress, finished goods or component parts inventory has an extremely negative impact on Cisco's profitability. Therefore, Cisco's top executives were fixated on the amount of work in progress and finished goods inventory and on the status of Cisco's component part inventories on hand, as well as those that Cisco was committed to purchase.
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precise amount of inventory of each type of component part, work in progress and finished goods product on hand and also monitored on a daily basis the sell-through of its products which, in turn, impacts inventories.
66. As Cisco's inventories ballooned, this created another very serious problem for Cisco, which its top executives were immediately aware of. Earlier in F00, in an effort to assure itself of a sufficient quantity of component parts to be able to manufacture its new products in quantity if the new products were successful, Cisco had entered into unusual purchase agreements with component parts suppliers which provided that Cisco would have to pay substantial financial penalties if it cancelled component parts orders. Normally, a company of Cisco's size is such a desirable customer that it is able to obtain component parts without exposing itself to the risk of financial penalties upon cancellation. However, when Cisco was attempting to secure commitments to supply it with component parts for its products, demand was so strong that component part manufacturers were able to force Cisco to agree to these unusual penalty terms. Thus, any slowing of sales of Cisco's products would create a double-whammy. In addition to depriving Cisco of revenue needed to meet its revenue and EPS forecasts and causing its finished goods inventories to balloon, Cisco was now faced with the prospect of being overwhelmed by a tsunami of unneeded component parts which would, of course, further exacerbate its already seriously deteriorating inventory position.
67. As a result of this sophisticated sales and inventory monitoring system, Cisco's top executives knew by 3/00 that demand for Cisco's products was weakening, that Cisco's products were selling more slowly than expected, and that Cisco was accumulating excessive inventories.
68. The slowdown in sales of Cisco products created a crisis inside Cisco as early as 3/00, as Cisco's inventories began to balloon due to the slower than expected sales of its products, which was exacerbated by the arrival of millions and millions of dollars of now unneeded and unwanted computer parts. As a result, by 3/00, Cisco's top executives knew that Cisco was accumulating millions and millions of dollars of excessive inventories, all of which would have a terribly negative impact on Cisco's revenues, net income and EPS.
The Monterey Optical Switch
69. Contrary to defendants' statements that Cisco's "top of the line" Monterey switch was being successfully developed for commercial release, the product was never commercially viable. The monumental failure of the product has been described in articles since the end of the Class Period:
(a) The 4/6/01 edition of The Industry Standard reported:
After a while, it became clear Monterey couldn't get its switch to market. Part of the problem seemed to be Monterey's choice of technology. There are two basic types of optical switches; opaque switches, which are partially optical and partially electronic; and transparent switches, which are purely optical. Monterey decided to go with the slower, less-sexy opaque switch, arguing that the switch could handle some electronic routing, and more important, it could get to market quicker.
But Monterey couldn't get the job done. The project met delay after delay. Cisco promised it would work, but it didn't show up in the marketplace. Competitors, once afraid of incurring the wrath of mighty Cisco, began to point out its inability to ship the Monterey switch. In February, Elizabeth Perry, head of optical switching for Ciena, http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 41 of 223
openly mocked Cisco's inability to ship the Monterey switch, while Ciena had 10 customers for its optical switch. The day after her speech, shares of Cisco dropped 3.6 percent to $28.50.
(b) The 5/14/01 Forbes reported:
Cisco scrapped the Monterey part of its strategy last month, in essence walking away from a $500 million investment. It had bought Monterey before the latter's core product was finished, and in 20 months Cisco couldn't get past field trials. The effort was hurt by the exit of Monterey founders Michael Zidikian and Zareh Baghdasarian shortly after the sale.
Nor does the Pirelli deal look all that promising. Cisco won't say how much long-haul gear it has sold since buying the Italian firm in late 1999, but outsiders are dubious. "We never understood why they bought Pirelli. It was never on our shortlist of suppliers," says one big Cisco customer.
Volpi admits that, after two years of pursuing an "end-to-end" strategy, Cisco's "initial focus" is now only on the first end served by Cerent. That's hard to glean from Cisco's perky press releases. In its February earnings report Cisco said it "was chosen to build out optical networks" for BellSouth, among other telcos. The Bell, however, says Cisco sold it old-line routers, not the new optical wares.
Insider Stock Sales
70. During the Class Period, Cisco's officers owned Cisco stock and/or held vested options to purchase Cisco stock. This large equity stake gave Cisco's top officers a very strong motive to do everything they could to keep Cisco's stock price up, including lying about the actual state of development of Cisco's newest products and the current state of demand for Cisco's products, as well as Cisco's inventory - and Cisco's future financial results - all to help support Cisco's stock price. These top insiders did this because they knew that they faced little or no individual risk for such misconduct as, if they were caught and sued, they would be protected by the unusually huge amounts of directors' and officers' liability insurance Cisco maintains on its officers (purchased not with their funds, but rather with Cisco's stockholders' monies) and by Cisco's own assets (over $32 billion), which they would use to defend themselves and settle any securities suits against them with Cisco's money and the insurance company's money - not their own.
71. During the Class Period, while defendants were continuing to issue false and misleading statements about Cisco, Cisco's senior officers and directors named as defendants sold 11.8 million shares of their personally held Cisco stock for proceeds of at least $604 million. These Cisco senior officers and directors took the opportunity to sell significant amounts of their Cisco stock while in possession of materially adverse non-public information. The extent of these stock sales is graphically presented below:
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Cisco Management's Self Dealing Through Acquisitions of Companies in Which They Secretly Held an Interest
72. Moreover, the insider trading proceeds described herein were only a portion of the monies Cisco officers received from their role in making false statements about the success of Cisco. Due to their investments in customers, partners and vendors of Cisco, these same insiders made millions of dollars more from undisclosed related party transactions, including:
(a) One of the key relationships of many of Cisco's officers to customers, partners and vendors was through Sequoia Capital. Sequoia Capital invested in vendors or partners of Cisco and then Cisco would do business with these entities, causing the stock price of these entities to rise, allowing Sequoia Capital to reap huge benefits. In fact, Cisco executives, including Chambers, were partners of Sequoia entities.
(b) The Sequoia connection was also a major factor in acquisitions made by Cisco. Volpi and Vice Chairman Valentine oversaw Cisco's acquisition program and both were investors in Sequoia. At the same time, Sequoia was a venture capital fund owning a significant part of many of the companies Cisco was acquiring, placing Volpi and Valentine on both sides of many of these deals. The following companies were purchased by Cisco which were also major holdings of Sequoia Capital: Allegro Systems, Inc., Ardent Communications Corp., MaxComm Technologies, Monterey Networks, Netiverse, Inc., Netsys Technologies, PentaCom, Ltd., PipeLinks, Inc., Sentient Networks and Precept Software, Inc.
(c) Chambers was also an investor in Kleiner Perkins, Caufield & Byers, which was an investor in Cerent. Cisco purchased Cerent for $7.4 billion in 99, the largest acquisition ever by Cisco.
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(d) Cisco senior executive Charles Giancarlo was an investor in Mirapoint. After he and another Cisco executive, Andreas Bechtolsheim, invested, Cisco placed the largest order Mirapoint had ever received.
(e) Listwin purchased 300,000 shares of Software.com for pennies on the dollar, after which Cisco purchased millions of shares and became a purchaser of Software.com products. (f) Daichendt was an investor in Click Action and Convergent Technology, which was a Cisco reseller and finance partner.
(g) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers that received financing from Cisco Capital (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc., Greenwich Technology Partners, Inc.), including warrants and stock in those companies. In many cases, the customer's financing was dependent upon a Cisco executive receiving a special benefit, including a "kickback" of money from the customer to the Cisco executive. Defendants, including Chambers, were aware that these illegal practices were pervasive throughout Cisco's sales and executive ranks, but allowed the practices to continue. When customers refused to pay money to Cisco executives, their financing was cut off. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
Cisco failed to adequately disclose the related-party transactions to the investing public. Defendants' self-dealing violated Cisco's own internal "conflicts of interest policy," which states that "Cisco employees should not invest in companies that are Cisco partners or suppliers." Indeed, in nearly all cases the partnerships were undisclosed in Cisco filings. Ultimately, throughout the Class Period, Kleiner Perkins, Caulfield & Byers and Sequoia Capital disposed of the Cisco shares acquired in the related-party transactions described above. Yet, Cisco never disclosed the substantial benefit that Chambers, Valentine and Volpi received through their interest in these venture capital funds.
73. As The New York Post reported on 2/18/02:
Between 1997 and 2000, Cisco's executives put together more than 60 major mergers and acquisitions, many of which appear to have been funneled through various partnership funds set up by a West Coast venture capital fund named Sequoia Capital,
As it happened, one of Sequoia Capital's long-time wheels was, and is, a chap named Donald Valentine, who also just happened to be vice chairman of Cisco Systems' board of directors. As such, he immediately wound up wearing two hats in every deal involving Cisco and any Sequoia Capital partnership fund: as a stand-in for the general partner (Sequoia Capital) in the fund, and as the vice chairman of the board of Cisco Systems that was conducting business with it.
ONE such fund - dubbed Sequoia Capital VII - is notable for our purposes here. The fund was set up in late 1995, with initial capital of $150 million, and it wasn't long before Valentine got to have an argument with himself in the mirror as a result. That's because, in July of 1996 - or roughly five months after Sequoia Capital VII was set up - Cisco Systems issued 76.4 million shares of Cisco stock, valued at around $4 billion, to acquire the ownership of a networking company down the street in San Jose, named Stratacom, Inc. And guess what: One of Stratacom's owners was none other than Sequoia Capital - the general partner in the Sequoia Capital VII partnership. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 44 of 223
A Cisco proxy report filed with the SEC in 1999 shows that Cisco's president and chief executive officer, John Chambers, had as well by then become an investor in the Sequoia Capital VII partnership. Yet more financial filings show that Sequoia Capital VII had by then paid $10 million to acquire a 15 percent investment stake in a Richardson, Texas, networking startup called Monterey Networks, Inc.
In September of 1999, Cisco Systems acquired Monterey Networks in its entirety for $517 million in Cisco stock. Some 1 million of those Cisco shares were exchanged in the deal for the 15 percent stake in Monterey that was held by the Sequoia partnership.
Two months later, Cisco Systems filed papers with the SEC allowing the Sequoia partnership to sell the Cisco shares from the Monterey deal on the open market. With Cisco by then trading for roughly $70 per share and heading higher, the whole rigamarole enabled the Sequoia partnership to reap what would appear to translate into a more than 600 percent profit on Sequoia's original $10 million investment in Monterey.
And Sequoia Capital VII looks to have been only one of many, many such partnerships through which the Sequoia Capital people did deals with Cisco. Cisco's latest proxy statement (Oct. 1, 2001) contains footnotes showing stakes of unspecified size in eleven different Sequoia partnerships in which Cisco Vice Chairman Donald Valentine served as the general partner.
* * * The involvement of Chambers also seems indefensible. Did Chambers, as well, have to get up and leave the room every time the subject of the Monterey deal came up? Company officials say he didn't have to because his stake in the partnership was so small that he wound up with only a few hundred shares from the transaction. But if the stake was that small, why bother investing in the first place?
* * * Contrary to the company's statements in its proxy filings since 1999, the officials now asserted that Chambers didn't actually have an interest in Sequoia Capital VII, after all. Instead, said an official, Chambers had held - and continues to hold - a stake in a different partnership: Sequioa [sic] Technology Partners VII.
MORE confusing, still, they now claimed it was this fund - and not Sequoia Capital VII - that had held the shares in Monterey Networks - a fact that would make the registration statement that Cisco filed on the transaction in November of 1999 in error also. Even more unsettling, the officials said that, upon checking, they had also discovered errors as to how many beneficial shares Chambers actually held in the Sequoia Technology Partners VII fund - meaning yet another set of errors in the filings.
Unfortunately for Cisco's shareholders, while Valentine and Chambers were apparently either busying themselves with leaving the room (or not needing to) regarding the Monterey deal - or maybe simply being confounded by the complexity of their spaghetti plate of partnerships - the Monterey acquisition went completely into the dumper. Widely viewed as an overpriced dog from day one, the operation was soon shut down by Cisco and written off as a $517 million wipeout. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 45 of 223
And the Monterey disaster was only one of many.
Christopher Byron, Cisco's Web of Deals, NYPOST.Com (Feb. 18, 2002).
74. These relationships were not adequately (if at all) disclosed in Cisco's filings. GAAP, as set forth in SFAS No. 57, Related Party Disclosures, requires that financial statements include disclosures of material related party transactions, including the nature of the relationship, a description of the transactions, the dollar amount of the transactions and amounts due from or to related parties. See SFAS No. 57, ¶¶2-3. SFAS No. 57 defines related parties as affiliates of the enterprise, principal owners of the enterprise, management of the enterprise and other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other. See SFAS No. 57, ¶24.
75. Moreover, these transactions were not disclosed in Cisco's annual SEC filings or Form 10-K as required by Item 404 of Regulation S-K:
(a) Transactions with management and others. Describe briefly any transaction, or series of similar transactions, since the beginning of the registrant's last fiscal year, or any currently proposed transaction, or series of similar transactions, to which the registrant or any of its subsidiaries was or it to be a party, in which the amount involved exceeds $60,000 and in which any of the following persons had, or will have, a direct or indirect material interest, naming such person and indicating the person's relationship to the registrant, the nature of such person's interest in the transaction(s), the amount of such transaction(s) and, where practicable, the amount of such person's interest in the transaction(s):
(1) Any director or executive officer of the registrant ....
76. Despite the financial interest of many members of Cisco's management to these entities, Cisco did not disclose any related party transactions as required by GAAP and as necessary to apprise the market of these close relationships and the benefits Cisco insiders were deriving from these arrangements.
Acquisition Binge/Dependency
77. During the Class Period, Cisco acquired the following companies, issuing the following amounts of Cisco stock:
Company Acquired Date No. Shares Issued Value
StratumOne 9/99 13,300,000 $ 435,000,000 Monterey Networks 9/99 14,600,000 $ 500,000,000 TransMedia 9/99 13,900,000 $ 517,000,000 Cerent 11/99 200,000,000 $6,900,000,000 WebLine Comm. 11/99 8,600,000 $ 325,000,000 Pirelli 2/00 30,000,000 $2,081,000,000 Aironet Wireless 3/00 10,600,000 $ 835,000,000 Atlantech http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 46 of 223
Technologies 6/00 3,000,000 $ 179,000,000 JetCell, Inc. 6/00 3,300,000 $ 203,000,000 PentaCom, Ltd. 6/00 1,700,000 $ 102,000,000 Qeyton Systems 7/00 14,300,000 $ 887,000,000 SightPath, Inc. 5/00 11,400,000 $ 800,000,000 InfoGear Technology 6/00 4,700,000 $ 301,000,000 ArrowPoint Comm. 6/00 90,200,000 $5,700,000,000 IP Mobile 9/00 6,500,000 $ 422,000,000 Komodo Technology 9/00 3,000,000 $ 184,000,000 HyNEX, Ltd. 9/00 2,300,000 $ 129,000,000 Netiverse, Inc. 10/00 3,200,000 $ 168,000,000 NuSpeed, Inc. 10/00 8,800,000 $ 463,000,000 IPCell Technologies 11/00 3,700,000 $ 213,000,000 Vovida Networks 11/00 5,200,000 $ 275,000,000 PixStream, Inc. 12/00 4,900,000 $ 395,000,000 CAIS Software (part acquired) 12/00 Cash $ 157,000,000 Radiata, Inc. 2/01 8,600,000 $ 266,000,000 Active Voice Corp. 2/01 5,900,000 $ 155,000,000
78. A 5/00 article about Cisco in Fortune magazine discussed Cisco's acquisition program:
Growth by acquisition has become the most famous piece of Cisco's strategic plan. Cisco has now bought 55 companies, for $20.4 billion [and] it plans to buy about 20 companies this year. Using its soaring stock as currency, the company bought its way into the market to sell the super-high-speed switches that customers like AT&T and MCI need to run their networks, allowing it to compete with heavyweights like Lucent, Nortel, Siemens, Alcatel, and Fujitsu. It bought its way into the optical networking market, the next high- speed frontier. Thanks to acquisitions, Cisco's offerings run up and down the entire product hierarchy, giving customers one-stop shopping for their networking needs. "End to end" is how Chambers puts it (although his staff jokes that it sounds like he's saying "Indian").
79. Cisco's business plan and strategy was completely dependent upon making acquisitions, as this was how Cisco acquired new technology and products and boosted its apparent growth rate. Cisco accounted for these transactions using the "pooling of interests" technique. Chambers aggressively lobbied and gave more than $200,000 to members of Congress in an effort to stave off the inevitable banning of this practice. The pooling technique has recently been banned by the SEC. By 99, Cisco had become an acquisition machine. Cisco's dependence upon making acquisitions to obtain needed technology, employees and boost its revenues and EPS was often commented upon. For instance:
• Over the next three years, Cisco would buy six more switching companies, including the $4.0 billion acquisition of StrataCom in 1996, which was then the largest purchase in the history of Silicon Valley.
Continuing the six networking companies, Cisco acquired one company in 1993, three companies in 1994, four companies in 1995, and seven in 1996. It picked up six more companies in 1997, nine in 1998, 18 in 1999 and has bought 10 so far this year, for a total of 58 acquisitions. Says Ammar Hanafi, Cisco's director of business development: "Doing http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 47 of 223
acquisitions is now wired into the DNA of the company."
• Chambers: Now we will acquire 10 to 12 companies a year ... acquiring next generation technology.
• Chambers: ... We will acquire probably 10 to 15 companies a year.
• Cisco fueled its growth by acquiring more than 35 companies in the past six years, often using its high-flying stock as currency.
... [I]t requested approval of a plan to boost the number of shares it's authorized to issue to 10 billion from 5.4 billion. Cisco ... wants to make sure it has the flexibility to issue shares to complete acquisitions or other transactions or for its stock-option and other employee-benefit plans.
• Comments from Bill Nuti, president Europe, Middle East and Africa, Cisco Systems Inc., on the outlook for acquisitions: "We'll acquire between 15 and 25 companies over the next 12 to 18 months."
• Cisco Systems, Inc., the biggest Internet-equipment maker, may acquire as many as 25 companies next year, Chief Executive John Chambers said in an interview with financial news cable-television channel CNBC.
• Forty-Two Acquisitions and Counting; the Internet giant's awesome M&A machine can acquire and integrate six companies at once.
* * * Think of Cisco as an acquisition engine .... In the past six years, Cisco has spent $18.8 billion .... [W]ith a killer currency (Cisco stock has risen 162% in the past year and is now trading at $72) ... the company prowls Silicon Valley - and the world - snapping up companies to expand existing product lines or support entirely new initiatives.
• ... [R]ather than spending on its own internal research, Cisco reached out to acquire small companies that were coming up with innovations in Internet communications and computer networking. Cisco has made more than 60 acquisitions in the last decade ....
• Historically, Cisco has been able to acquire the technology it wanted in part because its stock kept rising. A flat or falling stock makes acquisitions tougher, by reducing the shares' allure to entrepreneurs and by increasing the dilution to existing shareholders. "The stock price is the currency with which they fund their research and development," says Walter Casey, co-manager of the technology portfolio for Banc One Investment Advisors. "If they have trouble using the stock to make acquisitions, that would be a big deal for them."
So far, that hasn't seemed to be an issue. Mr. Volpi notes that entrepreneurs frequently weigh competing offers, and stumbles by rivals have made Cisco's stock more attractive by comparison. "We haven't even talked about adjusting our acquisition strategy," he says.
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• As it diversifies into fiber-optic communications gear and other new fields, Cisco continues to grow at an astonishing rate ... and devours, on average, a high-tech start-up every two weeks.
• Cisco to Continue Acquisitions. Cisco, which has already acquired stakes in 21 companies this year, indicated that it will continue to add new technologies to its portfolio because they believe, as do we, that it is easier and cheaper to acquire companies in down times when valuations come down a bit.
• Acquisitions - Acquisitions are a core part of Cisco's growth strategy. Cisco completed five acquisitions in the quarter and reiterated its plan to buy 20-25 companies in this fiscal year, and at least 30 for fiscal 2001.
• In order to grow at a rate faster than the market, we think Cisco has no choice but to turn to acquisitions for technology, products and headcount. The company has developed this strategy into an art form. In fact, giving Cisco the leeway to make acquisitions - which it does in a highly disciplined manner - is in fact a less risky prospect than simply waiting for the target company to fund its own growth and scale.
• Cisco announced 7 acquisitions during the third quarter. The company expects to make a total of 20-25 acquisitions this year .... Employee retention continues to be an issue in light of the multitude of technology start-ups entering the market and competing for IT talent.
• Acquisitions Provide Key Technology, Time-To-Market, And Scarce Talent
Given the rapid adoption of the Internet, disaggregation of proprietary, vertically integrated equipment and the importance of first-mover advantage, Cisco has quickened its acquisition pace to meet new market requirements. The company acquired nine, 18, 11 and 59 companies in 1998, 1999, 2000 to date, and in total, respectively, and these acquisitions have not only provided key technology, they also have provided Cisco with valuable, scarce technology talent.
• Acquisition Strategy Is Difficult to Emulate And Even More Difficult For Competitors To Ignore. Cisco's acquisition program is well known and an extremely successful core component of Cisco's growth strategy. Using a disciplined approach with an intense focus on cultural compatibility and people retention, Cisco has been able to achieve perhaps the highest sustained success rate in acquisitions over time of any company in history.
• We believe that Cisco is likely to continue its strategy of growing through acquisition where necessary, however, the strategy will increasingly target companies in the earlier stages of their development. Cisco has one of the highest acquisition success rates in the industry, with more than 3 in 4 being successful and a similar percentage of CEO's staying on board after integration.
• Cisco Systems Inc. Chief Executive John Chambers said a slumping market for computer networking stocks won't slow the No. 1 Internet equipment maker's acquisition strategy.... "We are the white knight in many ways," Chambers said ... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 49 of 223
• HERERA: I would assume, from the statements that you just made, that you are not planning necessarily to slow down your pace of acquisition as some on the Street would suggest you might have to.
CHAMBERS: No, It's the reverse of that. When the market slows down, the competition for people is easier for Cisco, and the competition for companies is easier. You pay a much lower price for the acquired companies - companies who would have never considered going - being bought three to six months ago, are coming to Cisco on a daily basis. So, actually, it helps in our acquisition strategy and actually helps in our people retention as well. In prefer rapidly growing market but actually we've historically gained more market share during these transitions, particularly when they're tough. So I'm very optimistic for Cisco either way it goes.
80. On 4/4/01, Kehoe and Luce of the Financial Times wrote:
First and foremost, many investors are questioning whether Cisco can adapt its high- growth strategy to the unfamiliar new world of falling share prices. Since it went public in 1991, Cisco has relied on acquisitions to power much of its revenue growth.
Following its first acquisition eight years ago, of Crescendo Communications for $97m, Cisco has bought more than 70 companies, at a pace of almost two a month in 1999 and 2000. This kept it at the cutting edge of networking technology.
"Cisco understood that it could never hope to anticipate the next sharp bend in the river, so it bought all the boats it could get its hands on," says a venture capitalist who has funded several start-ups that went on to be acquired by Cisco.
* * * It also enabled Cisco to buy the brainpower of some of the best engineering talent in the sector.
As a result, Cisco rapidly became the dominant force in the enterprise market (where it supplies the products used to build high-speed corporate networks) and the telecoms service provider market (where deregulation has enabled a flood of new entrants to challenge established companies).
Cisco managed to fund all of its acquisitions with equity, rather than cash, owing to the fact that its share price was on average doubling every 12 months. By printing new shares, the company could pay for the intellectual capital it needed and retain the best employees by providing generous stock options.
"Cisco's shares were the most rapidly appreciating currency in the world," says Junaid Islam, chief executive of Network Robots and a former business unit manager at Cisco.
"It was easy for Cisco to make purchases without affecting its bottom line."
81. By 10/00-11/00, Cisco's top executives knew potential acquisitions were backing away from Cisco and were very reluctant to be acquired by Cisco. In fact, after the 12/00 collapse of Cisco's stock, it http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 50 of 223
has made only two minor acquisitions during 01. Volpi, previously charged with making acquisitions as Chief Strategy Officer, has been reassigned and is no longer Chief Strategy Officer. The chart below shows Cisco's acquisition history:
82. The 5/1/01 Business 2.0 reported:
Michael Zadikian, a former Cisco executive ... is also critical of the Cisco acquisition strategy, maintaining that products from so many acquired firms don't work well together because they weren't built to do so. The approach puts the onus on customers to make the products work. "There are interface compatibility problems, software mismatches and integrating these businesses is still a problem," he says. "From the outside looking in it seems Cisco integrates well. Inside, it looks horrendous. The pieces don't fit together."
83. The 5/1/01 Business 2.0 also reported that, referring to Cisco's acquisition program, the man in charge of it stated:
"We've made more mistakes than anyone else," says Cisco's M&A guru Ammar Hanafi.
84. A Light Reading article on 1/9/02 stated:
Ultimately, the specifics of Cisco's M&A activity raise many questions that aren't easily answered. Some details will probably remain clouded indefinitely in layers of hearsay, financial complexity, and discarded agendas.
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perhaps the surest signal that the company's been burnt in reaching for profits from startups and doesn't want to repeat the exercise any time soon.
85. Another reason Cisco had to keep its stock price high was to create value in its stock options and thus help it recruit and retain employees, which were in short supply in Silicon Valley. On 12/9/00, Chambers was asked: "Your stock price really has been your currency for keeping employees," and he stated, "Yes!" Other comments evidence this fact. For instance:
• As a CEO you want your stock to go up gradually. That's very important in terms of your motivation of your employees, your ability to continue to staff your organization, et cetera.
• Despite Cisco's own spectacular stock performance, Chief Executive John Chambers said the biggest threat to the company is that its employees are being lured away with "out of this world" stock option packages from start-up companies.
• Employee retention continues to be an issue in light of the multitude of technology start- ups entering the market and competing for IT talent.
• Management did mention a number of times that it is getting tougher to find and keep employees.
86. A 5/00 Fortune magazine article described Cisco's use of stock options to attract, maintain and incentivize employees:
Speaking of compensation, the currency of choice for Cisco employees isn't the U.S. dollar. Oh, no. After all, the greenback doesn't appreciate 100% a year, as Cisco's shares have! Cisco hands out options to all of its employees.
87. Purchasers of Cisco's stock during the Class Period paid artificially inflated prices for the stock and have suffered billions of dollars of damage. However, Cisco's insiders named as defendants did not do nearly so poorly. During the Class Period, the Cisco insiders named as defendants sold over 11.5 million shares of their Cisco stock at artificially inflated prices as high as $80.24 per share, pocketing $604 million in illegal insider trading proceeds - one of the largest insider bail-outs in history! The graphic below shows the insider stock sales of the Individual Defendants in the aggregate from 9/98 through 2/6/01 and demonstrates that the Individual Defendants' stock sales during the Class Period, when they knew Cisco's stock was artificially inflated, greatly exceeded their Cisco stock sales in the eight months prior to the Class Period:
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88. The Cisco insiders named as defendants sold the following amounts of stock during the Class Period:
% of Shares Defendant Shares Sold Owned Sold Proceeds
Bartz 60,400 21.8% $ 2,545,262 Carter 2,134,400 48.3% $ 83,523,632 Chambers 2,300,000 9.7% $151,512,500 Daichendt 2,216,866 46.4% $109,623,108 Estrin 1,058,626 50.8% $ 65,777,167 Kozel 993,690 46.4% $ 54,980,565 Listwin 56,248 1.4% $ 1,794,592 Puette 190,000 82.6% $ 14,124,500 Redfield 1,110,000 29.3% $ 61,715,700 Valentine 940,000 19.0% $ 29,344,400 Volpi 390,000 21.2% $ 23,325,600 West 100,000 35.7% $ 6,571,350 TOTAL: 11,550,230 22% $604,838,376
BACKGROUND TO CLASS PERIOD
89. Cisco was incorporated in California in 84 and shipped its first commercial multi-protocol router in 86. Beginning in F94, Cisco began entering new markets and broadening its product offerings through a series of acquisitions. Cisco's acquisitions helped it report enormous growth in sales and have its market capitalization increase. By 99, Cisco was moving beyond the router and switch business to the area of integrated voice and data transmission. The reason for Cisco's decision to enter the carrier market was that while it still received major revenues from the Enterprise market, selling fundamental networking equipment, by 99 Cisco's traditional business had more limited growth potential and many competitors had entered the market with superior products, hurting Cisco's competitive position.
90. Due to Cisco's rapid growth, by 99 it had reached an annual sales level of $12+ billion. Due to Cisco's increasing size, analysts and investors became concerned over Cisco's ability to continue to achieve the strong 30%-50% annual revenue growth it had reported in the past. As a result of these concerns, Cisco's stock, which had been a strong performer, stagnated during 99, trading at $29-3/8 on 2/1/99 and $29-3/8 on 8/10/99 - the start of the Class Period - meaning Cisco's stock - a http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 53 of 223
supposedly unique growth stock - had shown no net price gain in over six months! The concern about Cisco's future was highlighted by a 5/99 presentation by Estrin in which she told 150 Cisco officers and employees (including Chambers, Carter and Listwin) about the threat from Microsoft which could turn Cisco into a hardware company. This situation and the stagnation in the stock price concerned Cisco's top executives. They feared that if analysts and investors perceived that Cisco's phenomenal revenue and EPS growth rates were slowing, they would be unwilling to pay the type of huge premium that Cisco's stock had enjoyed, resulting in a sharp decline in Cisco's stock price. Any such decline in Cisco's stock price would be a disaster for Cisco and its top executives, as it would curtail (if not eliminate) Cisco's ability to continue to make the large number of acquisitions upon which Cisco's business plan and financial growth had become dependent. Such a price decline would also reduce (if not eliminate) the value of the stock options held by Cisco's executives, management and other employees, resulting in a huge loss of wealth for them and even an exodus of valued employees.
91. By the beginning of the Class Period, Cisco was attempting to sell products to the hottest part of the new economy - the Internet Service Providers ("ISPs") and, later, to smaller telecommunications companies, including CLECs. While these companies offered growth opportunities, they also suffered a problem common to start-ups - lack of capital. In the Summer of 99, CLECs were entering into the multi-billion dollar local and long distance market by deploying new technology. What they lacked was capital. Cisco used Cisco Capital and other Cisco finance companies, including Sunrise Capital, to provide financing for these companies so long as they purchased Cisco product. Cisco used intermediaries such as distributors or Cisco Value Added Partners ("VAPs"), wherein ISPs and CLECs would buy Cisco products from distributors and Cisco VAPs and pay for the product using Cisco Capital funding; the distributors and Cisco VAPs would then pay Cisco allowing Cisco to recognize revenue. This also gave Cisco leverage over these CLECs and ISPs to force them to purchase more product than they wanted or needed. The Cisco financing had several unique features for a financing agreement. Cisco would secretly lend up to a third over the retail price of the equipment being sold such that loan amounts frequently exceeded the cost of the equipment to the customer by more than 100%. Payment terms were extremely liberal with terms as long as nine years and no payments due the first two years. Sales personnel were able to dictate the terms such that they could promise increased capital in exchange for a much needed order at quarter-end or a larger sale than the customer desired. Moreover, requirements for credit were waived such that millions of dollars in credit could be granted without so much as financial statements. Cisco utilized these unique financing actions to manipulate its sales. In fact, the ISPs and CLECs could not pay Cisco what they owed as they were poorly capitalized and in many cases received non-functional Cisco equipment, including incomplete product shipped by Cisco to make quarterly revenue goals. As one former customer described Cisco: "Chambers set a corporate policy to create growth through acquisition and to report growing earnings by overstocking customers with worthless product."
92. As the Class Period commenced, Cisco was preparing for the largest tech acquisitions ever - Cerent for nearly $7 billion, as well as Monterey Networks for $500 million. It was thus essential Cisco report favorable financial results to continue its trend of beating forecasted levels of revenues and EPS so Cisco's stock would move higher, enabling it to use its stock to complete these and other acquisitions it was planning. When reporting its 4thQ F99 and F99 results after the close of trading on 8/10/99 - the beginning of the Class Period - and then, throughout the Class Period, Cisco continued its pattern of beating the Street, affirming strong demand for its products, forecasting 30%-50% growth going forward and increasing its forecasted EPS growth. FALSE AND MISLEADING STATEMENTS DURING THE CLASS PERIOD http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 54 of 223
93. During late 7/99 and early 8/99, rumors circulated that Cisco would "miss" its 4thQ F99 and F99 numbers - and not "beat the Street," as had become its custom. Cisco stock fell from $33-7/16 on 7/16/99 to $28-5/64 on 8/10/99. However, after the close of trading on 8/10/99, Cisco reported better-than-expected 4thQ F99 and F99 results that "beat the Street":
Net sales for the fourth quarter were $3.55 billion, compared with $2.40 billion for the same period last year, an increase of 48%. Pro forma net income ... was $727 million or [$.11] per share, compared with pro forma net income of $525 million or [$.08] per share for the fourth quarter of 1998, increases of 38% and 31%, respectively.
* * * Net sales for fiscal 1999 were $12.15 billion, compared with $8.49 billion for the same period last year, an increase of 43%. Pro forma net income was $2.55 billion or [$.37] per share, compared with pro forma net income of $1.88 billion or [$.29] per share during fiscal 1998, increases of 35% and 29%, respectively....
* * * [Said John Chambers, president and CEO of Cisco Systems:] "... [W]e are growing faster than all of our key competitors and have been the fastest growing and most profitable company in the history of the computer industry."
94. On 8/10/99, subsequent to the release of its 4thQ 99 results, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss Cisco's 4thQ 99 results. During the call and in follow-up conversations with analysts, Chambers and Carter stated:
• Cisco's better-than-expected EPS were due to very strong demand for its products which generated higher revenues than expected. The quality of Cisco's revenue was very good.
• Cisco's book-to-bill ratio was better than 1-to-1, reflecting strong orders and accelerating contract wins.
• Linearity was strong throughout the quarter.
• Cisco was the fastest growing and most profitable company in the history of the computer industry.
• Cisco's inventories increased due to the need to acquire component parts in short supply and the ramping up of production of new products. Cisco was very comfortable with its levels of inventories and expected inventory levels to increase as Cisco attempted to reduce product delivery times to customers.
After the conference call, in follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• Cisco was increasingly optimistic over its business and prospects.
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• Cisco expected its sales to continue to grow by 30%-50% and its EPS to grow by 35%-40%.
• Cisco was guiding analysts to increase the F01 EPS forecast for Cisco to $.60-$.77.
95. On 8/10/99, the Associated Press reported:
CISCO SYSTEMS POSTS 48 PERCENT JUMP IN QUARTERLY REVENUES
* * * Capping a stunning fiscal year in which revenues grew 43 percent and operating profits improved 35 percent, Cisco's fourth-quarter results showed that it continues to dominate the frenzied race to upgrade systems for Internet communications.... Cisco ... earned $727 million or [$.11] cents per share, in the quarter .... The results edged most forecasts by industry analysts, which averaged [10] cents a share .... [Chambers] boasted, Cisco is "the fastest growing and most profitable company in the history of the computer industry."
96. Following Cisco's 8/10/99 release and conference call and discussions with Chambers and Carter, based on what Chambers and Carter told them, virtually every analyst that followed Cisco increased the forecasted revenue, net income and EPS for Cisco and the price target for Cisco's stock.
97. On 8/11/99, Gerard Klauer Mattison issued a report on Cisco by Cristinziano, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.64, forecast a 30% five-year EPS growth rate for Cisco and forecast the following quarterly F01 EPS for Cisco:
EPS/F01 QTR 1st: $ .14 2nd: $ .16 3rd: $ .16 4th: $ .17 Year: $ .64
• 4Q99 operating EPS ... beat consensus by $0.01....
• The quarter had no flaws .... The company continues to fire on all cylinders, actually accelerating sales during the quarter .... We are increasing our revenue forecast ....
98. On 8/11/99, Lehman Brothers issued a report on Cisco by Luke, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.60, forecast a 30% five-year EPS growth rate for Cisco and stated:
CSCO Cisco Systems: Another Outstanding Quarter, Ests Raised, Reiterate Buy
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* ... Cisco Systems delivered yet another excellent quarter.... Cisco earnings came in a penny above our consensus estimate of [$0.11] ... investors are likely to be greatly impressed by very strong sales growth ....
* * * * During conf call mgmt confirmed no change from 3Q99's more confident outlook ....
* ... [W]e are ... introducing new FY01 est of [$.61]....
* * * Following the release of earnings, management, [led] by CEO John Chambers, held an upbeat conference call with investors.
* * * With a book to bill at the end of quarter above one, impressive linearity, and accelerating contract wins, we believe the outlook for Cisco remains extremely robust.
* * * Cisco saw robust trends across all major key markets with the exception of Japan ....
99. On 8/11/99, A.G. Edwards issued a report on Cisco by Andrew, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.59 and stated:
CISCO ANNOUNCES ANOTHER BLOWOUT QUARTER
* * * Cisco reported another incredibly strong quarter with revenues for the 6th consecutive quarter in a row accelerating. EPS above expectations due to stronger revenues .... Raising estimates ....
* * * In typical Cisco fashion, the company announced fourth quarter and fiscal year end results ... that came in slightly better than expected. The upward surprise was driven by stronger than expected revenues .... Bottom line, the company is executing perfectly on its business plan ....
* * * Inventories increased due to necessity for flexibility in product mix, as well as for the ramping of new products. Cisco stated that its is happy with their inventory management ....
100. On 8/11/99, CIBC WorldMarkets issued a report on Cisco by Pyykkonen, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.63 and stated:
CSCO: REVENUE GROWTH ACCELERATES AGAIN
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Book/bill at the end of the quarter was greater than 1.0x and linearity was strong throughout the quarter.
Revenue exceeded our expectations ...[with] the highest sequential growth rate since 1996 ....
* * * [W]e are raising our ... EPS estimates ... in fiscal 2000 ....
* * *
EPS/F01 QTR 1st: $ [$.14] 2nd: $ [$.16] 3rd: $ [$.16] 4th: $ [$.17] Year: $ [$.63]
101. On 8/11/99, J.P. Morgan issued a report on Cisco by Rabin, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.61 and stated:
EPS ... was ... (a penny better than the Street consensus) and revenues actually beat our projection by $86 million.... Cisco once again delivered impressive results across all major product and customer segments.
102. On 8/11/99, S.G. Cowen issued a report on Cisco by Stix, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.63 and stated:
CSCO BLOWS AWAY REVENUE ESTIMATES ....
* * * Estimates Raised To Reflect CSCO's Exceptional Revenue Growth ....
... Forward Looking EPS Growth Rate Now Above 33% ....
* * * We heard concerns from clients over the last several days, that CSCO might have only delivered EPS of [$0.10]. The company delivered a very solid [$0.11] EPS, +$0.01 ahead of Street expectations ....
103. On 8/11/99, Prudential Securities issued a report on Cisco by Szymczak, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.60 and stated:
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* * * * Quality of revenues is extremely strong as evidenced by ... a book-to-bill above 1.00.
* * * Cisco reported fiscal fourth-quarter earnings from operations of [$.11] per share, which was above ... estimates .... * * * The quarter was strong and balanced by any measure. Excluding Japan, orders were up 60% over the prior year in Asia. The strong bookings progress includes a comeback in Korea, and a 44% growth in China. In Europe, virtually all major countries delivered order growth in excess of 50%. In the Americas, booking growth was also over 45%, with North America leading the way.
* * * Customer financing activity continues to grow. It is nearing the $1 billion level at quarter-end, and the objective is $3 billion in several years.
104. On 8/11/99, Sutro & Co. issued a report on Cisco by Houghton, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.61, forecast a 30% three-year EPS growth rate for Cisco and stated:
* EPS of [$.11] ahead of our estimate ....
* * * * Revenues and bookings driven by strength in US, Europe and Asia.
* * * * Providing preliminary FY 2001 EPS estimate of [$.61].
* * * * Raising Estimates .... Based on the company's better than expected performance in 4Q'99 and continued outlook for strong growth, we are ... providing a preliminary FY 2001 EPS estimate of [$.61].
105. On 8/11/99, First Boston issued a report on Cisco by Weinstein, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report forecast a 35% five-year EPS growth rate for Cisco and stated:
Conference Call Summary
The outlook was bullish and the overall tone was positive ... there is no fundamental reason why the stock should do anything but go higher.... Cisco reiterated its long term top line growth target of 30-50%.
106. On 8/11/99, Alex. Brown issued a report on Cisco by Wade, which was based on and repeated information provided him in the 8/10/99 conference call and in follow-up conversations with Chambers or Carter. The report forecast a 30% three-year EPS growth rate for Cisco and stated: http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 59 of 223
48% Year-to-Year Revenue Growth Bring Cisco in Ahead of Estim. - Strong Buy
* * * HIGHLIGHTS:
- Cisco reports Q4 revenue of $3.55 billion ... easily surpassing our 3.3 billion estimate.
- EPS of $0.21 beats ... consensus by 1 cent.
- Book to Bill above 1 ....
* * * - Cisco's long-term guidance stays at 30-50%, quelling fears that slowing enterprise growth would mute Cisco growth.
107. As a result of Cisco's very strong 4thQ F99 results and positive statements about its business in the 8/10/99 conference call and in follow-up communications with analysts, Cisco's stock advanced from $29-13/16 on 8/9/99 to $35-5/32 on 8/26/99, more than recovering its late 7/99, early 8/99 decline. As Cisco's stock increased in price due to these positive statements about Cisco's business, the Cisco insiders named as defendants took advantage of this artificial inflation of Cisco's stock by selling off 4,289,482 shares of Cisco stock they owned, pocketing $134 million in illegal insider trading proceeds.
108. Each of the statements set forth above made in connection with the reporting of Cisco's 4thQ F99 and F99 results were false or misleading when issued. The true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 4thQ F99 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working product in the following quarter;
(ii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers was moved across a "yellow line" in the facility, but not actually shipped to a customer;
(iii) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(iv) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
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(v) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customers did not need and did not want, which Cisco knew would reduce demand for its products in the future. Some of this equipment was not working and had expired warranties. In fact, Cisco extended additional credit to American MetroComm ("AMC") even though AMC was insolvent by 8/99 according to a complaint filed by Cisco in 01. Cisco employees were present at AMC and had access to AMC's financial statements which indicated that AMC's solvency was deteriorating significantly from a net equity of $850,000 in 5/99 to a negative equity of $2.8 million by 7/99. By 8/99, AMC had current assets of $3.6 million and current liabilities of $11.4 million;
(vi) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(vii) Cisco frequently shipped product at the end of the quarter to warehouses in order to make quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of the 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
(viii) Cisco utilized third-party intermediaries, such as Sunrise Capital, Deutsche Bank, GE Capital, American Express, and Silicon Valley Bank to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on loans; and
(ix) Cisco booked large deals before quarter-end to Commercial Value Added Partners ("CVAPs") and Commercial Value Added Resellers ("CVARs") without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product;
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶108(a)(i)-(ix).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶108(a)(i)-(ix).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
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(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customer did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away if they were to get it in the near future. In many cases, Cisco delivered incomplete product to customers;
(v) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vi) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(f) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% (or sometimes more) financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. ICG, Comindigo, and Resilient were uncreditworthy companies to which Cisco provided funds. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. AMC had received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
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(g) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipments to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor financed loans, as represented.
(h) Cisco was not successfully penetrating the large telecom service product market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford and that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(i) Cisco did not provide an "end-to-end" solution as it had represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(j) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing and several executives of acquired companies had left Cisco, leaving it with serious management and leadership problems with those entities.
(k) Contrary to Cisco's assurances that its Asian markets, including Japan, were recovering from prior slowness and that Cisco was seeing strengthening sales there, in fact, demand for Cisco's products in Asia and Japan remained soft and was not improving in any material way.
(l) Cisco's sales representatives pressured resellers/CVAPS (such as SBC Datacom, Bay Data Consultants, Solarcom, Ameritech, and G.E. Capital IT Solutions) to place orders in advance of end- user commitments.
(m) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(n) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
109. On 8/26/99, Cisco issued a release announcing the very important acquisitions of Cerent Corporation for $7.4 billion and Monterey Networks for $500 million, stating:
Cisco Systems, Inc. today announced definitive agreements to acquire privately-held Cerent Corporation of Petaluma, CA and Monterey Networks, Inc. of Richardson, TX for a combined $7.4 billion in stock. With these acquisitions Cisco is entering a new business, the optical transport market, which is expected to be a $10 billion market in http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 63 of 223
2002 according to analysts.
Today's announcement is significant because ... Monterey's technologies substantially broaden Cisco's optical product portfolio to help customers take advantage of New World solutions....
Cerent, with more than 100 customers nationwide, is a leading developer of next- generation optical transport products. These devices allow service providers to transition to New World data and voice networks. Monterey is an innovator of infrastructure-class, optical cross-connect technology that is used to increase network capacity at the core of an optical network.
* * * Cerent's technology is the first generation of transport equipment designed around the Internet. It is a low-cost, single platform that allows service providers to offer New World services and traditional voice services without investing in old world equipment. Using this technology, service providers can easily accommodate rapid changes in network traffic in a matter of minutes instead of days. Cerent's single system solution also makes it easier for service providers with limited space for equipment.
"Cisco's acquisitions of Cerent and Monterey are expected to accelerate the market for optical transport by providing the transport technology necessary to ease service providers migration to the New World," said Lewis O. Wilks, Qwest's President of Internet and multimedia markets. "The combination of Cisco, Cerent and Monterey provides a compelling product portfolio that gives communications service providers maximum choice, flexibility and functionality while helping them meet their business needs for today and tomorrow," he added.
Monterey's technology focuses on the core of next-generation optical networks. Its infrastructure-class, optical cross-connect technology gives service providers the ability to instantly add capacity at the core of the network cost effectively.... Monterey brings a complete infrastructure solution to help customers transition to New World networks.
* * * Monterey strengthen[s] Cisco's optical internetworking strategy to enable a more complete transport solution through Internet architecture.
110. On 8/26/99, subsequent to the release of its 8/26/99 press release, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss Cisco's acquisition of Monterey and Cerent. During the call and in follow-up conversations with analysts, Chambers, Carter and other Cisco executives stated:
• Monterey made a very reliable high-capacity interoperable optical cross-connect.
• Monterey gave Cisco state-of-the-art technology aimed at high-growth emerging market opportunities.
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ahead than its competitor.
• Monterey provided Cisco a core optical switch, bringing routing to wave lengths.
• Final development of the Monterey product was on or a bit ahead of schedule.
In follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• The market for the Monterey optical cross-connect system would be very good, limited only by the supply of product.
• Cerent and Monterey would together represent a $10 billion opportunity by 02.
• Cisco expected big things in terms of revenue from Monterey.
• The price for the acquisitions was fair if Cisco executed well.
• Customer trials would commence in the next one to two months - a few months ahead of schedule.
• Volume shipments to customers were expected in first half of 00.
• The Monterey optical switch would provide meaningful revenues in F01-F02.
• The Cerent 454 optical platform would support speeds of OC-192 in the near future, and the platform could handle 150,000 T1s or 3.8 million calls.
• Cisco's recent acquisitions of NetSpeed and DeGaz had bought Cisco a leading position in the deployment of DSL.
• NetSpeed had unique technology called digital off-hook which allowed service providers to pool access lines.
111. On 8/26/99, Chambers was interviewed on CNN Moneyline. After the interview, the interviewers commented:
VARNEY: Interesting isn't it, that Cisco stock goes up when it spends nearly seven billion on a company that makes no money.
BAY: Well, John Chambers spent a lot of time today, using that legendary charm of his, talking up that deal.
112. On 8/26/99, Sutro & Co. issued a report on Cisco by Houghton, which was based on and repeated information provided him in the 8/26/99 conference call and in follow-up conversations with Chambers or Carter, which stated:
* Believe acquisition [of Monterey Networks is] very positive for Cisco and give[s] Cisco much-needed expertise in optical transport and access
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* Believe Cisco's acquisitions combined with its leadership position in core routers position Cisco firmly as a leading supplier of equipment for next-generation transport and access networks
* * * * Believe Monterey will likely ship units to trials in 2H'99
113. On 8/26/99, First Boston issued two reports on Cisco by Weinstein, which were based on and repeated information provided him in the 8/26/99 conference call and in follow-up conversations with Chambers or Carter. The report stated:
Cisco's purchase of two optical companies (Cerent and Monterey) ... gives Cisco a larger optical product arsenal against Nortel, Alcatel, Fujitsu in the near term and Lucent in the long term.
Cerent offers Cisco a next generation optical access platform, a surprisingly large customer base and a compelling customer value proposition; Monterey is more of a longer term opportunity providing Cisco a core optical switch, bringing routing to wavelengths.
* * * Monterey's automatic wavelength provisioning and capacity planning tools will provide the extra flexibility carriers look for beyond just the number of wavelengths supported.
* * * We look for meaningful revenues in fiscal 2001/02.
* * * Bottom line is these acquisitions will help not hurt Cisco over the next two years ....
* * * The Monterey platform is a bit ahead of schedule with customer trials at 2 or 3 site[s] happening in the next 1-2 months, vs. the original November schedule. Volume shipments to customers still expected in the first half of 2000.
114. On 8/26/99, J.P. Morgan issued a report on Cisco by Rabin, which was based on and repeated information provided him in the 8/26/99 conference call and in follow-up conversations with Chambers or Carter. The report stated:
Cisco announced the acquisition of Cerent Corp. and Monterey Networks for a combined total of $7.4 billion. These acquisitions are strategically important for Cisco as they attempt to further penetrate the carrier market with next-generation, voice/data systems.... Monterey has developed an "optical" cross-connect system, which will be used to manage bandwidth at the core of carriers' networks. We are definitely positive on these moves by Cisco, as it gives the company an immediate entrance into the market for carrier class transport and service provisioning equipment - both high- growth markets that were two of the few remaining holes in Cisco's product portfolio.
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* * * What Is Monterey?
Monterey has developed a very high capacity "optical' cross-connect system. This product is aimed at core network applications where carriers have numerous high bandwidth pipes converging together.... The market for these huge cross-connect systems has only recently emerged, primarily the result of the exponential increases in bandwidth in the core network. Aside from managing bandwidth, the Monterey product enables carriers to deploy what is termed a "mesh-network" architecture, rather than the traditional SONET ring architecture... [C]arriers are interested in this architecture because it offers an increased levels [sic] of efficiency and flexibility in network operations. We believe that the market for these core "optical" switches will be very significant, and at least initially, should be only held back by a limited supply of products.
Why these Acquisitions Are Important To Cisco
... [T]hese products address very significant emerging market opportunities. More importantly, these products represent a large chunk of the total solution that carriers are looking for in their deployment of next-generation networks. The carrier Market in general is a huge growth opportunity for Cisco (up 80% yoy last quarter). More importantly, Cisco's product portfolio has only begun to address the total solution telecom carriers are demanding. With these acquisitions, we believe Cisco gains state- of-the art technology, aimed at high-growth, emerging market opportunities, while filling an important hole in its product portfolio.
115. On 8/27/99, Warburg Dillon Read issued a report on Cisco by Theodosopoulos, which was based on and repeated information provided him in the 8/26/99 conference call and in follow-up conversations with Chambers or Carter. The report stated:
* ... Monterey's wavelength router is currently on schedule to be shipped to 2-3 carriers within the next 45 days. Cisco anticipates trials in the winter and revenue contribution in the second calendar quarter of 2000.
116. On 8/27/99, S.G. Cowen issued a report on Cisco by Stix, which was based on and repeated information provided him in the 8/26/99 conference call and in follow-up conversations with Chambers or Carter. The report stated:
Cerent And Monterey Acquisitions Fill In the Most Important Holes In CSCO's Carrier Product Line. As CSCO becomes a leader in delivering converged voice/data products for carrier backbones, it was completely lacking in SONET and optical transport products. The two acquisitions announced today fill those holes. The Cerent 454 is an exceptionally strong optical transport platform replacing both SONET ADMs and 3/1, 3/3 cross connect. The 454 has a 240 Gbps backplane and can support a very high density of T1 lines. The 454 can handle 150,000 T1s or 3.8MM phone calls. The 454 currently supports OC3 and OC48 speeds and it is adding OC192 in the near future....
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Connect.... Monterey ... is expecting to achieve revenue shipments in the first half of C00. Its Monterey 2000 Series Wavelength Router enables service providers to build a highly scalable, highly reliable networked mesh of DWDM.... It is exceptionally reliable and can flexible [sic] route bandwidth as needed. Using the Wavelength Router, service providers can rapidly scale up and traffic engineer optical networks without legacy ATM switches. Customers for the Monterey product are likely to be very large service providers.
* * * The NetSpeed and DeGaz acquisitions bought Cisco a leading position in the deployment of DSL, with aggressive rollouts at US West, Cincinnati Bell, Covad, Rhythms, Frontier, and Spring, as well as Chungwha Telecom in Taiwan. The NetSpeed DSLAM has unique technology called digital off hook, that enables service provides to pool access lines, lowering the cost of the solution.
117. On 8/31/99, CIBC World Markets issued a report on Cisco by Pyykkonen, which was based on and repeated information provided him in the 8/26/99 conference call and in follow-up conversations with Chambers or Carter. The report stated:
Cisco Systems also announced the acquisition of Monterey Networks, a privately held provider of high-end cross-connect equipment for the service provider market, for $500 million in stock on a purchase accounting basis.
* * * Monterey Networks announced a large-capacity cross-connect product at the Supercomm trade show in June 1999 and expects to be able to ship the product in the first half of calendar 2000. Although not yet shipping, it appears that this product, at a 256 x 256 OC-48 cross-connect, is larger and further ahead than its competition.
118. The statements set forth above made in connection with Cisco's announcement of the acquisitions of Cerent and Monterey were false or misleading when issued. The true but concealed facts were those described in ¶108, as well as:
(a) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(b) The Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
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blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still result only in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s (the channels by which voice calls travel).
(d) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(e) Contrary to the assertion that Cisco had a leading position in the deployment of DSL, Cisco never held the market share lead in DSL.
(f) NetSpeed's "unique technology" was not the benefit represented and was not used by customers because the off-hook feature was non-standard.
(g) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(h) Through their interest in venture capital funds, Chambers, Valentine and Volpi were on both sides of the Cerent and Monterrey deals, as discussed in ¶72. Cisco's statement in ¶109, however, fails to disclose defendants' conflicted involvement in these deals.
(i) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-60% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
119. On 10/12/99, Cisco issued a press release with TeleWare Global about the deployment of the VCO/4K switch, which stated in part:
Cisco Systems, Inc. and software integrator TeleWare Global Corporation (formerly Worldwide Web Systems) announced today that American MetroComm (AMC) has selected the Cisco VCO/4K Programmable Switch controlled by TeleWare Global's Spider(TM) integrated software suite as the foundation for AMC's network deployment of next-generation voice, data and video technology.
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designated AMC a Cisco Powered Network (CPN) provider to highlight the company's end-to-end deployment of Cisco equipment, as well as its commitment to using intelligent broadband IP networking to deliver enhanced connectivity and network-based applications to its customers.
* * * "AMC's aggressive deployment of this Cisco/TeleWare Global New World solution demonstrates that they are a leader in the telecommunications industry, committed to quickly and efficiently meeting the needs of their customers," said Kevin DeNuccio, vice president of Service Provider Operations at Cisco Systems. "This deployment also exemplifies how Cisco's ecosystem strategy is effectively helping service providers deliver profitable New World services with rapid time to market."
120. On 11/9/99, Cisco reported better-than-expected 1stQ F00 results:
Net sales for the first quarter were $3.88 billion, compared with $2.60 billion for the same period last year, an increase of 49%. Pro forma net income ... was $837 million or [$.12] per share, compared with pro forma net income of $561 million or [$.09] per share for the first quarter of 1999, increases of 49% and 41%, respectively.
121. On 11/9/99, subsequent to the release of its 1stQ F00 results, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss Cisco's 1stQ results, its business and its prospects. During the call and in follow-up conversations with analysts, Chambers, Listwin and Carter stated:
• Cisco enjoyed an exceptionally strong quarter with strong sales across all lines of business.
• All of Cisco's engines were on afterburner - Cisco was firing on all cylinders.
• Cisco's linearity was very good; book-to-bill ratio was better than 1-to-1, reflecting continuing strong demand.
• Cisco's inventories increased due to the decision to purchase more component parts that were in short supply and build more product to meet very strong demand.
• Cisco was enjoying accelerating strong demand from the SP segment.
• Cisco's optical business was on fire.
• Monterey, Cisco's most recent acquisition, was off to a good start.
In follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• Cisco expected its sales to continue to grow by 30%-50% and its EPS to grow by 35%-40%.
• Cisco was increasingly optimistic over its business and its prospects.
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• Cisco expected to increase its levels of inventories to improve lead times and product availability for customers.
• Cisco had increasing confidence in its F01-F02 forecasts.
• Cisco was guiding analysts to increase the F01 EPS forecast for Cisco to $.62-$.67 and its F01 revenues to $22+ billion.
122. On 11/9/99, Associated Press reported:
CISCO TOPS FORECASTS AGAIN AS QUARTERLY SALES SOAR 49 PERCENT
Cisco earned $837 million or [12] cents a share in its first quarter ended Oct. 30 .... Analysts had expected Cisco to report an operating profit of [11] cents a share for the just-ended period ....
123. On 11/9/99, Bloomberg reported:
"Lo and behold, they did it again," said Martin Pyykkonen, an analyst with CIBC World Markets, who rates Cisco shares a "buy." The quarter was "very strong, particularly in terms of top line again," he said.
124. On 11/10/99, Chambers was interviewed on CNN's "In the Money" program:
BILL TUCKER, CNN ANCHOR: All right, in our "Stock Story" segment today, Cisco Systems. The stock very heavily traded, it is up at the moment 4-5/16. A few weeks ago, there was a rumor on Wall Street that Cisco might not meet Wall Street's expectations for quarterly earnings. It was a scare to investors because Cisco has been one of the Street's most consistent earning performers for years, which is one reason it is such a favorite for investors.
Last night, Cisco reported earnings and, as usual, they were rock solid.
* * * PETER VILES, CNN CORRESPONDENT (voice-over): In baseball, the model of consistency was Joe DiMaggio who once hit safely in 56-straight games. On Wall Street, the closest thing to DiMaggio is Cisco Systems which, yesterday, beat earnings expectations by a penny a share, marking the 39th quarter in a row it has met or beat Wall Street expectations.
* * * TERRY KEENAN, CNN ANCHOR: Well, joining us now ... [is] Cisco Systems' president and CEO, John Chambers.
Mr. Chambers ... [c]onsistent and compelling returns, how do you do it?
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TUCKER: ... [I]f you have an Achilles's Heel ... it would be in the optic area. What are your plans in terms of moving into optic technology, John?
CHAMBERS: Well, that's where we made the acquisition on Monterey ... and the optical interconnect for Monterey.... Monterey is off to a good start.
125. Following Cisco's 11/9/99 release and conference call and later discussions with Chambers and Carter, virtually every analyst that followed Cisco increased the forecasted revenue, net income and EPS for Cisco and the price target for Cisco stock based on the information provided them by Chambers and Carter.
126. On 11/10/99, J.P. Morgan issued a report on Cisco by Rabin, which was based on and repeated information provided him in the 11/9/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.63. It also stated:
CISCO POSTS VERY STRONG FIRST QUARTER RESULTS
* * * Cisco reported a very strong fiscal first quarter with EPS of [$.12], a penny above our estimate and the Street consensus. Revenue came in at $3.88 billion (49.8% year-over- year growth), almost $50 million ahead of our expectations.
* * * We are increasing our fiscal 2001 EPS estimates to [$.63] from [$.61] .... First quarter results were very strong, and all of Cisco's engines are on afterburner.... On the conference call, Chambers noted Cisco's book-to-bill in the first quarter was greater than 1 ....
The real story here for Cisco investors is that there's no change to the story.
127. On 11/10/99, Alex. Brown issued a report on Cisco by Wade, which was based on and repeated information provided him in the 11/9/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.65, forecast a 30% three-year EPS growth rate and the following quarterly F01 EPS for Cisco:
EPS/F01 QTR 1st: [$ .15] 2nd: [$ .16] 3rd: [$ .17] 4th: [$ .17] Year: [$ .65]
It also stated:
HIGHLIGHTS:
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- ... Linearity was good ... and book to bill was over one
* * * DETAILS:
In a quarter in which we heard the most Cisco rumors since 2Q January 1997, Cisco reported an exceptionally strong quarter without any notable weaknesses. On the contrary, Cisco's strong sequential revenue growth, impressive linearity and positive book to bill made any effort chasing rumors of problems seem a huge waste of time.
* * * Management seems quite confident in the future growth, reiterating its traditional 30- 50% growth comments .... Cisco continued its string of strong sequential quarters ....
128. On 11/10/99, Lehman Brothers issued a report on Cisco by Luke, which was based on and repeated information provided him in the 11/9/99 conference call in and follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.63 and forecast a 27% five-year EPS growth rate for Cisco. It also stated:
Cisco Systems reported strong 1Q00 earnings ... of [$.12] beating the consensus estimate ... in classic Cisco style.... [M]anagement led by CEO John Chambers led a positive conference call with investors and provided some positive commentary related to the outlook for FY00....
Strong Revenue Growth Continues
Cisco posted very strong 1Q00 revenues of $3.88 billion which represents an impressive increase of 49% YoY and 9% QoQ to come in ahead of our high end estimate of $3.79 billion. Sales continued to be driven by accelerating demand from service provider ... segment .... While competitors have seen some softness in the enterprise market in recent months, Cisco continued to see strong demand during the quarter growing this segment 30% YoY .... Cisco saw improvements in all major geographic regions .... Based on increasing[] confidence in FY00 and FY01 outlook our estimates fine tune upwards ....
129. On 11/10/99, S.G. Cowen issued a report on Cisco by Stix, which was based on and repeated information provided him in the 11/9/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.65 and stated:
ANOTHER OUTSTANDING QUARTER FOR CISCO
* * * The optical business ... is on fire. Its initiatives to converge voice and data favorably position CSCO to continue achieving exceptional growth. With sustainable EPS growth of above 30% and revenue growth of more than 40%, Cisco achieves the fastest growth among the industry leaders.
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investor concerns in days preceding earnings, followed by the announcement of outstanding results. The company delivered very solid EPS ... $0.01 ahead of Street expectations .... Book to bill was 1.05 to 1.09 for the ninth consecutive quarter.
* * * Strong Buy Rating Retained ... Estimates Raised.... We remain very bullish on the story.... Fiscal 2001 EPS ... raised by [$.03] to [$.65] based on increase[d] revenue growth expectations.
130. On 11/10/99, Gerard Klauer Mattison issued a report on Cisco by Cristinziano, which was based on and repeated information provided him in the 11/9/99 conference call and in follow-up conversations with Chambers or Carter. The report increased the forecasted F01 EPS for Cisco to $.64 and forecast a 30% five-year EPS growth rate for Cisco. It also stated:
CISCO SYSTEMS ... 1Q00 RESULTS: FULL STEAM AHEAD; RAISING PRICE TARGET ...
* * * • 1Q00 operating EPS ... beat consensus by $0.01. Cisco reported revenue of $3.88 billion, up 9% sequentially and 49% year-over-year on strong sales across all lines of business. Revenue growth accelerated for the eighth consecutive quarter and book-to- bill was again greater than one....
• The quarter showed many signs of strength. The company continues to fire on all cylinders ... increasing our revenue forecast ....
131. On 11/10/99, Josephthal & Co. issued a report on Cisco by Hochfeld, which was based on and repeated information provided him in the 11/9/99 conference call and in follow-up conversations with Chambers or Carter. The report stated:
CSCO reported very strong 1Q00 operating results.... EPS were [$.12] ... which ... beat the consensus estimate ... by a penny.... More importantly, Cisco ... was more optimistic about opportunities across all channels ....
132. On 11/16/99, Chambers was interviewed on CNNfn by Jan Hopkins:
HOPKINS: ... One of your suppliers, MMC Network shares were down very sharply today, the company saying that you just aren't ordering a lot of products from that company. Is something going on at Cisco that we need to know about?
CHAMBERS: Well, we just announced our quarter a little bit over a week ago. We gave a pretty bullish quarter for Cisco and good confidence in the future: ... actually our guidance has not changed. We've gotten a little bit more comfortable with.... So I would not draw any conclusions from a specific supplier's announcement.
133. The statements made in connection with the reports of Cisco's 1stQ F00 results and the description of the VCO/4K (Summa Four) products, set forth above, were false. The true but concealed facts were:
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(a) Cisco's Summa Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments. The statement regarding AMC selecting the Cisco VCO switch was misleading since it failed to disclose that AMC had no need for the switches at that time, and Worldwide was forced by Cisco to "store" the completed Summa switches so Cisco could book its sales, and AMC would have access to working capital from Cisco Capital.
(b) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 1stQ F00 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working product in the following quarter;
(ii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers was moved across a "yellow line" in the facility, but not actually shipped to a customer;
(iii) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(iv) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned more than 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
(v) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customer did not need and did not want, which Cisco knew would reduce demand for Cisco's products in the future. Some of this equipment was not working and had expired warranties;
(vi) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(vii) Cisco frequently shipped product at the end of the quarter to warehouses in order to make quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of the 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
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American Express and Silicon Valley Bank to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on their loans; and
(ix) Cisco booked large deals before quarter-end to CVAP's and CVAR's without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product.
(c) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶133(b)(i)-(ix).
(d) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶133(b)(i)-(ix).
(e) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customer did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(v) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vi) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
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(f) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability.
(g) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. ICG, Comindigo, and Resilient were other uncreditworthy companies to which Cisco provided funds. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. One customer, AMC, received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(h) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipments to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor financed loans as represented.
(i) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(j) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(k) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
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(l) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey, Cerent and Summa Four) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(m) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. The Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(n) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s (the channels by which voice calls travel).
(o) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(p) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(q) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
134. On 12/1-2/99, Cisco executives Chambers and Carter appeared at the annual Cisco Analyst Conference in Santa Clara, CA. In a formal presentation and break-out sessions, they told the assembled analysts, money and portfolio managers, institutional investors, brokers and stock traders that:
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• Cisco's vendor financing program would not adversely impact Cisco's balance sheet.
• Cisco was confident in its ability to sustain at least 30% top and bottom line growth over the next three years.
• Cisco was forecasting F01 revenues of $22+ billion and EPS of $.62-$.67.
135. On 12/2/99, PaineWebber issued a report on Cisco by Piecyk, which was based on and repeated information provided him at the analyst conference and in follow-up conversations with Chambers or Carter. The report forecast F01 EPS of $.62, a 35% secular growth rate and the following quarterly F01 EPS for Cisco:
EPS/F01 QTR 1st: [$ .14] 2nd: [$ .15] 3rd: [$ .16] 4th: [$ .17] Year: [$ .62]
It also stated:
* Management is confident in its ability to sustain 30% top and bottom line growth over the next 3 years.
* * * * Cisco believes its pursuit of the carrier market is not likely to substantially erode ... the balance sheet.
136. On 12/2/99, Lehman Brothers issued a report on Cisco by Duke, which was based on and repeated information provided him at the analyst conference. The report forecast F01 EPS of $.62, a 27% five-year growth rate for Cisco and stated:
* This morning [Cisco] kicked off an upbeat analyst meeting .... CEO John Chambers highlighted strong overall demand trends ....
* Investors are likely to be encouraged that guidance remains unchanged ....
* * * * Offline, CFO Larry Carter has confirmed his comfort level with current guidance, and we continue to view our estimates as conservative. Based on the upbeat general tone of this morning's presentation and Cisco's exceptional positioning in a fast and dynamic market, we are reiterating our 1 Buy rating.
137. On 12/2/99, Credit Suisse First Boston issued a report on Cisco by Weinstein, which was based on and repeated information provided him at the analyst conference and in follow-up conversations with Chambers or Carter. The report forecast F01 EPS of $.67, a 35% five-year growth rate and the following quarterly F01 EPS for Cisco: http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 79 of 223
EPS/F01 QTR 1st: [$ .15] 2nd: [$ .16] 3rd: [$ .17] 4th: [$ .18] Year: [$ .67]
It also stated:
Yesterday's Cisco analyst meeting was well attended and provided insights into Cisco strategic, product and technology directions.
* * * Service Providers To Drive Growth in the Next Millennium. Nowhere was the shift in focus from selling plumbing to selling applications more apparent than in the way Cisco is approaching the service provider space....
Enterprise Business to be Steady and Predictable. Having grown better than 30% last year to over $6 billion in sales, Cisco appears as confident as ever that it can sustain this growth rate.
138. On 12/2/99, CIBC World Markets issued a report on Cisco by Pyykkonen, which was based on and repeated information provided him at the analyst conference and in follow-up conversations with Chambers or Carter. The report forecast F01 EPS of $.65 and stated:
Cisco Systems held its annual analyst meeting ....
* * * We estimate [$.65] EPS on revenue of $22.7 billion (36% year/year growth) for full year fiscal 2001.
* * * In the service provider market, the demand outlook remains strong looking well into the year 2000 ....
139. On 12/3/99, McDonald Investments issued a report on Cisco by Rubicam, which was based on and repeated information provided him at the analyst conference and in follow-up conversations with Chambers or Carter. The report forecast F01 EPS of $.65 for Cisco and also stated:
CSCO: ANALYSTS CONFERENCE VERY UPBEAT, RAISING ... TARGET TO $105; BUY
* * * CSCO hosted a two-day analysts conference .... [W]e would describe the tone of the sessions as extremely upbeat.... [W]e feel increasingly confident about the Company's prospects, and believe that revenue and earnings momentum could actually build as we move through calendar 2000 .... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 80 of 223
140. The statements issued in connection with Cisco's 12/99 analyst conference set forth above were false. The true but concealed facts were:
(a) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶133(b)(i)-(ix).
(b) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶133(b)(i)-(ix).
(c) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customer did not need and did not want - which artificially inflated Cisco's current period orders. In fact, by the end of 99, one customer, ICG, had warehouses full of unused Cisco gear it would never use which had been sold to ICG through vendor financing arrangements which obligated ICG to make purchases it did not want;
(iv) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(v) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vi) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(d) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 81 of 223
4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(e) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(f) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies, which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. AMC received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(g) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipments to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor-financed loans, as represented.
(h) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore, Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(i) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(j) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 82 of 223
either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(k) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey and Cerent) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(l) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(m) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s (the channel by which voice calls travel).
(n) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(o) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
141. On 12/20/99, Cisco announced in a press release that it had acquired Pirelli Optical Systems for $2.15 billion:
The acquisition of Pirelli Optical Systems enables Cisco to offer an end-to-end optical networking solution for service providers. Pirelli's optical products will be seamlessly integrated with optical products and technology that Cisco has acquired from start-ups Cerent, Monterey Networks and Pipelinks. When these optical acquisitions are combined with Cisco's leadership in Internet routing, the acquisition of Pirelli's optical business allows Cisco to immediately address the total optical networking market estimated to be http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 83 of 223
over $40 billion by 2005.
"Pirelli's optical business delivers innovative technology and systems from an early stage company and provides Cisco with additional European channel and sales support," said Don Listwin Cisco executive VP, service provider and consumer lines of business. "With this capability, Cisco becomes the only company in the world capable of delivering an end-to-end 10 gigabit - or OC-192 - Internet based optical network."
142. On 12/20/99, Warburg Dillon Read issued a report on Cisco by Theodosopoulos, which was based on and repeated information provided him by Chambers and Carter. The report focused on the Pirelli acquisition and reiterated a "buy" on Cisco and stated:
For some time now, Cisco has been publicly speaking of its intent on being a major player in the optical space. This announcement fills a major void in Cisco's optical networking strategy (DWDM technology), and clarifies the direction that Cisco is taking to get there. With the close of this acquisition, Cisco will now be able to focus in on delivery of its four major components, Cerent 15454, Monterey Wavelength Router, Pirelli WaveMux and the Cisco GSR 12000 router to customers as a complete end to end solution for building multi-service IP/optical networks. Going forward, we believe that this acquisition will now enable Cisco be more competitive with rivals Nortel (NT-$93.00-Buy) and Lucent.
143. On 12/21/99, Sutro & Co. issued a report on Cisco by Houghton, which was based on and repeated information provided him in the 12/20/99 conference call held to discuss the acquisition, and follow-up conversations with Chambers and Carter. The report maintained a buy rating and a $65 price target, and stated:
• Cisco also indicated that it expects this acquisition to be neutral or slightly accretive to its earnings in FY'00, excluding extraordinary items.
144. On 1/31/00, Cisco issued a press release about the adoption of the VCO/4K switch by PowerNet Global:
PowerNet Global Communications' VoIP network will include a Cisco VCO/4K open programmable switch for enhanced services switching, Cisco AS5300/Voice Gateways for local loop bypass, managed services, international toll arbitrage and fax relay, and Cisco 3600 series modular access multiservice platforms with voice/fax network modules for consolidating voice, fax and data traffic on a single network. PowerNet Global will take advantage of enhanced services capabilities provided by SynapSys, a Cisco New World Ecosystem voice applications partner, to deliver a variety of innovative voice applications over Cisco's infrastructure.
* * * The Cisco VCO/4K open programmable switch enables service providers worldwide to build scaleable, cost-effective networks that support the rapid deployment of wireline and wireless voice services. It integrates seamlessly into existing telecommunication infrastructures to deliver enhanced voice services for the PSTN as well as New World, packet-based networks. As an integrated option with the Cisco Access Path-VS3, the solution provides a flexible gateway for circuit- packet-switched networks. The Cisco VCO/4K open programmable switch is the basis for some of the most innovative http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 84 of 223
applications on the market today. In addition, it can support core switching functions such as tandem switching, international gateway and Internet offload.
145. On 2/8/00, Cisco reported better-then-expected 2ndQ F00 revenues, net income and EPS (the period ending 1/29/00), stating:
Net sales for the second quarter of fiscal 2000 were $4.35 billion, compared with $2.85 billion for the same period last year, an increase of 53%. Pro forma net income ... was $906 million or [$0.12] per share, compared with pro forma net income of $609 million or [$0.08] per share for the second quarter of fiscal 1999, increases of 49% and 47%, respectively.
146. On 2/8/00, subsequent to the release of its 2ndQ F00 results, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss its business. During the call and in follow-up conversations with analysts, Chambers and Carter stated:
• Cisco's business was very strong and accelerating across all geographies.
• Cisco's sales momentum was as strong as it had ever been. Cisco was enjoying strong demand for all of its products.
• Demand for Cisco's products was strong across-the-board and in all geographies.
• Cisco had received the first orders for its Monterey Optical Cross Connect Wavelength Router.
• Cisco's visibility was solid.
• Cisco's book-to-bill ratio was greater than one.
• Cisco enjoyed excellent linearity.
• Cisco was tightly managing its inventories.
• Cisco had improved its competitive position due to its new optical products, which demonstrated strong growth.
In follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• Cisco was increasingly optimistic over its business and its prospects.
• Cisco expected its sales to continue to grow by 30%-50% and its EPS to grow by 35%- 40%.
• Cisco expected to increase its levels of inventories to improve lead times and product availability for customers.
• Cisco was increasing its F01 EPS forecast to $.64-$.65 and its F01 revenues to $24.8 billion. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 85 of 223
147. On 2/9/00, Bloomberg reported:
Cisco Systems Inc. shares rose ... to a record after the No. 1 maker of computer- networking equipment's fiscal second-quarter sales surged a better-than-expected 53 percent and profit rose.
* * * The surge propelled 15-year-old Cisco to $440.7 billion in market value and nudged it past General Electric Co. to become the world's second-most valuable company.
* * * "They just knocked the cover off the ball," said Goldman Sachs & Co. analyst Ajay Diwan .... "What's more important is the outlook."
* * * "I was really impressed with the numbers," said Art Bonnel, manager of U.S. Global Investors' $290 million Bonnel Growth Fund .... "The long-term implications are extremely positive."
Cisco's stock climb and increasing market value aren't likely to stop anytime soon, analysts said.
148. On 2/9/00, the Los Angeles Times reported:
CISCO POSTS 49% JUMP IN PROFIT ... COMPUTER NETWORKER'S ROBUST RESULTS PUSH SHARES TO RECORD HIGH
... Cisco Systems ... fiscal second-quarter profit jumped a greater-than-expected 49%, showing again how the company has parlayed its dominance in providing the backbone of Internet and telecommunications networks into astonishing profit and revenue growth.
The news pushed Cisco share to an all-time high in after-hours trading.
* * * "Their underlying business is a lot stronger than people expected," said [Goldman, Sachs & Co. analyst Ajay] Diwan.... Executives said that they expected sales to keep growing by as much as 30% to 50% ....
149. On 2/9/00, The Wall Street Journal reported:
Cisco Systems Inc. reported unexpectedly strong fiscal second-quarter earnings amid astonishing revenue growth ....
The results ... surpassed analysts' estimates ....
"We are increasingly optimistic," Chief Financial Officer Larry Carter told Wall Street analysts.
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* * * It marked the 11th consecutive quarter that Cisco has beaten analysts' expectations by exactly a penny....
... It marked the ninth consecutive quarter of accelerating revenue growth .... Revenue far exceeded analysts' estimates ....
"This is stunning - far better than anyone was expecting," said Christopher Stix, an analyst for SG Cowen & Co....
"Flawless," echoed Michael Cristinziano of Gerard Klauer Mattison. Messrs. Cristinziano and Stix both described Cisco executives as "giddy" during their conference call with analysts.
150. On 2/9/00, The New York Times reported:
The love fest between Wall Street and Cisco Systems reached a new level of ardor today as the company surpassed earnings estimates ... prompting investors to send its shares to a 52-week high.... Cisco earned [$.12] cents a share, exceeding analysts' published estimates by a penny.
151. Following Cisco's 2/8/00 release and conference call and discussions with Chambers and Carter, based on information furnished by Chambers and Carter, virtually every analyst that followed Cisco increased the forecasted revenue, net income and EPS for Cisco and the price target for Cisco's stock.
152. On 2/9/00, A.G. Edwards issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.64 and stated:
Cisco announced results for their second fiscal quarter of 2000 ... that came in better than expected.... The upward surprise was driven primarily by stronger than expected revenues .... This marks the eighth consecutive quarter of accelerating year-over-year revenue growth for the company. This has just been mind-boggling ....
* * * [T]he company continued to improve their already spotless balance sheet .... Inventories increased [and] Cisco continues to expect to increase inventory dollar levels to provide flexibility for customers with respect to lead times and availability.
* * * [W]e are looking for Cisco to continue to grow revenues in excess of 30% year-over- year going forward ... to $24.8 billion in 2001.
* * * Bottom line we are increasing our estimates to ... [$.64] for fiscal ... 2001 .... [D]emand for its products around the world remains robust ....
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153. On 2/9/00, Soundview Technology Group issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.68 and stated:
Cisco exceeded our recently revised estimates for the quarter ... the eighth consecutive quarter with accelerating growth.
* * * * Carrier business was strong ... driven by sales of routers, switches, access, and optical;
* * * * Cisco received the first order for its Monterey Optical Cross Connect from an established carrier in the quarter;
* * * Despite seven consecutive quarters of accelerating growth, management maintains its guidance of 30-50% revenue growth ....
154. On 2/9/00, Thomas Weisel Partners issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.66 and stated:
* Cisco reported strong Q2F2000 results of [$.12] .... [A]bove ... estimates ... driven by continued strength in the service provider business and solid momentum in the enterprise market....
* Cisco's business appears to be accelerating across all geographies as the Company saw strong demand for its broadband access, core routing and core IP/ATM switching platforms. Near-term visibility is solid.
* ... Cisco continues to demonstrate its ability to execute above plan.
* * * Visibility is solid as book-to-bill came in above unity.... The balance sheet management remains a Cisco strong point .... Linearity was good ....
* * * OUTLOOK AND OUR ESTIMATES-MOMENTUM ACCELERATING
... [T]one from management was upbeat and the business outlook was positive. Business across all segments and geographies appears to be accelerating as Cisco looks to be hitting stride with key initiatives made last year ....
* * * Cisco has been among the phenomenal investment stories of this century. Underlying the tremendous performance of the stock has been stunning business execution and strategic maneuvering.
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155. On 2/9/00, Sutro & Co. issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.65 and stated:
* Operating EPS of [$.12] ahead of our estimate of [$.11] ....
* * *
* Revenues and bookings driven by strength in US, Europe and Asia Pacific ....
* * * Based on the company's better than expected performance in 2Q'00 and our continued outlook for strong growth, we are raising our ... FY'01 estimate to [$.65] from [$.61].
156. On 2/9/00, Pennsylvania Merchant Group issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.67 and stated:
Phenomenal Q2 FY00; Revenue Well Above Expectations ...; Raising Estimates ....
* Company ... posted 8th quarter of accelerating revenue growth.
* Outlook - very bullish ... industry growth continues at 30-50%.
* Q2 FY2000 ... $0.01 above ... consensus estimate ....
* Book-to-Bill was greater than one....
* * * * Continued excellent linearity ....
* * * Business Poised to Accelerate. We continue to believe that Cisco enjoys a new phase of growth as evidenced by increasing growth rates over the past eight quarters, which should last at least one to two years.
* * * Business strong across product lines, geographies and market segments.
* * * Very Strong Balance Sheet Getting Even Stronger. We continue to be amazed with the Company's management of Accounts Receivable ....
157. On 2/9/00, Wachovia Securities issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.65 and stated:
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ESTIMATES; RAISING ESTIMATES & RAISING PRICE TARGET TO $160 AND REITERATING STRONG BUY RATING
* FY 2000 Q2 Revenue and EPS exceed estimates .... Book to bill in all areas was greater than one....
* * * * ... [M]anagement stated they are again comfortable with growing at or above the industry growth rate of 30%-50%.
* * * * ... We are raising our FY 2001 revenue estimates by $3.4 billion to $24.5 billion ... and raising our EPS estimates by $0.05 to [$.65] vs. [$.50].
* * * We remain extremely bullish on Cisco's future .... This quarter's execution was superb and we truly believe that Cisco is in a class by itself for communications equipment .... We enthusiastically reiterate our Strong Buy rating ... with a new price target of [$80].
158. On 2/9/00, Gruntal & Co. issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.64, forecasted a 33% three-year EPS growth rate for Cisco and stated:
2Q FINANCIAL RESULTS ABOVE EXPECTATIONS ....
* Revenue and EPS exceed expectations .... Optical products demonstrate strong growth .... Raising revenues and EPS expectations as well as price targets
* * * We continue to recommend purchase of Cisco's stock .... Cisco has significantly improved its competitive position with competencies in optical access and transport.
159. On 2/9/00, Gerard Klauer Mattison issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.65, forecast a 30% five-year EPS growth rate for Cisco and stated:
Cisco Systems+-2Q00 Results: Another Stellar Quarter; Raising Ests.+Target = BUY
* * * • The quarter showed many signs of strength .... The company continues to fire on all cylinders.
* * * • Raising above-consensus estimates; new 12-month [$80] price target. We are increasing our revenue forecast due to better than anticipated prospects .... Our new ... FY01 EPS estimate [is] [$.65] .... We reiterate our BUY rating and raise our 12-month price target to [$80].
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Cisco posted accelerating revenue growth for the eighth consecutive quarter in fiscal 2Q00 ... an incredible feat for a company of its size ($17 billion run-rate). A positive book-to-bill, continued order linearity, geographic balance, strong demand for existing products and a number of new products - and markets - ramping over the next two years give us confidence in our FY00 and FY01 EPS estimates of [$.52] and [$.65], respectively.
* * * Cisco continues to execute to perfection.... We reiterate our BUY rating and raise our 12-month price target to [$80] ....
60. On 2/9/00, McDonald Investments issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.67 and stated:
CSCO: 2Q00 RESULTS; INCREASING FY00 AND FY01 ESTIMATES
* * * CSCO reported fiscal 2Q EPS ... ahead of our estimate .... Performance in the quarter was well-balanced across geographic regions and product segments, with strong growth continuing in new product areas such as broadband access and optical networking. CSCO continues to gain momentum .... In response to the strong quarterly results, we are raising ... our FY01 EPS estimate to [$.67] from [$.65].
* * * [T]he Company continues to tightly manage inventories.
161. On 2/9/00, PaineWebber issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.64, forecast a 35% secular growth rate for Cisco and stated:
* Cisco's strong Q2 revenue growth ... resulted in EPS ... better than our estimate.
* Revenue accelerated for the eighth consecutive quarter ... topping our estimate ....
* * * * We increased our fiscal 2001 revenue estimate by $2 billion to over $25 billion implying 40% growth ....
* * * * Increasing fiscal ... 2001 [EPS estimate] to [$.64] ....
* Increasing price target to [$100] ....
* * * OPTICAL RAMPING UP
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acquired from Monterey Networks in 1999.
INCREASING ESTIMATES
... [We have] increased EPS estimates .... We now expect 40% revenue growth in Fiscal 2001, adding $2 billion to our estimate....
... Increasing price target to [$100] ....
162. On 2/9/00, J.P. Morgan issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.65 and stated:
CISCO REPORTS 2Q BLOWOUT - RAISING ESTIMATE AND PRICE TARGET
* * * Cisco yesterday reported a very strong fiscal second quarter with EPS ... above ... consensus. Revenues grew ... well above our conservative estimate ....
* * * Cisco's second-quarter results clearly indicate that the company's momentum continues to build, and near and long-term visibility is as clear as it has ever been. We are raising our EPS estimates for fiscal ... 2001 to [$.65] from [$.62].
... [W]e would continue to be aggressive buyers of CSCO shares and are taking our ... price target to [$85] ....
163. On 2/9/00, Warburg Dillon Read issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.64, forecast a 30% five-year EPS growth rate for Cisco and stated:
CISCO: ANOTHER STRONG QUARTER FROM CISCO ....
Cisco reported 2Q00 EPS ... which exceeded our estimate .... Revenue growth was ... phenomenal .... The company saw strong growth in all major product areas (i.e., Routers, Switches, Access and Optical), customer segments (i.e., Service Provider, Enterprise and Small/Medium business) and geographical markets. The balance sheet remained strong.... Asia and Japan [are] showing signs of accelerating growth. We are raising our estimates to [$.64] and [$.82] for ... fiscal 2001 and 2002 respectively .... Our new price target is [$82] ....
... Cisco's sales growth has accelerated in each of the past eight quarters. This clearly reflects continued market share gains in the Enterprise market and successful service provider and small/medium business market strategies.
164. On 2/10/00, William Blair & Co. issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.64, forecast a 27% long-term growth rate for Cisco and stated:
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Cisco ... Trounces Second-Quarter Estimates
* * * * Cisco reported phenomenal fiscal second-quarter results yesterday, posting EPS of [$.12] and revenue of $4.35 billion. Earnings per share exceeded our estimate of [$.11] ... while revenue came in $450 million ahead of our $3.90 billion forecast.... Notably, this was the eighth quarter of accelerating revenue growth at Cisco.
* * * * Remarkably, things just keep getting better at Cisco. Sales momentum is as strong as it has ever been, management is executing nearly flawlessly, and Cisco's future looks extremely promising. We are raising ... our fiscal 2001 estimate from [$.59] to [$.64]. We reiterate our Long-term Buy rating on Cisco shares.
Cisco Delivers Stellar Financial Results Again
Like usual, Cisco wowed Wall Street with its quarterly financial performance.... The upside ... was due primarily to the whopping revenue figure.
* * * Business Shows No Signs of Slowing
Cisco's business continues to be red-hot.... [I]nvestors should expect 50% top-line growth and 35%-40% EPS growth.
* * * Cisco's business, and stock, is clearly on a roll. Near-term sales momentum is excellent, future prospects are extremely promising, and execution has been near- perfect recently.... [W]e believe that investors will continue to reward the company for ... its spectacular financial performance ....
165. Each of the statements made between 12/20/99-2/10/00 set forth above were false or misleading when issued. The true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 2ndQ F00 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working products in the following quarter;
(ii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers was moved across a "yellow line" in the facility, but not actually shipped to a customer;
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(iii) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(iv) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned more than 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
(v) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customer did not need and did not want, which Cisco knew would reduce demand for Cisco's products in the future. Some of this equipment was not working and had expired warranties;
(vi) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(vii) Cisco frequently shipped product at the end of the quarter to warehouses in order to make quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of the 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
(viii) Cisco utilized third-party intermediaries, such as Sunrise Capital, Deutsche Bank, GE Capital, American Express and Silicon Valley Bank, to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on their loans; and
(ix) Cisco booked large deals before quarter-end to CVAPs and CVARs without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product.
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶165(a)(i)-(ix).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶165(a)(i)-(ix).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 94 of 223
by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customers did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(v) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vi) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(f) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(g) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies, which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 95 of 223
being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. For example, Cisco loaned approximately $40 million to Onetel, Limited, a company losing money that eventually went bankrupt. ICG, Comindigo and Resilient were other uncreditworthy companies to which Cisco provided funds. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. AMC received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(h) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipment to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor-financed loans, as represented.
(i) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(j) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(k) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(l) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey, PixStream, Cerent and Pirelli) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(m) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 96 of 223
department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(n) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS3 (T1) is made up of 24 DS0s (the channels by which voice calls travel).
(o) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(p) Contrary to Cisco's representations that the decline in its stock price would not hurt its acquisition program, by 10/00, the decline in Cisco's stock price meant that Cisco's pace of acquisitions would slow dramatically if not come to a halt, which would adversely impact Cisco's ability to achieve the growth it had forecast or obtain the new technology it needed to remain competitive.
(q) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(r) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
166. Cisco stock, which sold at $50 on 1/31/00, soared to $67-1/2 on 2/9/00 in anticipation of and in reaction to Cisco's extremely strong 2ndQ F00 results and Cisco's positive and bullish communications and continued to advance to its Class Period and all-time high of $82 in late 3/00. On 3/27/00, Bloomberg reported:
Cisco Systems Inc., the No. 1 maker of computer-networking equipment, passed Microsoft Corp. to become the world's most valuable company .... Most of all, Cisco has rarely disappointed investors. It has beaten analysts' average earnings estimates for 10 straight quarters and increased its revenue growth rate for eight consecutive periods.
As Cisco's stock soared to its all-time high, Cisco's "giddy" insiders named as defendants sold 4.7 million shares of Cisco stock for $311 million in illegal insider trading proceeds during 2/11/00-3/24/00!
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167. On 4/19/00, Cisco issued a press release announcing a major billion dollar agreement to sell Cisco equipment to SBC Communications, its first major contract with a Baby Bell.
168. On 4/19/00, The Wall Street Journal reported:
SBC Communications Inc. will buy more than $1 billion of telecommunications equipment from Cisco Systems Inc. during the next two years, making it Cisco's biggest deal with a Baby Bell.
* * * The deal is a coup for Cisco, which is the unrivaled leader in computer-networking equipment but has had trouble selling to traditional telephone companies.
169. On 4/25/00, Dresdner Kleinwort Benson issued a report "initiating coverage" on Cisco. Because this was its first report on Cisco, it was issued only after its analyst Mahler had extensive discussions with Chambers and Carter and was based on and repeated information provided by them. Chambers or Carter reviewed this report before it was issued and assured Mahler it was accurate. The report forecast F01 and F02 EPS for Cisco of $.69 and $.87, respectively, and the following F01/F02 quarterly results for Cisco:
EPS/F01 EPS/F02 QTR 1st: $ .15 $ .20 2nd: $ .17 $ .22 3rd: $ .18 $ .22 4th: $ .19 $ .23 Year: $ .69 $ .87
The report also stated:
We are initiating coverage of Cisco with a Buy rating.... [W]e believe that revenue growth can be sustained around the already high 45%-50% level we have seen for the last year, with cash EPS growth above 30% ... justifying a target price of around 90 per share ....
* * * Success brings success
Because of its excellent track record, Cisco is well positioned to grow its customer base, attract the best people, and get the best acquisition candidates. As success continues to be reflected in a highly valued stock, Cisco is likely to remain the preferred merger partner with one of the most attractive acquisition currencies.
170. On 4/28/00, First Union Securities issued a report "initiating coverage" on Cisco. Because this was its first report on Cisco, it was issued only after its analyst Koffler had extensive discussions with Chambers and Carter and was based on and repeated information provided by them. Chambers or Carter reviewed this report before it was issued and assured Koffler it was accurate. The report forecast F01 EPS for Cisco of $.66, forecast a 33%-40% three- to five-year EPS growth rate for http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 98 of 223
Cisco and stated:
CSCO: INITIATING COVERAGE WITH A STRONG BUY
* * * - As a result of Cisco's unique positioning and execution, we expect the company to grow a minimum of 2.5 times the industry's growth rate of 15% for the next five years at least.... Our 12-month price target is $100 ....
* * * Cisco's Profitability Is Likely To Far Outstrip the Competitors' For Years To Come
We believe that Cisco will maintain a large profitability gap between itself and its new- found competitors for years to come. As the Cisco story has unfolded over the past ten years, one of the most remarkable elements has been the company's high profitability.
171. In early 5/00, a negative article about Cisco appeared in Barron's criticizing Cisco's acquisition practices, its accounting and its growing use of "vendor financing" to help sell its products. This negative article caused Cisco's stock to decline and put pressure on Cisco's executives to support the stock and, if possible, push it higher.
172. On 5/9/00, Bloomberg reported:
Cisco Chief Strategy Officer Mike Volpi said he disagreed with a Barron's story this week that said acquisitions will get tougher and more expensive for the company. Volpi reiterated the company's plans to buy 20 to 25 companies this year and said Cisco could make more than 30 acquisitions in 2001....
"We intend to maintain the same (acquisition) pace that the overall business is growing at," said Volpi, who has directed more than 100 purchases and investments for the company.
In the recent quarter, orders from large corporate customers rose 20 percent from the prior quarter, the first time growth in that area has outpaced other segments in "a long time" Chambers said. Businesses around the world are spending more quickly to upgrade their computer networks to handle more functions, he said.... "Cisco is better positioned than ever," Chambers said.
173. On 5/9/00, Cisco reported better-than-expected 3rdQ F00 revenues, net income and EPS for the period ending 4/29/00, stating:
Net sales for the third quarter of fiscal 2000 were $4.92 billion, compared with $3.17 billion for the same period last year, an increase of 55%. Pro forma net income ... was $1.03 billion or $0.14 per share, compared with pro forma net income of $649 million or $0.09 per share for the third quarter of fiscal 1999, increases of 58% and 56%, respectively.
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share, compared with $636 million or $0.09 per share for the same period last year.
* * * Cisco also continues to gain momentum in the IP + optical market furthering its commitment to build Internet-scale, carrier-class, optical networks.
174. On 5/9/00, subsequent to the release of its 3rdQ F00 results, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss its business. During the call - and in follow-up conversations with analysts - Chambers, Listwin, Volpi, and Carter stated:
• Demand for all of Cisco's products was strong worldwide. Cisco was gaining market share in all major business segments.
• Cisco's book-to-bill ratio was greater than one-to-one. Cisco's growth was accelerating.
• The acquisition of Pirelli made it possible for Cisco to have industry leading Dense Wavelength Division Multiplexing ("DWDM") equipment and Cisco's customer base for these products numbered 300.
• Cisco again enjoyed excellent linearity.
• Cisco's inventories - up by $183 million in the quarter to $878 million - were increasing due to a decision by Cisco to obtain larger supplies of important component parts and to increase finished goods to reduce lead or delivery times to customers.
• Cisco Capital's vendor financing program was well controlled and conservative. Ninety percent of loans were to highly creditworthy, financially secure customers. Its loan loss ratio was less than 1%. Revenue was not recorded on risky loans in the "structured" loan program until cash payments were received.
• Cisco's accounting for its vendor financing program was very conservative.
In follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• Chambers was more optimistic about Cisco's outlook than at any time in several years.
• Cisco's outlook was the strongest it had ever been.
• Cisco was forecasting 30%-50% revenue growth going forward.
• Cisco was increasing its F01 EPS forecast to $.67-$.70 and its F01 revenue to $27 billion and its F02 EPS forecast to $.87 and F02 revenue forecast to $37 billion.
175. On 5/10/00, The Wall Street Journal reported:
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Cisco Systems Inc. continued to break new ground by growing at a rate rarely seen in a large global company.
For the 10th time in a row, the ... company reported accelerating revenue growth .... [O]nce again, Cisco posted earnings ... a penny a share higher than analysts had predicted - the 12th consecutive quarter it has beat forecasts by exactly one cent.
... Cisco executives continued to be upbeat about their prospects.
176. On 5/10/00, the Los Angeles Times reported:
Cisco Tops Expectations for 9th Straight Quarter
* * * Defying concerns it cannot sustain its string of quarterly profits, Internet equipment provider Cisco Systems Inc. topped Wall Street expectations for the ninth consecutive period on strong sales of equipment for routing Web and data traffic.
* * * As has been the pattern, Cisco's earnings exceeded expectations by a penny a share....
Sales rose to ... $4.92 billion ... also topping Wall Street expectations.
* * * "Given our size and the fact that the third-quarter has historically been the most challenging quarter, we were very pleased with the results," Chambers said.
177. Following Cisco again reporting better-than-expected revenues, net income and EPS and Cisco's conference call and follow-up conversations with analysts, almost every analyst covering Cisco increased the forecasted F01/F02 revenue, net income and EPS for Cisco, as well as the price target for Cisco's stock.
178. On 5/10/00, McDonald Investments issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased forecasted F01 EPS for Cisco to $.69 and also stated:
CSCO: 3Q00 REVIEW; RAISING ESTIMATES; MAINTAINING BUY RATING
* * * CSCO reported another strong quarter last night, with accelerating revenue growth and EPS a penny higher than consensus. These results reinforce our view that CSCO's business is likely to continue to gain momentum .... We are raising ... our fiscal 2001 EPS estimate to $.69 from $.067.... We see nothing on the horizon that threatens to derail CSCO's strong business trends....
CSCO reported 3Q EPS of $0.14 ... a penny above consensus ....
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Book-to-bill in the quarter was greater than 1.0.
* * * Inventories rose in the quarter .... Inventories are expected to rise in dollar terms, as CSCO seeks to maintain adequate supply to meet customer demand.
CSCO provided some detail on its Cisco Capital operation .... Total outstanding financing ... is $2 billion.... 90% of financing is for large enterprise customers and Tier 1 carriers. 10% are structured loans to CLECs and ISPs, and these are accounted for on a cash basis, with revenue only being recognized when payment is received. The loss ratio is less than 1%.
179. On 5/10/00, J.P. Morgan issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.70 and also stated:
VERY STRONG 3Q RESULTS - RAISING 2000 AND 2001 EPS AND REVENUE ESTIMATES ...
* * * * Cisco posted EPS of $0.14 (a penny above consensus) ....
* Management indicated outlook is strongest it's been in several years.
* We are raising our EPS and revenue estimates for ... fiscal 2001 to $0.70 and $27 billion.
* * * CEO Chambers said Cisco continues to gain market share in all major business segments and that he's "more optimistic" about the company's outlook now than "at any time in the last several years." Other signs of strong visibility include the company's book to bill ratio .... Additionally, management said the pace of acquisitions (seven in the April quarter alone) will continue into 2001.
* * * On the balance sheet, accounts receivable increased $211 million ... while inventories were up $183 million .... Management expects inventories ... to increase in the coming quarters, as the company pushes to ensure product availability ....
* * * Once again, Cisco posted a phenomenal quarter, and we think its growth prospects ... have never been brighter. Growth in Cisco's core business segments is accelerating, its acquisitions are ramping successfully, and management's strategy of aggressively expanding the company's addressable market has been executed flawlessly.
In response to this quarter's results ... [f]or fiscal 2001, we are increasing to EPS of $0.70 (previously $0.65) on revenues of just under $27 billion (up from $24.7 billion). Our new ... 2001 revenue estimate[] represent[s] year-over-year growth of ... 45% ... - incredible growth rates given the size of Cisco[] .... As we look out at 2001 and beyond, http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 102 of 223
we believe Cisco's aggressive migration into the carrier market, combined with continued strength in the enterprise market, will allow the company to sustain - if not exceed - these growth rates.
We reiterate our $100 price target on CSCO shares ....
180. On 5/10/00, CIBC World Markets Corp. issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.68 and $.87 and forecasted the following F01/F02 quarterly results for Cisco:
EPS/F01 EPS/F02 QTR 1st: $ .16 $ .20 2nd: $ .17 $ .21 3rd: $ .17 $ .22 4th: $ .18 $ .24 Year: $ .68 $ .87
The report also stated:
CSCO: They Did It Again
Cisco Systems reported 3QF00 (April) results which exceeded expectations, ... revenue growth ... accelerated for the ninth straight quarter on a year/year basis ....
... EPS was $0.14 vs. our $0.13 estimate.... Book/bill was greater than 1.0x ....
... We are raising our EPS estimate for full year fiscal 2001 from $0.66 to $0.68 and raising our revenue estimate from $25.4 billion to $26.8 billion....
We are initiating a fiscal 2002 EPS estimate of $0.87 ... on revenue of $37.1 billion ....
* * * Cisco Systems' stock clearly has a premium P/E ... valuation relative to the market and its general competition in the industry. However, it should be noted that the stock has had a significant relative premium for at least the last five years, but, because of solid and consistent execution in earnings performance it has been justified and the stock has continued to move higher. This is especially true at this stage on the heels of nine straight quarters of accelerating year/year revenue growth.
A large part of Cisco Systems' premium P/E valuation is attributable to the consistency of their performance.... Cisco Systems clearly gets high marks for its overall growth and profitability execution.
* * * Low Vendor Financing Exposure
Vendor financing, especially for emerging service providers was discussed and should relieve some of the concerns which have recently been spread throughout the media.... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 103 of 223
Cisco Systems indicated that only 5% of the 3QF00 revenue was financed by them directly, and 90% of that was provided to financially secure enterprise accounts and well capitalized Tier 1 service provider accounts. The company has had a less than 1% cumulative credit loss in its total equipment financing programs. Recent media reports of Cisco Systems' vendor financing exposure clearly overstated the situation.
181. On 5/10/00, A.G. Edwards issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased forecasted F01 EPS for Cisco to $.67, forecast a 36% three-year EPS growth rate for Cisco and stated:
CISCO ANNOUNCES THIRD QUARTER RESULTS AHEAD OF EXPECTATIONS
* * * Cisco announced results ... that once again came in above expectations. It is becoming commonplace for negative press to surface a few days before Cisco's earnings release - this quarter was no exception. However, Cisco's third quarter results should quickly put to rest many of the concerns that have arisen.
First, in terms of results, Cisco announced third quarter sales of $4.92 billion ... up an amazing 55% year-over-year and 13% sequentially. This is the 9th consecutive quarter of increasing year-over-year growth rates and the best in 3 years. On a sequential basis, the growth rate was the best in 14 quarters.... EPS was $0.14 per share, which was a cent better than what we were expecting.
The upward surprise was driven by much stronger than expected sales.... [T]he third quarter is typically one of the toughest seasonal quarters, yet Cisco was able too blow right through it.
* * * The balance sheet remained rock solid .... Inventories were up about $183 million to $878 million and we expect this number to go up as sales grow and it tries to build strategic component levels.
The final item we would like to discuss is Cisco's financing activities through Cisco Capital. A few investors have started to question Cisco's financing activities. Bottom line, we are not concerned and believe that Cisco continues to follow its standard very conservative accounting position in this area. Nevertheless, here are comments for further detail. The program was originally established for large enterprise customers building New World networks and has extended into the service provider world. This program is similar to what Nortel and Lucent have been and continue to offer. Cisco Capital is now close to $2 billion in financings of all types. Overall, financing from 3rd parties and Cisco Capital, to put it into perspective, accounted for about 7% of 3rd quarter revenues. Excluding third parties, it was only about 5%. So it was very minor part of Cisco's sales. About 90% of Cisco Capital financings were to quality enterprise and tier 1 service provider customers. About 10% were structured loans, which are higher risk and therefore Cisco recognizes revenues only on a cash basis - when payment [is] received. Their loss rates so far have been less than 1% of total financings. So bottom line, this is not a material concern.
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* * * Cisco continues to target year-over-year growth rates of anywhere from 30% to 50% .... It is very important to note that Cisco has not wavered from this guidance, even when it was growing faster or slower than this. Clearly, given the current opportunities Cisco sees in its path, it is more optimistic about this outlook....
Going forward, we are increasing ... our fiscal year 2001 estimate from $0.64 to $0.67.
182. On 5/10/00, Gerard Klauer Mattison issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.68, forecast a 30% five-year EPS growth rate and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .16 2nd: $ .17 3rd: $ .17 4th: $ .18 Year: $ .68
The report also stated:
Cisco Systems - 3Q00 Results: Revenue Growth Accelerated Again; Raising Ests. - BUY
* * * • 3Q00 operating EPS, reported at $0.14 ... exceeded ... consensus by $0.01.... Revenue growth accelerated for the ninth consecutive quarter and book-to-bill was again greater than one. The results were particularly impressive ....
* * * • Management quantified the company's minimal risk tied to vendor-financing. Responding to building investor concern regarding vendor-financing of customer network projects, CFO Larry Carter gave specific details regarding Cisco's vendor- financing activity. Less than 7% of its quarterly revenue was financed by either Cisco Capital or third party entities. Only 10% of this amount was considered high-risk, in which case revenue is only recognized when payment is received.
• ... We are increasing our revenue forecast due to better than anticipated execution .... Our new ... FY01 EPS estimates are ... $0.68 (from $0.65) ....
* * * Inventory turns decreased to 8.9x for 3Q, from 9.1x for the prior quarter, as the company purposefully increased inventory slightly as a measure to lower any potential risk associated with unforeseen supply glitches.
* * * We reiterate our BUY rating and 12-month price target of $80 .... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 105 of 223
183. On 5/10/00, ABN/AMRO issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.7l, forecast a 35% three- to five-year EPS growth rate and the following F01 EPS for Cisco:
EPS/F01 QTR 1st: $ .16 2nd: $ .17 3rd: $ .18 4th: $ .20 Year: $ .71
The report also stated:
- We are revising our fiscal 2000-01 EPS estimates from $0.53 and $0.68 to $0.55 and $0.71, respectively.
- Business was stronger than expected across all major segments. We were especially surprised by the strength in enterprise revenues driven by router and switching products.
* * * - The outlook seems exceptionally bright for Cisco .... We reiterate our Buy rating and $85 price target.
* * * Cisco reported 3Q results of $0.14 ... $0.01 better than our estimate....
* * * What about vendor financing?
The financial data suggests this is not a big issue.... Over 90% of the capital lease financing is to high quality tier one customers and 10% of structured loans to higher credit risks such as start up service providers. Management emphasized that revenue from these customers is only recognized when cash payments are received.
184. On 5/10/00, Brean Murray & Co. issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.66 and forecast the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .15 2nd: $ .16 3rd: $ .17 4th: $ .18 Year: $ .66
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Cisco reported 3QFY00 EPS of $0.14, ahead of consensus estimates of $0.13.
* Sales increased ... to $4.9 billion, ahead of consensus ...
* * * * Addressed the criticisms in last week's Barrons [sic] as non-material accounting issues.
* * * * Book-to-bill remained slightly greater than 1.0 ....
185. On 5/10/00, Dresdner Kleinwort Benson issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.69 and $.87, forecast a 30% five-year EPS growth rate and the following F01/F02 quarterly results for Cisco:
EPS/F01 EPS/F02 QTR 1st: $ .15 $ .20 2nd: $ .17 $ .22 3rd: $ .18 $ .22 4th: $ .19 $ .23 Year: $ .69 $ .87
The report also stated:
High-quality fiscal Q3 results
Cisco reported better-than-expected results, with revenues and EPS growth accelerating.... EPS of $0.14 versus our $0.13 estimate. Top-line growth was 55%, continuing an accelerating trend started in Q2 1998 ....
186. On 5/10/00, RBC Dominion Securities issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.67 and stated:
FQ3 TOPS CONSENSUS BY A PENNY .... FQ3 marked the ninth quarter of accelerating topline growth.... Book:Bill was again greater than 1:1.... Receivables were $1.9 billion.... The inventory account will increase as Cisco deals with a tighter components market and longer lead times. Cisco continues to grow at a phenomenal pace.... Management discussed the issue of vendor financing, noting this accounted for only 5% of FQ3 revenues.
187. On 5/10/00, Lehman Brothers issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.70, forecast a 30% five-year EPS growth rate and the following F01 quarterly results for Cisco:
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QTR 1st: $ .16 2nd: $ .17 3rd: $ .18 4th: $ .19 Year: $ .70
The report also stated:
* ... Cisco Systems reported yet another quarter of impressive results, coming in ahead of consensus .... 3Q00 EPS of $0.14 came in the customary penny ahead of our consensus estimate of $0.13 ... with Cisco's revenue growth accelerating rapidly .... Book to bill was above 1. Order linearity was good .... Based on upbeat guidance & improving visibility, we are taking our FY01 revenue est sharply higher ... to $26.7B .... Our EPS ests increase from $0.66 to $0.70 & we reiterate our 1 Buy rating ....
188. On 5/10/00, First Union issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.68, forecast a 33%-40% three- to five-year growth rate for Cisco and stated:
Cisco comfortably exceeded revenue and EPS expectations.... EPS of $0.14 beat consensus by $0.01 .... This is the third quarter in a row of sequential revenue growth acceleration and the ninth in a row of year-over-year acceleration (55%).... Management tone was very positive .... Raising EPS ... for FY01 from $0.66 to $0.68. Maintain Strong Buy rating with $100 price target.
189. On 5/10/00, UBS Warburg issued a report on Cisco, which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.68 and $.85, forecast a 30% five-year growth rate and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .16 2nd: $ .17 3rd: $ .18 4th: $ .19 Year: $ .68
The report also stated:
Cisco reported 3Q2000 EPS of $0.14 ... which exceeded ... consensus of $0.13.... [T]he upside came from better than expected revenues .... Book to bill was greater than one and linearity was good throughout the quarter.... We are raising our fiscal ... 2001 and 2002 estimates to ... $0.68 and $0.85 ....
* * * Cisco commented on its vendor financing activities through Cisco Capital. Cisco http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 108 of 223
Capital has about $2B in outstanding financing in the form of equipment leases and structured vendor financing. The actual amount of Cisco's direct financing was about 5% of sales in 3Q, but only 10% of that was in the form of structured loans while 90% was mostly in equipment leasing activities. Revenues derived from customers utilizing structured loans from Cisco are recognized when cash is received from the customer and the average loss rate from such deals is about 1%. This level of exposure is typically much lower than other companies in the telecom equipment market.
190. On 5/10/00, Deutsche Banc Alex. Brown issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.69, forecast a 30% three-year secular growth rate and the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $ .16 2nd: $ .17 3rd: $ .18 4th: $ .19 Year: $ .69
It also stated:
CISCO SYSTEMS INC. (CSCO) "STRONG BUY"
Cisco Reports Very Solid Quarter and Tops Consensus Estimates
* * *
* Cisco reports a very solid Q3 with revenue up 13% sequentially and 55% year over year. This represents the largest sequential percentage increase in 14 quarters and the largest year over year percentage increase in 3 years.
* * * * ... [L]inearity continued to improve.
* * * * The optical business grew 60% sequentially and is expected to reach a $1 billion annual run rate next quarter.
* * * * We are raising our 2001 fiscal ... year revenue and EPS to $25.3 billion and ... $.69 ....
* * * Cisco's impressive sequential revenue growth, increasing linearity, and positive book to bill ratio indicated that demand remains strong and business is on track.
191. On 5/10/00, PaineWebber issued a report on Cisco, which was based on and repeated http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 109 of 223
information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.69, forecast a 35% secular growth rate for Cisco and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .15 2nd: $ .17 3rd: $ .18 4th: $ .19 Year: $ .69
The report also stated:
Cisco: Another Quarter of Stellar Performance
* Q3 EPS of $0.14 beat our estimate by $0.01 on strong revenue growth ....
* * * * We now expect ... 29.1% [EPS growth] in fiscal 2001 resulting in [a] $0.03 increase to our fiscal 2001 estimate.
* Increasing price target to $108 from $100 ....
192. On 5/10/00, CS First Boston issued a report "initiating coverage" on Cisco by Parmelee. Because this was First Boston's first report on Cisco, it was issued only after Parmelee had extensive discussions with Chambers and Carter and was based on and repeated information provided by them. Chambers or Carter reviewed this report before it was issued and assured Parmelee it was accurate. The report forecast F01 EPS for Cisco to $.72, a 35% three-year EPS growth rate and the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $ .16 2nd: $ .17 3rd: $ .29 4th: $ .20 Year: $ .72
It also stated:
CSCO reported FQ3:00 EPS of $0.14, above ... the consensus estimate of $0.13 ....
Upside surprise a function of higher than expected sales of $4.9 billion ....
* * * [C]ompelling fundamentals boost our confidence that Cisco Systems will continue to deliver annual top-line and bottom-line growth in the 40% range during the foreseeable future. This type of sustainable growth profile is unmatched among http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 110 of 223
companies of similar size ....
We are establishing earnings per share estimates of ... $0.72 for fiscal 2001 based upon our sales forecasts of ... $26.5 billion .... [A] top-line growth rate of ... over 40% for fiscal 2001 reflecting outstanding growth in both the Enterprise and Carrier segments of the company's business.
193. Despite Cisco's very positive 3rdQ F00 results and its very positive and bullish comments, unlike the stock's reaction to Cisco's earlier reported quarterly reports and its bullish statements, Cisco's stock fell from $64-7/16 on 5/9/00 to $58-1/8 on 5/10/00 and to as low as $50 on 5/22/00. During this period when Cisco's stock price was falling, none of the Cisco insiders sold any stock. This stock pullback wiped out almost $100 billion in Cisco market capitalization and put tremendous pressure on Cisco's top insiders to try to support the stock and halt its decline!
194. On 5/18/00, Josephthal & Co. issued a report on Cisco which repeated information provided to it by Chambers or Carter during the prior few days. The report increased the forecasted F01 EPS for Cisco to $.77 and forecast the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $ .17 2nd: $ .18 3rd: $ .20 4th: $ .21 Year: $ .77
It also stated:
CSCO: Raising Estimates; Raising Price Target
Despite its large size, Cisco delivered another quarter of over 50% growth year over year and 13% growth sequentially.... This marked the eleventh consecutive quarter of accelerating top-line growth....
... EPS were $0.14, exceeding ... the consensus estimate by a penny, as is the company's custom to do.
We have raised our revenue and EPS estimates for ... 2001.... [W]e are raising our FY01 revenue estimate to $28.7 billion .... We are raising ... our FY01 EPS to $0.77 from $0.73.... [W]e are establishing our 12-month price target at $100.
* * * * Vendor Financing - Some observers have voiced concern over the company's arrangements for financing equipment sales, as Cisco Capital is now approaching $2 billion in financing, including various forms of lease and structured financing. Originally financing was offered as an option only for Cisco's large enterprise customers; however, with Cisco's move into the Service Provider markets, financing arrangements have become a regular part of the sales package to quality enterprise customers and to Tier One service providers. Overall financing, including third party, http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 111 of 223
represented 7% of third-quarter revenue, while Cisco's own financing represented 5% of third-quarter revenue. The company said that 90% of its financing activities were leasing arrangements and the remaining 10% were structured loans, with somewhat higher credit risk. (In the higher credit risk category the company recognizes revenues only when payment is received). The loss rate for Cisco Capital is less than 1%; the company maintains that its business practices are conservative ....
195. On 5/23/00, SG Cowen issued a report "re-initiating coverage" on Cisco by Armacost. Because this was SG Cowen's first report on Cisco in some time, it was issued only after Armacost had extensive discussions with Chambers and Carter and was based on and repeated information provided by them during the prior week. Chambers or Carter reviewed this report before it was issued and assured Armacost it was accurate. The report forecasted F01 EPS of $.71 and the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $ .16 2nd: $ .17 3rd: $ .18 4th: $ .20 Year: $ .71
It also stated:
Strong Demand: Broad-based, pervasive and long-lasting acceleration of demand for telecom equipment * * * We are resuming coverage of Cisco Systems with a Strong Buy rating. Cisco Systems is the most successful company in the traditional networking industry ....
* * * Financial Consistency Second To None; Momentum Builds .... Cisco ... reported FQ3 results, exceeding our expectations by several measures.... [I]ts book to bill ratio remained above one. Cisco's FQ3 marked the 41st consecutive quarter of increasing revenue and profitability, its highest annual growth rate since January 1997, and its fastest sequential growth since fiscal 1996.... This type of consistency and growth remains unmatched in the industry and continues to warrant a premium ....
196. On 5/30/00, Cisco issued a press release about its VCO/4K switch:
Cisco Systems, Inc., today announced that Telekom Austria, that country's number one telecommunications provider, has chosen Cisco hardware and software for its Intelligent Multimedia IP (Internet Protocol) Contact Center. This center will provide state-of-art directory assistance and customer care services using a Cisco networking solution comprised of Cisco Network Applications Manager (NAM) software and Cisco's VCO/4K open programmable switch with network Interactive Voice Response (NIVR) developed by APEX Voice Communications - a Cisco New World Ecosystem partner.
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The Cisco VCO/4K open programmable switch enables service providers worldwide to build scalable, cost-effective networks that support the rapid deployment of wireline and wireless voice services. It is the basis for some of the most innovative applications on the market today, such as prepaid calling, IVR, voice-activated dialing, and messaging services.
197. Each of the statements made between 3/00/00-5/30/00 were false or misleading when issued. The true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 3rdQ F00 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as was necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working product in the following quarter;
(ii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers was moved across a "yellow line" in the facility, but not actually shipped to a customer;
(iii) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(iv) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned more than 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
(v) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customers did not need and did not want, which Cisco knew would reduce demand for Cisco's products in the future. Some of this equipment was not working and had expired warranties;
(vi) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(vii) Duplicate orders from customers were recorded as sales throughout 00, but product was returned leading to inventory build-up;
(viii) Cisco frequently shipped product at the end of the quarter to warehouses in order to make quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of the 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
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(ix) Cisco utilized third-party intermediaries, such as Sunrise Capital, Deutsche Bank, GE Capital, American Express, and Silicon Valley Bank, to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on their loans; and
(x) Cisco booked large deals before quarter-end to CVAPs and CVARs without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product.
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶197(a)(i)-(x).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶197(a)(i)-(x).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customers did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Contrary to defendants' assertion that riskier Cisco Capital loans were limited to 10% of loans made, in fact, the percentage of risky loans was many times higher than this. By the Spring of 2000, risky loans to customers in financial trouble included AMC with $70 million outstanding, ICG ($99 million), Digital Broadband ($70 million), HarvardNet ($30 million), Pacific Gateway ($15 million), Rhythms ($60 million) and CTC ($30 million). These loans alone totaled over 10% of Cisco Capital loans and each were to customers who could not pay;
(v) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers; http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 114 of 223
(vi) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vii) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) The growth in Cisco's inventory of component parts, work in progress and finished goods during the 3rdQ F00 was not the result of any deliberate decision on the part of Cisco to increase its inventories to secure necessary supplies of custom-made component parts or to build more finished goods to attempt to reduce lead times on customer shipments due to continuing strong demand for Cisco's products. Rather, it was due to a slowdown in demand for Cisco's products which was resulting in a sharp build-up in component parts inventory which Cisco could not control or halt because Cisco had secretly entered into several long-term, non-cancellable supply contracts for over $3 billion in component parts; as a result, Cisco was rapidly accumulating hundreds of millions of dollars of excess unusable, unsaleable and over-valued inventory of component parts, work in progress and finished goods.
(f) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(g) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(h) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies, which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. ICG, Comindigo and Resilient were uncreditworthy companies to which Cisco provided funds. Cisco also loaned money to Vectris Communications and continued to sell equipment to Vectris in 00 despite knowing that Vectris was in financial distress, which resulted in its filing bankruptcy. Cisco's senior management, including Cisco's Credit Board, was aware on a weekly basis during 00 of http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 115 of 223
the severe problems with the vendor-financed loan portfolio as a result of a Deloitte & Touche review. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. AMC received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(i) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipments to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor financed loans, as represented.
(j) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(k) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(l) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(m) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey and Cerent) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(n) The statement that Pirelli gave Cisco the industry leading DWDM equipment was false as the equipment was behind competitors' products and the statement about a customer base of 300 for these products was false. In fact by 7/20/01, the Pirelli product would only have 25 customers which would include those who Cisco helped finance.
(o) Cisco's Pirelli acquisition was a failure as it has been unable to develop new technology to increase the capacity of fiber optic networks and has been eclipsed by Nortel and Ciena. In fact, Cisco's sales of Pirelli products in 00 was $180 million, less than Pirelli's pre-acquisition sales of $218 million in 99.
(p) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 116 of 223
growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(q) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s (the channels by which voice calls travel).
(r) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(s) Contrary to Cisco's representations that the decline in its stock price would not hurt its acquisition program, by 10/00 the decline in Cisco's stock price meant that Cisco's pace of acquisitions would slow dramatically if not come to a halt, which would adversely impact Cisco's ability to achieve the growth it had forecast or obtain the new technology it needed to remain competitive.
(t) Contrary to Cisco's assurances that its Asian markets, including Japan, were recovering from prior slowness and that Cisco was seeing strengthening sales there, in fact, demand for Cisco's products in Asia and Japan remained soft and was not improving in any material way.
(u) Cisco's sales representatives pressured resellers/CVAPS (such as SBC Datacom, Bay Data Consultants, Solarcom, Ameritech, and GE Capital IT Solutions) to place orders in advance of end- user commitments.
(v) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(w) Cisco's acquisition of Infogear, a maker of an Internet appliance product, was a disaster. Cisco was shipping product even though the product did not work. One major customer - Big Planet - eventually returned a significant amount of product due to product defects. Cisco eventually discontinued the whole product line.
(x) Cisco's forecasts of future revenue growth were unachievable because Cisco had shipped excessive http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 117 of 223
inventory into the channel such that customers would be working through excess inventory in future quarters rather than making new purchases. In 3/00, Cisco had shipped so many Cerent switches to Worldcom that most were in warehouses awaiting deployment. Thus, the $500 million in sales Cisco hoped to sell to Worldcom would not occur. The sales forecast would ultimately be cut from $500 million to $2 million.
(y) Cisco executives had knowledge of declining sales to telecommunications companies because these entities made purchasing commitments 6-12 months in advance. Cisco was experiencing a sales shortfall in Summer 00 in various regions. Order Status Reports for the Central Region showed declining sales from Spring 00 forward. Cisco's Professional Services Group was experiencing declining numbers in Summer 00. By Fall 00, software revenues were 20%-30% below projections for 1stQ F01. Cisco was reducing and cancelling orders from suppliers (such as Insight Electronics) in 8/00-9/00 due to weakening demand.
(z) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
198. On 6/7-8/00, Cisco executives Listwin and Russo appeared at the Supercomm Conference in Atlanta. In a formal presentation and break-out session they told the assembled analysts that:
• Cisco's business was strong - all businesses were strong. Cisco had more business opportunities than it could address.
• Business in all regions was very strong. Japan had bottomed and turned around and was now strong. Europe and China were very strong.
• Cisco was successfully evolving from a product centric networking company to a provider of integrated solutions supplying "end-to-end" systems to telecommunications service providers.
• Cisco's growth in optical was very strong. This growth was important to Cisco's continuing growth and success. The Monterey ONS 15900 switch was in trials and performing well. Five to six companies would test that switch shortly. The product was a bit late but performing well.
• Cisco was building inventory to help shorten delivery times to customers and to meet very strong demand.
• Cisco was forecasting F01 EPS of $.68-$.71 and continuing strong growth.
199. On 6/7/00, ABN/AMRO issued a report on Cisco which repeated information provided by Cisco executives at the Supercomm analyst conference. The report forecast F01 EPS of $.71, a 35% three- to five-year EPS growth rate and the following F01 quarterly results for Cisco:
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1st: $ .16 2nd: $ .17 3rd: $ .18 4th: $ .20 Year: $ .71
It also stated:
We met with Don Listwin, EVP Service Provider Group .... Business conditions across the regions look good. Mr. Listwin visited Japan in April and reported that the market has bottomed and shows new life.
200. On 6/7/00, J.P. Morgan issued a report on Cisco which was based on and repeated information provided by Cisco executives at the Supercomm analyst conference. The report forecast F01 EPS of $.70 for Cisco and stated:
CISCO HIGHLIGHTS FROM JPM SUPERCOMM MEETING OPTICAL NETWORKING SEGMENT REMAINS EXTREMELY STRONG
* * *
We met yesterday at Supercomm with Carl Russo, VP and GM of Cisco's Optical Networking Group, who provided an update on Cisco's progress ....
* * * The Monterey optical cross connect (now known as the Cisco ONS 15900) is in a couple of trials, and Russo said those trials are progressing well, however Cisco doesn't expect to book any revenue from Monterey until late calendar 2000/early 2001. While Cisco had initially expected commercial deployment to begin sooner, Russo was very open about the fact that the company had not anticipated the extensive nature of the testing carriers require for a product to be deployed in the core of a network. Additionally, Russo said Cisco does not expect any difficulty transitioning the Monterey product to an all-optical switching fabric (from its current opto-electric conversion fabric) as components for all-optical systems become available.
Russo said customer interest in the Monterey product remains very high, and we are not discouraged by the length of testing .... We continue to expect the Monterey product to be a significant contributor to revenue growth in 2001 and beyond.
201. On 6/8/00, First Union issued a report on Cisco which was based on and repeated information provided by Cisco executives at the Supercomm analyst conference. The report forecast F01 EPS of $.68, a 33%-40% three- to five-year growth rate and the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $ .16 2nd: $ .16 3rd: $ .17 4th: $ .18 Year: $ .68 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 119 of 223
It also stated:
CSCO: UPBEAT PRESENTATION FROM CISCO MANAGEMENT
Don Listwin's lunch with sell-side analysts at Supercomm was extremely upbeat.
In discussing Cisco's growth prospects, he said that he "had never seen such opportunities to grow" in his ten years with the company.
Listwin was particularly positive on the tone of business in Japan.... Listwin said that Japan had "bottomed" and attributed the turnaround to implementing more direct- touch selling there.
On the component shortage issue ... Listwin ... re-emphasized Cisco's plans to build inventory as a response.
We reiterate our Strong Buy and ... price target of $100 ....
202. On 6/8/00, McDonald Investments issued a report on Cisco which was based on and repeated information provided by Cisco executives at the Supercomm analyst meeting. The report stated:
We attended a CSCO analysts meeting yesterday, featuring Don Listwin, CSCO's Executive Vice President in charge of Service Provider and Consumer businesses. We would characterize the tone of the meeting as very positive ....
* * * CSCO continues to see far more opportunities in the market than the Company can adequately address ....
* * * Geographically, Japan has turned around after a long period of lackluster growth .... Europe is also strong ....
The industry continues to experience short supplies of some components. CSCO describes this as being a tertiary issue right now, but the Company's position is to not allow component shortages to impact its ability to ship product. The goal will be to optimize market share, and inventories may need to be built up in order to accomplish this goal. This is the same position articulated on last month's earnings conference call.
203. On 6/8/00, Lehman Brothers issued a report on Cisco which was based on and repeated information provided by Cisco executives at the Supercomm analyst conference. The report forecast F01 EPS of $.70 for Cisco. It also stated:
Don Listwin, Executive Vice President ... discussed Cisco's evolution from a product centric networking company to that of a[n] integrated solutions provider that provides end to end systems for the service providers ....
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* * * International To Fuel Growth
Cisco management highlighted that Asia continues to trend well and that the company remains well positioned to grow 25% sequentially in the region .... We note that both enterprise and service provider products remain in strong demand .... In the service provider segment, the demand for high-end routers is being fueled by the rapid data traffic growth ....
Within the Asia countries, we believe Cisco is experiencing solid growth in China, Taiwan, Singapore, Australia, and Japan and very strong growth in Hong Kong and South Korea which we previewed last week.
* * * Highlights from Wavelength Routing Division
Joe Bass, Vice President and General Manager of Cisco's wavelength routing division, articulated the role of the Monterey optical switch in aiding large service providers to migrate from today's prevalent SONET architecture to that of a streamlined IP over mesh topology network. While acknowledging that the development of the (lambda router) may not be on target with its aggressive internal target, management is suggesting that the market for such high-end devices are still in the early stages of development. Monterey's multi-channel electrical core device may also find itself in the ideal situation of coming to market when the cost of optical components decrease and new technologies are available so that its switch matrix may be swapped for an optical crossbar matrix.
The Monterey has been shipped to one incumbent service provider and Cisco has stated that 5 or 6 additional customers are likely to test the product over the next several months.
204. On 6/8/00, SG Cowen issued a report on Cisco which was based on and repeated information provided by Cisco executives at the Supercomm analyst conference. The report forecast F01 EPS of $.71 and stated:
Business is good, opportunities are even better
* * *
1. Positive momentum across all business units ....
2. Current optical portfolio providing necessary customer momentum.
* * * We are reiterating our Strong Buy rating. Summarizing two days of Cisco-hosted meetings, the message remains that market opportunities continue at unprecedented levels ... and new products are enabling the company to gain share in markets where Cisco is not #1. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 121 of 223
* * * Optical: ... Monterey, the optical switching platform (O-E-O), is currently in trials with customers and will be available in the 2nd half 2000. While some have focused on the product being late, the number of service providers targeted that can use the product today are probably 2 dozen or less. We believe the number of trials is in the 3-5 range and are domestic.
* * * Fiscal 2001: We are projecting ... fiscal 2001 revenue of $26.4 billion.... EPS to be $0.71 ....
205. On 6/9/00, PaineWebber issued a report on Cisco which was based on and repeated information provided by Cisco executives at the Supercomm analyst conference. The report forecast F01 EPS of $.69, a 35% secular growth rate and the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $.15 2nd: $.17 3rd: $.18 4th: $.19 Year: $.69
It also stated:
* Cisco's penetration into the service provider market appears to be on track and is a key driver of growth.
* Cisco began shipping its optical switch (AKA wavelength router), an important milestone.
* Growth in optical remains strong ....
* * * * Price target of $108 ....
* * * Cisco's management team discussed its Service Provider market strategy with a group of financial analysts at the Supercomm conference in Atlanta. Cisco's management was confident in the company's ability to continue expanding its recent success in the optical markets.... [G]rowth in optical networking is an important element of the future growth for the company.
206. On 6/28/00, First Union issued a report on Cisco which was based on and repeated information provided by Russo at investor meetings hosted by First Union. The report forecast 01 EPS of $.68, a 33%-40% three- to five-year growth rate and the following F01 quarterly results for Cisco.
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QTR 1st: $ .16 2nd: $ .16 3rd: $ .17 4th: $ .18 Year: $ .68
It also stated:
CSCO: CISCO'S OPTICAL BUSINESS: "HAIR-ON-FIRE" GROWTH
* * * Yesterday, we hosted a set of investor meetings with Carl Russo, head of Cisco's Optical Networking Group .... As a general summary, we found Russo to be extremely bullish about Cisco's current optical business and prospects over the long term. On more than one occasion, Russo used the expression, "hair-on-fire growth" to describe the dramatic ramp-up that his group is currently experiencing.
* * * Contrary to a recent spate of negative rumors on Monterey, the product development is on track with Cisco's internal schedule. The product - the 15900 - is in more than one customer trial, and is expected to generate revenue in the first half of calendar 2001. Russo conceded that relative to early indications at the time of the Monterey acquisition late last summer, the schedule has slipped by about three months. However, as of the formal plan adopted by Russo when he became the Group Head last December, the product is on time.
207. On 8/8/00, Cisco reported better-than-expected 4thQ F00 and F00 revenues, net income and EPS (the period ending 7/29/00) via a release stating:
Net sales for the fourth quarter of fiscal 2000 were $5.72 billion, compared with $3.56 billion for the same period last year, an increase of 61%. Pro forma net income ... was $1.20 billion or $0.16 per share for the fourth quarter of fiscal 2000, compared with pro forma net income of $710 million or $0.10 per share for the fourth quarter of fiscal 1999, increases of 69% and 60%, respectively.
* * * Net sales for fiscal 2000 were $18.93 billion, compared with $12.17 billion for fiscal 1999, an increase of 55%. Pro forma net income was $3.91 billion or $0.53 per share for fiscal 2000, compared with pro forma net income of $2.52 billion or $0.36 per share for fiscal 1999, increases of 56% and 47%, respectively.
* * *
"We were very pleased with the balance of our business across all key geographies, products, and lines of business,"[said John Chambers, president and CEO of Cisco Systems].
208. On 8/8/00, Bloomberg reported: http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 123 of 223
Cisco Systems Inc. ... said fiscal fourth-quarter net income rose as revenue surged 61 percent, topping the highest forecasts.
* * * "It was a blowout. There's no ifs, ands or buts about it," said Ned Brines, a fund manager ....
The sales growth rate was Cisco's highest in four years, Chief Executive John Chambers said .... He cited especially strong and increasing growth in Japan, where "we are finally seeing evidence of this commitment to change" in using Internet technology.
Chambers said orders were strong in all three major lines of business: large organizations, or enterprises; telecommunications-service providers; and small and midsize businesses.
* * * Cisco's business of financing loans and equipment leases for customers more than doubled in the past year, reaching about 10 percent of revenue in the quarter, Chief Financial Officer Larry Carter said ....
The company records revenue in the business only when it actually receives cash payments, Carter said.
209. On 8/9/00, The Wall Street Journal reported:
STRONG CISCO REVENUE SURPRISES ANALYSTS
Cisco Systems Inc. defied skeptics with another quarter of exceptional growth ... [and] surprised analysts with its 11th consecutive quarter of accelerating revenue growth. Cisco said revenue for the fiscal fourth quarter ended July 29 leapt 61% to $5.72 billion from $3.56 billion a year earlier.
* * * "We have executed beyond even our own stretch goals," Chief Executive John Chambers told Wall Street analysts.... Mr. Chambers said he was "more bullish" than usual about Cisco's prospects, and now expects revenue to grow close to 50% in the fiscal year that started last week.
Cisco also narrowly exceeded analysts' expectations for earnings per share. But that was hardly news: It marked the 13th consecutive quarter Cisco topped the Wall Street consensus by exactly one penny.
210. On 8/9/00, the Los Angeles Times reported:
CISCO TOPS FORECAST AS SALES SURGE 61%
... Cisco Systems Inc. on Tuesday reported fiscal fourth-quarter profit that topped http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 124 of 223
expectations ....
* * * Cisco Chief Executive John Chambers said that sales were balanced across all geographic regions where it sells its wares, and across all its lines of business.
"Given our size, we're very pleased with our results," Chambers said .... "We see more opportunities in the combined video, voice and data markets than we can meet."
211. On 8/9/00, The New York Times reported:
Cisco ... reported a 61 percent gain in sales for its fiscal fourth quarter today .... It was the company's 10th consecutive quarter of accelerating year-over-year revenue growth.
... Cisco earnings exceeded analysts' published estimates by a penny a share.
* * * "The quarter, as expected, looks very strong," said Greg Geiling, an analyst with J.P. Morgan. Revenue growth of 61 percent year over year, and 16 percent over the immediately previous quarter, "are tremendous numbers for a company this size," he said. "And it looks like very balanced growth across all the business lines, which is just what you like to see."
212. On 8/8/00, subsequent to the release of its 4thQ F00 results, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss its business. During the call - and in follow-up conversations with analysts -- Chambers, Listwin, Volpi and Carter stated:
• Cisco was enjoying strong demand for all its products in all its lines of business in all geographic regions.
• Cisco's book-to-bill ratio was over one.
• Demand was especially strong in Japan and other regions of Asia and in Europe.
• Demand for Cisco's products was increasing.
• The Monterey and Pirelli acquisitions were successful with increased product sales and product development.
• Cisco was more optimistic about the next 12 months than ever before.
• Inventories increased $360 million to $1.2 billion, due to Cisco's decision to accumulate critical component parts that were in short supply. Inventories would continue to increase to meet higher sales volumes, as Cisco built product to meet strong demand.
• $400 million of $570 million in vendor financing loans in the quarter were to tier-one http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 125 of 223
carriers and large creditworthy corporations. Cisco's lending practices in and accounting for its vendor financing operations was very conservative.
In follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• Cisco had excellent revenue and EPS visibility going out 12-18 months.
• Cisco was forecasting revenue growth at 30%-50% going forward, with F01 revenue growth at the high end of that range.
• Cisco was increasing its F01 revenue forecast to $29-$30 billion and its F01 EPS forecast to $.74-$.75.
• Cisco was increasing its F02 revenue forecast to $40+ billion and its F02 EPS forecast to $.90-$1.00.
213. Following Cisco again reporting better-than-expected revenues, net income and EPS and Cisco's very bullish conference call and follow-up conversations with analysts, virtually every analyst covering Cisco raised the forecasted F01/F02 revenue, net income and EPS for Cisco, as well as the price target for Cisco's stock.
214. On 8/9/00, A.G. Edwards issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.75 and $.90, forecast a 36% three-year EPS growth rate and the following F01 quarterly results for Cisco:
EPS/01 QTR 1st: $ .17 2nd: $ .18 3rd: $ .19 4th: $ .21 Year: $ .75
It also stated:
Cisco announced results ... that once again came in a penny above expectations. This is becoming a broken record but once again the press was running numerous negative stories about the company and creating quite a buzz about possible surprises in the quarter a few days before the earnings release. Hopefully Cisco's fourth quarter and year end results will quickly put to rest many of the concerns that have arisen.
First, in terms of results, fourth quarter sales of $5.72 billion, well above our $5.43 billion estimate and up an amazing 61% year-over-year and 16% sequentially. This is the tenth consecutive quarter of increasing year-over-year growth rates and the best in three years.
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was again above 1.0.... There was balanced demand across all geographies, product lines and lines of business.... Cisco remains optimistic about the future ....
* * * The balance sheet remained rock solid .... Inventories were up about $358 million to $1.2 billion and we expect this number to grow with sales especially as it tries to build strategic component levels.
Last quarter there were some investor concerns about vendor financing terms so this quarter management addressed the issue head on again. Overall Cisco Capital financed projects, which includes various 3rd party lenders, represented 10% of total quarterly revenue including various types of leasing arrangements. Of the roughly $570 million in customer financing Cisco underwrote about $400 million with the majority of the customers being tier 1 carriers and large corporations. This is a normal business process when selling capital intensive short life cycle products and a moderate level to overall revenues. Financing is now on a $2.5 billion runrate but the company continues to use very conservative revenue recognition for these sales and accounts for them on a cash basis when payment is received. Bottom line, we are not concerned and believe that Cisco continues to follow its standard very conservative accounting position in this area.
... Cisco continues to execute amazingly well .... [W]e are increasing our revenue growth rate to 50% from roughly 42% previously .... Accordingly, we are going to be taking our numbers up slightly to $0.75 for fiscal year 2001. For fiscal year 2002, we are currently projecting an approximate 35% year-over-year growth to $38.4 billion and earnings per share of $0.90.
215. On 8/9/00, J.P. Morgan issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. This report increased the forecasted F01 and F02 EPS for Cisco to $.75 and $1.00 and stated:
CISCO POSTS INCREDIBLY STRONG Q4 RESULTS - RAISING 2001 ESTIMATES OUTLOOK GOING FORWARD IS BETTER THAN EVER
* Cisco reported Q4 EPS of $0.16 (a penny above our estimate) on revenues of $5.7 billion
* Management said the outlook going forward is stronger than ever ...
* * * Cisco posted its strongest quarterly growth in four years, and management said they are "more optimistic than ever" about the outlook going forward.... Revenue growth was 61% year-over-year and 16% sequentially - making this Cisco's 10th consecutive quarter of accelerating revenue growth.
* * * Looking ahead, CEO Chambers said book-to-bill was greater than 1 ....
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Going forward, Cisco expects inventory levels to continue to increase as the company builds to keep up with demand and adds inventory in components to offset supply shortages.
* * * While we have been very bullish on Cisco's prospects for the last several quarters, even we were surprised by the incredible strength in Q4 results. We believe business at Cisco remains extremely healthy, and think this quarter's results and management's guidance confirm our view that this is a company capable of growing revenues over 50% for the next few years.
In light of these very strong results, we are raising our fiscal 2001 EPS estimate for Cisco to $0.75 from $0.70 and establishing a new 2002 estimate of $1.00....
The opportunities in Cisco's carrier segment, particularly in optics, and continued strength in the enterprise business give us confidence in our outlook going forward.... [W]e would continue to be aggressive buyers of CSCO shares and reiterate our $100 price target.
216. On 8/9/00, McDonald Investments issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.74 and $.95 and stated:
CSCO reported another strong quarter last night, with accelerating revenue growth and EPS a penny higher than consensus. These results reinforce our view that CSCO's business is likely to continue to gain momentum .... We are raising our fiscal 2001 EPS estimate to $0.74 from $0.69, and initiating a preliminary fiscal 2002 EPS estimate of $0.95.... We see nothing on the horizon that threatens to derail CSCO's strong business trends.
* * * Inventories rose in the quarter, as expected, as CSCO stocked up on components to avoid stock-outs and keep lead times down.... Inventories are expected to rise in dollar terms, as CSCO seeks to maintain adequate supply to meet customer demand.
Financed deals in the third quarter accounted for 10% of revenue, including third party financing, and 7% for CSCO Capital alone. The bulk of financing is for large enterprise customers and Tier 1 carriers, with the remainder being structured loans to CLECs and ISPs. These loans carry more risk, and are accounted for on a cash basis, with revenue only being recognized when payment is received.
217. On 8/9/00, SG Cowen issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.76 and forecast the following F01 quarterly results for Cisco:
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3rd: $ .20 4th: $ .21 Year: $ .76
It also stated:
CSCO/CISCO REPORTS STRONG Q4, EXCEEDS EXPECTATIONS... /STRONG BUY
Key Points:
1. Cisco reported a blowout quarter, raising estimates
* * * 4. Optical ... strateg[y] on track
* * * Cisco reported blowout results for its Q4 yesterday .... Strength was seen in all four geographic theaters, especially in Japan and other regions of Asia. In the Enterprise business, strong growth was seen for the second consecutive quarter .... We expect optical ... to ramp revenue in 2001 from a base under $500MM today, underscored by customer and product announcements expected in the next 1-2 quarters. Overall, the company delivered another outstanding quarter, causing us to increase our estimates for F2001.
218. On 8/9/00, CS First Boston issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.77 and forecast a 35% three-year EPS growth rate for Cisco and also stated:
Outstanding Quarter; Demand Outlook Superior; Boosting Estimates; Reiterate STRONG BUY.
* * * CSCO reported FQ4:00 EPS of $0.16, above ... consensus estimate of $0.15 .... Revenue of $5.72B topped our $5.5B projection; Raising F2001 EPS to $0.77 from $0.72 and sales to $28.4B from $26.5B.
* * * Balance Sheet Remains Strong .... Management noted on the call that turns will experience slight sequential decreases over the next several quarters as the company increases its dollar inventory levels to meet higher projected sales volumes and assure the continuity of component supplies.
219. On 8/9/00, Gerard Klauer Mattison issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.75 and $.94, forecast a 35% five-year EPS growth rate and the following F01/F02 quarterly results for Cisco:
EPS/F01 EPS/F02 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 129 of 223
QTR 1st: $ .17 $ .22 2nd: $ .18 $ .23 3rd: $ .19 $ .24 4th: $ .20 $ .25 Year: $ .75 $ .94
It also stated:
Cisco Systems - 4Q00 Results: Momentum Continues; Raising Ests; ... BUY
* * * • 4Q00 operating EPS, of $0.16 (vs. $0.10) exceeded ... consensus by $0.01.... Revenue growth accelerated for the tenth consecutive quarter and book-to-bill was again greater than one.
* * * • ... We are increasing our revenue forecast for FY01 .... Our new FY01 EPS estimate is $0.75 (from $0.68). We are also initiating a FY02 EPS estimate of $0.94.
... A positive book-to-bill ... and strong demand for existing products and a number of new products/markets ramping over the next two years, give us confidence that the company can continue to meet or exceed our estimates.
* * * We are raising our five-year growth rate estimate to 35% (from 30%) ....
* * * The balance sheet remains solid.... [T]he company purposefully increased inventory slightly as a measure to lower any potential risk associated with unforeseen supply constraints....
Cisco continues to execute to perfection ....
220. On 8/9/00, PaineWebber issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.75, forecast a 35% secular growth rate and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .17 2nd: $ .18 3rd: $ .19 4th: $ .20 Year: $ .75
It also stated:
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Cisco: Continues to Accelerate Growth in Q4 ...
• Q4 EPS of $0.16 exceeded our estimate by a penny on a stronger than expected revenue.
• Revenue growth accelerated for the 10th consecutive quarter ... driven by the strong demand for optical, packet and broadband access products.
* * * • We increased our Fiscal 2001 EPS estimate to $0.75 from $0.69 ....
221. On 8/9/00, Brean Murray issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.74 and $.92 and stated:
Cisco's 4QFY00 EPS of $0.16 exceeded ... expectations of $0.14 ....
* * * * Book-to-bill remained at greater than 1.
* * * We are increasing our EPS estimates to $0.74 for FY2001 and introducing our FY2002 EPS estimate of $0.92 to reflect Cisco's excellent 12-18 month sales, and market visibility.
* * * * Revenue should increase to $29.4 billion and $40.8 billion ... for FY2001 and FY2002, respectively. This is being driven by visible increases in demand in the enterprise and service provider markets .... Management expects that revenue can continue to grow at or above the 30% - 50% market growth rate.
222. On 8/9/00, UBS Warburg issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.75 and $.93, forecast a 30% five-year EPS growth rate and the following F01/F02 quarterly results for Cisco:
EPS/F01 EPS/F02 QTR 1st: $ .17 $ .22 2nd: $ .18 $ .23 3rd: $ .19 $ .24 4th: $ .20 $ .25 Year: $ .75 $ .93
It also stated:
CSCO: ANOTHER TYPICAL STRONG QUARTER - OUTLOOK STRONGER
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* * * Cisco reported 4Q EPS of $0.16, which exceeded our estimate of $0.15 .... The upside was due to higher than expected revenues.... The business was strong across all geographies and all business areas. Guidance for the upcoming year was for revenue growth at the high end of the 30%-50% range which Cisco has discussed in the past. We are raising our EPS estimates to $0.75 and $0.93 for fiscal 2001 and 2002 from $0.68 and $0.85. We maintain our Buy rating and price target of $85 ....
223. On 8/9/00, ABN/AMRO issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.74, forecast a 35% three- to five-year EPS growth rate and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .16 2nd: $ .18 3rd: $ .19 4th: $ .21 Year: $ .74
It also stated:
- Cisco reported record revenues in fiscal 4Q00 ... above our est. EPS was $0.16 vs. ... consensus at $0.15 ....
- All product segments were up significantly.... We have revised our FY01 revenues est from $27.3 bil to $28.2 bil .... We are revising our FY01 est from $0.71 to $0.74.... We reiterate our Buy and $85 price target.
* * * What about vendor financing?
The financial data suggests this is not a big issue. Cisco maintains a conservative vendor financing business model, with operating leases being the majority of the financing. These leases usually last 2-3 years in duration and are renewable. During the quarter total vendor financing from both Cisco Capital and third parties equaled about 10% of total revenue. Financing from Cisco Capital alone represented roughly 7% of total revenue. Cisco is exiting FY00 with $2.5 billion run rate on its balance sheet. Management emphasized that though there was a small amount of higher credit risk customers that received structured loans, revenue from these customers is only recognized when cash payments are received.
224. On 8/9/00, Lehman Brothers issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.74 and stated:
* ... CSCO reported impressive results w/ ... a highly upbeat demand outlook .... Ests move higher & we reit our buy rating. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 132 of 223
* * * * Cisco saw strong growth across all key product lines & all regions....
* Book to bill >1 & upbeat guidance on sales growth at high end of 30-50% range ....
* Our ests for FY01 move higher to $28.6B+52% & EPS of $0.74 up from $26.7B+44% & $0.70.
225. On 8/9/00, Deutsche Banc Alex. Brown issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.74, forecast a 30% three-year growth rate and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .17 2nd: $ .18 3rd: $ .19 4th: $ .20 Year: $ .74
It also stated:
CISCO SYSTEMS INC. "STRONG BUY" Cisco Reports Strongest Year to Year Growth In 4 Years - Management Very Optimistic About Prospects of Business
* * *
Cisco reported a very solid Q4 with revenue increasing 16% sequentially and 61% year over year as management continues to be highly optimistic about the company's prospects over the next 12 months....
This quarter's results represent the largest percentage sequential increase in 15 quarters and the largest year over year percentage increase in 4 years. Q4 marks the 7th quarter in a row of double digit sequential growth.
* * * The optical business is quickly approaching a $2 billion dollar run rate and experienced very strong growth during the quarter.
Management was very bullish on the role that the company will play as an IP interface to wireless networks....
We are raising our 2001 fiscal year revenue and EPS estimates from $26.1 billion and $.69 to $28.5 billion and $.74.
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Cisco's strong sequential revenue growth, increasing linearity and success in both traditional and emerging marketplaces indicate that demand remains strong and business remains robust.
* * * Cisco Capital continues to be a core competitive tool for winning business. Sales financed via Cisco Capital reached a $2.5 billion dollar run rate and management believes that offering financing to Tier 1 customers is attractive and represents a complete customer package.
... Management is more optimistic than ever about the company's prospects over the next 12 months.
226. On 8/9/00, First Union issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.75 and $1.00, forecast a 33%-40% three- to five-year growth rate and the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .17 2nd: $ .18 3rd: $ .19 4th: $ .20 Year: $ .75
It also stated:
CSCO: BEST QUARTER IN 5 YEARS; RAISING ESTIMATES
* * * - Cisco comfortably exceeded revenue and EPS expectations....
- This is the fourth quarter in a row of sequential revenue growth acceleration and the tenth in a row of year-over-year acceleration (61%).
- Our read on overall management guidance is that we should expect higher revenue growth for fiscal year 2001....
- Our forecast for fiscal year 2001 now calls for 50% revenue growth ....
* * * - Management tone was very positive, although supply constraints at the component level are still challenging. To deal with this, the company has entered into more long- term supply agreements for components and is carrying more inventory as well.
- Raising EPS for FY2001 from $0.68 to $0.75 and initiating FY2002 of $1.00. Raising revenue for FY2001 from $26.2 billion to $28.5 billion and initiating FY2002 of $39.15 billion. Maintain Strong Buy rating with $100 price target. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 134 of 223
227. On 8/11/00, CIBC World Markets issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 and F02 EPS for Cisco to $.74 and $.94 and stated:
Cisco Systems reported 4QF00 (July) results which included a tenth straight quarter of accelerating year/year revenue growth.
* * * The company reported well balanced growth by products and geography, solid linearity in the quarter and book/bill greater than 1.0x.
* * * For full year 2001 we estimate ... EPS growth to $0.74 on 50.5% revenue growth to $28.4 billion and for full year fiscal 2002, we estimate ... EPS growth to $0.94 ... [and] revenue growth to $39.7 billion.
* * * In 4QF00, 10% of Cisco's revenue involved Cisco's capital subsidiary financing or third party financing. Cisco's direct equipment financing was about 7% of revenue, which was only slightly up from 5% of revenue last quarter. We fully expect vendor financing to be an increasingly necessary feature of Cisco's and other equipment suppliers' offerings. For now, we remain comfortable that there is a prudent risk management program in place at Cisco.
228. On 8/11/00, Josephthal & Co. issued a report on Cisco which was based on and repeated information provided by Chambers and Carter. The report increased the forecasted F01 EPS for Cisco to $.79 and forecast the following F01 quarterly results for Cisco:
EPS/F01 QTR 1st: $ .17 2nd: $ .19 3rd: $ .20 4th: $ .22 Year: $ .79
It also stated:
CSCO: Raising Estimates; Reiterate Buy Rating with a $100 Price Target
Cisco delivered a superb fiscal Q4 .... Revenues were $5.7 billion, exceeding our estimate of $5.5 billion and marking the tenth consecutive quarter of accelerating top-line growth .... EPS were $0.16, exceeding the consensus estimate by a penny, as is the company's custom.
We are raising our revenue and EPS estimates for 2001 and introducing estimates for 2002. In light of the record Q4, we are increasing our revenue estimate for 2001 to $29.3 billion ... from $28.7 billion, and our EPS estimate to $0.79 from $0.77. For fiscal http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 135 of 223
2002, we are forecasting $49 billion in revenues ... and EPS of $1.14....
Cisco's ability to consistently achieve aggressive, over-50% growth despite its large size is truly remarkable; and yet we see this trend continuing through fiscal 2002 and beyond. The company is clearly in a strong market and management continues to see more opportunity in the Internet marketplace than it is able to fund....
Balance Sheet Metrics - The balance sheet remains robust .... Inventory increased by $368 million to $1.2 billion. The company indicated that inventory dollar levels should increase during the course of the coming fiscal year, in order to provide for increased sales volumes and continued supply in a components-constricted market....
Vendor Financing - Cisco Capital, offering various forms of lease and structured financing, more than doubled revenues over the fiscal year, exiting the year at a $2.5- billion run rate. Financing was originally offered as an option only for Cisco's large enterprise customers; however, with Cisco's move into the service provider markets, financing arrangements have become a regular part of the sales package to quality enterprise customers and to Tier One service providers. Overall financing, including third party, represented 10% of Q4 revenue, while Cisco's own financing represented 7% of Q4 revenue. The company indicated that about 90% of its financing activities were leasing arrangements and the remaining 10% were structured loans, with somewhat higher credit risk. (In the higher credit risk category, the company recognizes revenues only when payment is received, so that, in our opinion, the quality of Cisco's earnings is not affected).
229. Each of the statements made between 6/7/00 - 8/11/00 were false or misleading when issued. The true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 4thQ F00 and F00 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as was necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working product in the following quarter;
(ii) In 6/00, Cisco had shipped more than $100 million in equipment to KMC Telecom Holdings through Qwest Communications. Qwest agreed to be the intermediary because Cisco sold it the equipment at a discount so Qwest was guaranteed a profit, Qwest did not have to pay for it right away and Qwest was being paid immediately by KMC from funds generated from financing guaranteed by Cisco. Thus, by using Qwest, Cisco recognized revenue since it was a valid reseller which had sold the product through. In substance though, Cisco had sold to a customer, KMC, which could not pay for the equipment;
(iii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers were moved across a "yellow line" in the facility, but not actually shipped to a customer; http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 136 of 223
(iv) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(v) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned more than 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
(vi) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customers did not need and did not want, which Cisco knew would reduce demand for Cisco's products in the future. Some of this equipment was not working and had expired warranties;
(vii) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(viii) Duplicate orders from customers were recorded as sales throughout 00, but product was returned leading to inventory build-up;
(ix) Cisco frequently shipped product at the end of the quarter to warehouses in order to make quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of the 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
(x) Cisco utilized third-party intermediaries, such as Sunrise Capital, Deutsche Bank, GE Capital, American Express, and Silicon Valley Bank, to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on their loans; and
(xi) Cisco booked large deals before quarter-end to CVAPs and CVARs without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product.
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶229(a)(i)-(xi).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶229(a)(i)-(xi).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 137 of 223
the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customers did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Contrary to defendants' assertion that riskier Cisco Capital loans were limited to 10% of loans made, in fact, the percentage of risky loans was many times higher than this. By the Spring of 2000, risky loans to customers in financial trouble included AMC with $70 million outstanding, ICG ($99 million), Digital Broadband ($70 million), HarvardNet ($30 million), Pacific Gateway ($15 million), Rhythms ($60 million) and CTC ($30 million). These loans alone totaled over 10% of Cisco Capital loans and each was a customer who could not pay;
(v) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(vi) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vii) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) The growth in Cisco's inventory of component parts, work in progress and finished goods during the 3rdQ and 4thQ F00 was not the result of any deliberate decision on the part of Cisco to increase its inventories to secure necessary supplies of custom-made component parts or to build more finished goods to attempt to reduce lead times on customer shipments due to continuing strong demand for Cisco's products. Rather, it was due to a slowdown in demand for Cisco's products which was resulting in a sharp build-up in component parts inventory which Cisco could not control or halt because Cisco had secretly entered into several long-term, non-cancellable supply contracts for over $3 billion in component parts; as a result, Cisco was rapidly accumulating hundreds of millions of dollars of excess, unusable, unsaleable and over-valued inventory of component parts, work in progress and finished goods.
(f) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 138 of 223
4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems that were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(g) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(h) Cisco was making large amounts of vendor-financed loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. For example, Cisco loaned approximately $40 million to Onetel, Limited, a company losing money that eventually went bankrupt. ICG, Comindigo and Resilient were other uncreditworthy companies to which Cisco provided funds. Cisco also loaned money to Vectris Communications and continued to sell equipment to Vectris in 00 despite knowing that Vectris was in financial distress, which resulted in it filing bankruptcy. Cisco's senior management, including Cisco's Credit Board, was aware on a weekly basis during 00 of the severe problems with the vendor-financed loan portfolio as a result of a Deloitte & Touche review. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. One customer, AMC, received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(i) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipment to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor-financed loans, as represented.
(j) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
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(k) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(l) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(m) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey and Cerent) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(n) The statement that Pirelli gave Cisco the industry leading DWDM equipment was false, as the equipment was behind competitors' products and the statement about a customer base of 300 for these products was false. In fact by 7/20/01, the Pirelli product would only have 25 customers which would include those who Cisco helped finance.
(o) Cisco's Pirelli acquisition was a failure as it has been unable to develop new technology to increase the capacity of fiber optic networks and has been eclipsed by Nortel and Ciena. In fact, Cisco's sales of Pirelli products in 00 was $180 million, less than Pirelli's pre-acquisition sales of $218 million in 99.
(p) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(q) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s.
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(r) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(s) Contrary to Cisco's representations that the decline in its stock price would not hurt its acquisition program, by 10/00, the decline in Cisco's stock price meant that Cisco's pace of acquisitions would slow dramatically, if not come to a halt, which would adversely impact Cisco's ability to achieve the growth it had forecast or obtain the new technology it needed to remain competitive.
(t) Contrary to Cisco's assurances that its Asian markets, including Japan, were recovering from prior slowness and that Cisco was seeing strengthening sales there, in fact, demand for Cisco's products in Asia and Japan remained soft and was not improving in any material way.
(u) Cisco's sales representatives pressured resellers/CVAPS (such as SBC Datacom, Bay Data Consultants, Solarcom, Ameritech, and G.E. Capital IT Solutions) to place orders in advance of end- user commitments.
(v) Cisco's acquisition of Infogear, a maker of an Internet appliance product, was a disaster. Cisco was shipping product even though the product did not work. One major customer - Big Planet - eventually returned a significant amount of product due to product defects. Cisco eventually discontinued the whole product line.
(w) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(x) Cisco's top management actually knew their sales forecasts were unreasonable and could not be achieved. Debbie Traficante, who met frequently with Cisco's top management to discuss actual and forecasted sales, was told that sales projections for 00 in the SP space were unattainable. Traficante had earlier requested that sales personnel in her group set forth their most optimistic projections, presuming that Cisco could deliver all the products that were supposed to be available for sale and shipment during the year (notwithstanding that Cisco was already having, and would continue to have, extreme difficulty in timely bringing products from its new acquisitions to market). The sales personnel at this meeting adhered to Traficante's request to set forth their most optimistic projections, which Traficante then increased by 200% and which became the sales goals for the group for 00. The personnel told Traficante "there's no way we can meet this number" because the market had already been saturated and oversold with too much Cisco gear during 99.
(y) Cisco's forecasts of future revenue growth were unachievable because Cisco had shipped excessive inventory into the channel such that customers would be working through excess inventory in future quarters rather than making new purchases. In 3/00, Cisco had shipped so many Cerent switches to Worldcom that most were in warehouses awaiting deployment. Thus, the $500 million in sales Cisco hoped to sell to Worldcom would not occur. The sales forecast would ultimately be cut from $500 million to $2 million.
(z) Because of Cisco's improper sales practices, it was required to reduce reported revenue by the expected amount of returns and non-collectibility. Cisco offered unlimited return rights for defective http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 141 of 223
products and at least 10% of shipments for any reason. Additionally, Cisco would accept returns as a matter of practice to protect relationships with customers. During mid-00, Cisco's internal financial staff calculated a reserve of 22% on invoiced shipments to distributors. Because of the adverse effect this would have had on earnings (i.e., Cisco would not beat projections by one penny), Cisco's financial management (under Carter) told the staff that the reserve could not be more than 20%. Ultimately due to the under-reserving, after the Class Period the reserve needed to be increased to 35%, which was included in the charges taken in the $2.5 billion write-off in 4/01.
(aa) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
230. As a result of Cisco's very strong 4thQ F00 and F00 results and positive statements on its business, Cisco's stock, which had fallen to $58-1/2 on 8/3/00, soared to as high as $70 on 8/9/00 and traded in the mid-$60 range during the balance of 8/00. As Cisco's stock moved higher, the Cisco insiders named as defendants took advantage of this increased inflation in the stock's price by selling off 2.1 million of their Cisco shares between 8/11/00-8/18/00, pocketing $134 million in illegal insider trading proceeds! However, after these Cisco insiders had unloaded their shares, in late 8/00-early 9/00 Cisco's stock declined due to increasing concerns among investors over a possible slowdown in capital expenditures by telecom SPs. Over the next several weeks, Cisco repeatedly assured investors that it was not seeing any slowdown in orders or demand for its products and would continue to post very strong revenue and EPS growth, achieving even higher growth rates than earlier forecast.
231. On 9/5/00, Morgan Stanley Dean Witter issued a detailed report on Cisco which was based on and repeated information provided analyst Stix by Michael Ashby, Cisco's Vice President of Corporate Finance. The report forecast F01 and F02 EPS of $.75 and $1.00 for Cisco, and stated:
• We Think Accounting Very Conservative
Cisco is reserving for its "risky" customer financing. Financing carried on the books only generates 2-3% of revenues.
* * * We recently met with Michael Ashby, Cisco's Vice President of Corporate Finance, to review the accounting for Cisco's customer financing. We requested this meeting because we had received a number of phone calls from investors concerning the Cisco's [sic] leasing transactions. We came away impressed with how conservative Cisco has been. Cisco engages in four types of customer finance transactions: leases written by third parties, leases carried on the company's books, leases and structured loans that are reserved due to the quality of the credit; and operating leases. At the end of Q4, Cisco carried about $500MM of the $2.5B that it had financed on its balance sheet. About 30% of the amounts financed are handled by third parties, with no recourse to Cisco. The company recognizes revenues on these immediately; it takes on new recourse and generates no lease profits. We estimate that another 30-35% are reserved, due to questions about the financial health of the lessee. All of its structured loans to service providers are reserved. Revenue is recognized from these leases on a cash basis. Less than http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 142 of 223
5% are carried on Cisco's books as operating leases. We estimate that the remaining leases have been paid off. By reserving 30+% of its lease revenue, our analysis suggests the company has understated its already-strong near-term revenue growth and its gross margins.
Our meetings with members of management left us impressed with the progress that the company is making in optical as well as IP infrastructure for GPRS wireless.
* * * Very Conservative On Customer Financing
We came away impressed by Cisco's conservative approach to customer financing after meeting with Michael Ashby, the company's Vice President of Finance last week. Cumulatively, Cisco has financed or facilitated the finance of about $2.5B of its equipment. In the last two quarters, 7% (Q3) and 10% (Q4) of sales were financed. We expect the volume of financing transactions to sustain at about 9-10% of revenues over the coming year. The company engages in four types of leasing transactions: sales leases handled by third parties (29 to 30% of leasing transactions), with no recourse to Cisco; sales leases and structured loans with financially weaker service providers, where revenue is recognized as cash is received (we estimate that this lease class represents about 30- 35% of cumulative leases); sales leases carried on Cisco's books (about 20-25% of the total); and operating leases (less than 5% of the total).
* * * Revenue Recognized On Quality Credits
When Cisco leases a product to a high quality credit using a sales lease, it recognizes the revenue and carries the lease receivable on its balance sheet as an other current and long-term asset until it is paid.
* * * Revenue Reserved On Riskier Credits
On structured loans and leases to weaker or emerging carriers or CLECs, Cisco reserves 100% of the revenue from the leasing transaction and only recognizes revenues and profits as cash is received. We feel Cisco's policy on these transactions is extraordinarily conservative.
232. On 9/25/00, Morgan Stanley Dean Witter issued a report on Cisco by analyst Stix, which was based on repeated information provided Stix by Chambers and Carter. The report forecast F01 EPS of $.75 for Cisco and stated:
• Cisco seeing strength in Europe.... Strong visibility .... Maintaining conservative accounting .... Demand and visibility continue to grow throughout the world.
* * * Conservative Financing Policy
We continue to stress that Cisco's accounting policies regarding emerging service http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 143 of 223
providers has been extremely conservative....
We believe that business is very strong at Cisco, and that our estimates are conservative. We believe the company is seeing significant demand in [sic] throughout the world, and that visib[ility] on the business is very strong.... We are maintaining our Strong Buy rating and price target of $90.
233. On 10/1/00, Cisco announced the acquisition of PixStream, Inc. for $369 million in stock. PixStream was represented to be an important step in Cisco's plan to accelerate the delivery of broadcast-quality video over broadband networks. PixStream's technology would extend Cisco's broadband market leadership into video services, allowing cable, DSL and wireless providers to deliver a single end-to-end solution for the delivery and management of broadband video services.
234. Each of the statements made between 9/5/00-10/1/00 were false or misleading when issued. The true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 4thQ F00 and F00 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as was necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working product in the following quarter;
(ii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers was moved across a "yellow line" in the facility, but not actually shipped to a customer;
(iii) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(iv) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
(v) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customer did not need and did not want, which Cisco knew would reduce demand for Cisco's products in the future. Some of this equipment was not working and had expired warranties;
(vi) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(vii) Cisco frequently shipped product at the end of the quarter to warehouses in order to make their quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 144 of 223
customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
(viii) By recognizing revenue on shipments to distributions prior to end-user customers being identified;
(ix) Duplicate orders from customers were recorded as sales throughout 00, but product was returned leading to inventory build-up;
(x) Cisco utilized third-party intermediaries, such as Sunrise Capital, Deutsche Bank, GE Capital, American Express, and Silicon Valley Bank, to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on their loans; and
(xi) Cisco booked large deals before quarter-end to CVAPs and CVARs without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product.
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶234(a)(i)-(xi).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶234(a)(i)-(xi).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customers did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Contrary to defendants' assertion that riskier Cisco Capital loans were limited to 10% of loans http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 145 of 223
made, in fact, the percentage of risky loans was many times higher than this. By the Spring of 00, risky loans to customers in financial trouble included AMC with $70 million outstanding, ICG ($99 million), Digital Broadband ($70 million), HarvardNet ($30 million), Pacific Gateway ($15 million), Rhythms ($60 million) and CTC ($30 million). These loans alone totaled over 10% of Cisco Capital loans and each was to a customer who could not pay;
(v) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(vi) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vii) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) The growth in Cisco's inventory of component parts, work in progress and finished goods during the 4thQ F00 was not the result of any deliberate decision on the part of Cisco to increase its inventories to secure necessary supplies of custom-made component parts or to build more finished goods to attempt to reduce lead times on customer shipments due to continuing strong demand for Cisco's products. Rather, it was due to a slowdown in demand for Cisco's products which was resulting in a sharp build-up in component parts inventory which Cisco could not control or halt because Cisco had secretly entered into several long-term, non-cancellable supply contracts for over $3 billion in component parts; as a result, Cisco was rapidly accumulating hundreds of millions of dollars of excess, unusable, unsaleable and over-valued inventory of component parts, work in progress and finished goods.
(f) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(g) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(h) Cisco was making large amounts of vendor-financed loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 146 of 223
repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. For example, Cisco loaned approximately $40 million to Onetel, Limited, a company losing money that eventually went bankrupt. ICG, Comindigo and Resilient were other uncreditworthy companies to which Cisco provided funds. Cisco also loaned money to Vectris Communications and continued to sell equipment to Vectris in 00 despite knowing that Vectris was in financial distress, which resulted in its bankruptcy filing. Cisco's senior management, including Cisco's Credit Board, was aware on a weekly basis during 00 of the severe problems with the vendor financed loan portfolio as a result of a Deloitte & Touche review. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. One customer, AMC, received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(i) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipments to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor financed loans, as represented.
(j) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(k) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(l) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(m) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey and Cerent) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(n) The statement that Pirelli gave Cisco the industry leading DWDM equipment was false, as the http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 147 of 223
equipment was behind competitors' products and the statement about a customer base of 300 for these products was false. In fact by 7/20/01, the Pirelli product would only have 25 customers which would include those who Cisco helped finance.
(o) Cisco's Pirelli acquisition was a failure as it has been unable to develop new technology to increase the capacity of fiber optic networks and has been eclipsed by Nortel and Ciena. In fact, Cisco's sales of Pirelli products in 00 was $180 million, less than Pirelli's pre-acquisition sales of $218 million in 99.
(p) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(q) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS1s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s.
(r) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(s) Contrary to Cisco's representations that the decline in its stock price would not hurt its acquisition program, by 10/00, the decline in Cisco's stock price meant that Cisco's pace of acquisitions would slow dramatically if not come to a halt, which would adversely impact Cisco's ability to achieve the growth it had forecast or obtain the new technology it needed to remain competitive.
(t) Contrary to Cisco's representations that a decline in SP capital expenditures would hurt it less than its rivals, in fact, it would hurt Cisco as much if not more because Cisco had already shipped out more product than its customers desired, which customers had accepted so that they could get Cisco-backed financing. Thus, not only would the cutbacks hurt future sales, but they would result in defaults and returns.
(u) Contrary to Cisco's representations that an economic slowdown would benefit it, that Cisco would actually be better off if the market stayed tough for the next 12-18 months and that Cisco would grow in good times and bad because most of Cisco's revenues came from commodity router products, demand for which was very much dependent on and impacted by macro-economic growth, an http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 148 of 223
economic slowdown, tough market and bad timing would very adversely impact Cisco's business and growth.
(v) Contrary to Cisco's assurances that its Asian markets, including Japan, were recovering from prior slowness and that Cisco was seeing strengthening sales there, in fact, demand for Cisco's products in Asia and Japan remained soft and was not improving in any material way.
(w) Cisco's sales representatives pressured resellers/CVAPS (such as SBC Datacom, Bay Data Consultants, Solarcom, Ameritech, and G.E. Capital IT Solutions) to place orders in advance of end- user commitments.
(x) Cisco executives had knowledge of declining sales to telecommunications companies because these entities made purchasing commitments 6-12 months in advance. Cisco was experiencing a sales shortfall in Summer 00 in various regions. Order Status Reports for the Central Region showed declining sales from Spring 00 forward. Cisco's Professional Services Group was experiencing declining numbers in Summer 00. By Fall 00, software revenues were 20%-30% below projections for 1stQ F01. Cisco was reducing and cancelling orders from suppliers (such as Insight Electronics) in 8/00-9/00 due to weakening demand.
(y) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(z) Cisco's acquisition of Infogear, a maker of an Internet appliance product, was a disaster. Cisco was shipping product even though the product did not work. One major customer - Big Planet - eventually returned a significant amount of product due to product defects. Cisco eventually discontinued the whole product line.
(aa) In 10/00, Chambers and Carter received a worldwide forecast report which was based on forecasts from each sector in the world which indicated that F01 and F02 revenues would be much lower than published forecasts.
(bb) Cisco's top management actually knew their sales forecasts were unreasonable and could not be achieved. Debbie Traficante, who met frequently with Cisco's top management to discuss actual and forecasted sales, was told that sales projections for 00 in the SP space were unattainable. Traficante had earlier requested that sales personnel in her group set forth their most optimistic projections, presuming that Cisco could deliver all the products that were supposed to be available for sale and shipment during the year (notwithstanding that Cisco was already having, and would continue to have, extreme difficulty in timely bringing products from its new acquisitions to market). The sales personnel at this meeting adhered to Traficante's request to set forth their most optimistic projections, which Traficante then increased by 200% and which became the sales goals for the group for 00. The personnel told Traficante "there's no way we can meet this number" because the market had already been saturated and oversold with too much Cisco gear during 99.
(cc) Because of Cisco's improper sales practices, it was required to reduce reported revenue by the expected amount of returns and non-collectibility. Cisco offered unlimited return rights for defective products and at least 10% of shipments for any reason. Additionally, Cisco would accept returns as a http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 149 of 223
matter of practice to protect relationships with customers. During mid-00, Cisco's internal financial staff calculated a reserve of 22% on invoiced shipments to distributors. Because of the adverse effect this would have had on earnings (i.e., Cisco would not beat projections by one penny), Cisco's financial management (under Carter) told the staff that the reserve could not be more than 20%. Ultimately due to the under-reserving, after the Class Period, the reserve needed to be increased to 35%, which was included in the charges taken in the $2.5 billion write-off in 4/01.
(dd) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-50% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
235. Cisco was to report its 1stQ F01 results (the quarter ended 10/28/00) on 11/6/00. During 9/00- 10/00, due to the growing concern over a capital expenditure slowdown by telecom SPs, there was increasing concern in the investment community over Cisco's ability to continue to grow at the 30%- 50% pace it had achieved in past years. Thus, investors were especially interested in Cisco's 1stQ F01 results and Cisco's commentary on its business. For instance:
(a) On 11/2/00, Bloomberg reported:
Cisco Systems Inc., the No. 1 maker of computer-networking equipment, is expected Monday to report that fiscal first-quarter sales rose 61 percent, the 11th straight quarter of faster revenue growth.
* * * "Investors are on edge with Cisco," said Bruce Bartlett, a portfolio manager at OppenheimerFunds Inc. ... Every quarter now is kind of expected to have a higher probability that it's the quarter that shows the company is slowing down."
* * * "The big worry with Cisco is when is the law of large numbers going to catch up with this company and growth start to slow?" said Oppenheimer's Bartlett.
The report comes as investors become increasingly worried that providers of telecommunications services will slow equipment spending next year.
(b) On 11/3/00, a major article about Cisco appeared in The Wall Street Journal headlined and stating:
SUPERSTAR'S PACE: CISCO KEEPS GROWING, BUT EXACTLY HOW FAST IS BECOMING AN ISSUE; AS DEBATE OVER ITS STOCK MOUNTS, THE OUTCOME COULD HAVE BIG RIPPLES
... Every three months for the past two years, John Chambers, chief executive of Cisco Systems Inc., has told Wall Street analysts that Cisco's revenue can grow 30% to 50% a year in a healthy economy.
* * * But now, for the first time in years, there is serious debate about how fast Cisco can http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 150 of 223
grow. Telecommunications companies, which have accounted for a disproportionate share of Cisco's growth in recent years, are curbing their budgets for new equipment. Some telecom start-ups are running out of money. Dot-coms are vanishing, and with them some purchases of Cisco gear. The economy is showing signs of slowing, which could curtail spending by big businesses, Cisco's core customers.
The result: Many investors are starting to take Mr. Chambers literally. Some are trimming projections for Cisco's long-term revenue growth to around 40% a year.
* * * The difference between revenue growth of 50% and 40% may not sound like much, but it's crucial for tech investors, who place a premium on growth.
* * * Cisco executives remain extraordinarily bullish as well, though they are reluctant to discuss specifics in advance of Monday's earnings report. "We haven't seen any sign of a slowdown," says Michelangelo Volpi, chief strategy officer. He says Cisco has made no changes to its internal plans since the beginning of its fiscal year in August. "We have guided the Street accurately, and we can execute to plan."
* * * Corporate sales this year "have surprised even us," Cisco's Mr. Volpi says.
* * * Cisco won't feel the worst effects of that slowdown, because it doesn't make any of the telephone equipment whose sales are dropping....
236. Due to these concerns, Cisco's stock fell to $45-1/4 on 10/30/00. This decline hurt the value of Cisco's outstanding stock options and adversely impacted its ability to pursue and make acquisitions, increasing the pressure on Cisco's executives to stabilize the stock price and, if possible, push it back up higher. Thus, when reporting Cisco's 1stQ F01 results in early 11/00, Cisco's top executives knew it was critical to continue its trend to again "beat the Street" by one cent per share, and present a very positive picture about the state of Cisco's business and the outlook for the Company to convince investors and analysts that Cisco's business was strong and its growth prospects remained intact.
237. On 11/6/00, Cisco issued a release reporting better-than-expected 1stQ F01 results (the period ending 10/28/00), stating:
Net sales for the first quarter of fiscal 2001 were $6.52 billion, compared with $3.92 billion for the same period last year, an increase of 66%. Pro forma net income ... was $1.36 billion or $0.18 per share for the first quarter of fiscal 2001, compared with pro forma net income of $814 million or $0.11 per share for the first quarter of fiscal 2000, increases of 67% and 64%, respectively.
238. On 11/7/00, The Wall Street Journal reported:
Cisco executives said they remained as optimistic as ever. "We continue to see more opportunity than we're able to fund," said Chief Executive John Chambers. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 151 of 223
Indeed, Chief Financial Officer Larry Carter urged analysts to increase their estimates for revenue and earnings for the fiscal year ending next July. Mr. Carter said Cisco expects fiscal-year revenue to grow 50% to 60%, faster than its traditional guidance of 30% to 50% growth. He urged analysts, who now expect Cisco to earn 72 cents to 75 cents a share for the year, to raise those estimates by two cents to five cents a share.
* * * Chief Financial Officer Larry Carter said Cisco had sharply increased the amount of revenue it deferred from sales through resellers or Cisco's financing arm, suggesting continued strong revenue growth ahead. * * * Mr. Chambers said Cisco had been able to avoid the missteps of its competitors and other tech giants because of its unusually diverse customer base. Bookings from big companies, small companies and telecommunications carriers each grew more than 50% annually, as did bookings in each major geographic area.
"It is this balance that dramatically differentiates us from all our competitors," Mr. Chambers said.
* * * Inventories grew far faster than sales, climbing 59% to $1.96 billion, from $1.23 billion on July 29. Cisco officials said they had stockpiled some components to guard against potential shortages, and built up inventories of finished products to reduce lead times, which had stretched beyond three months in recent months. Mr. Carter told analysts that Cisco would maintain higher levels of inventory for at least another three months.
239. On 11/6/00, subsequent to the release of its 1stQ F01 results, Cisco held a conference call for analysts, money and portfolio managers, institutional investors and large Cisco shareholders to discuss Cisco's 1stQ F01 results. During the call, Chambers, Daichendt, Volpi and Carter stated:
• Cisco's better-than-expected EPS were due to exceptionally strong revenue growth resulting from strong demand for its products. Cisco's book-to-bill was over 1. Cisco saw more opportunities that it could fund. Cisco was as optimistic as ever.
• Cisco had been able to avoid the missteps of its competitors and other tech giants because of its unusually diverse customer base. Bookings from big companies, small companies and telecommunications carriers each grew more than 50% annually, as did bookings in each major geographic area.
• Cisco's sequential revenue growth was 14%, slightly lower than the previous quarter. This was due to seasonal factors and not slowing sales or demand.
• Cisco was accepting orders for its new Monterey 15900 optical switch.
• Cisco's business was exceptionally well developed in terms of products, size of customers and growth, which differentiated Cisco from competitors and insulated it http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 152 of 223
from weakness in any one product line, region or industry.
• Cisco's inventory turns declined while its inventories grew to $1.96 billion during the quarter from $1.23 billion on 6/29/00. However, this was due to a deliberate decision by Cisco to purchase more component parts that were in short supply and build more finished goods inventory to reduce lead times - due to continued strong demand.
• Cisco's days sales outstanding increased to 40 from 37 in the prior quarter. This was due to increased shipments near the end of the quarter due to better product availability and was not any cause for concern.
• Cisco's collections were on track. Cisco's vendor financing program was conservative and prudently managed. Cisco would not suffer any major losses on its vendor loans. Cisco was deferring revenue recognition on its structured loans. Cisco had no major vendor financing loan losses and its accounting practices were very conservative.
In follow-up one-on-one conversations with analysts, Chambers and Carter also stated:
• Cisco's expected SP order growth to reaccelerate to double digits in the 2ndQ F01.
• Cisco was increasing its revenue growth forecast to 50%-60% and increasing its F01 revenue forecast to $29+ billion.
• Cisco was increasing its F01 EPS forecast to $.74-$.80.
240. Following Cisco's 11/6/00 release (for its 1stQ F01) and conference call and discussions with Chambers and Carter, based on what Chambers and Carter told them, virtually every analyst that followed Cisco increased the forecasted revenue, net income and EPS for Cisco and the price target for Cisco's stock.
241. On 11/7/00, UBS Warburg issued a report on Cisco by Theodosopoulos, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.79 and forecast the following F01 quarterly EPS for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .21 Year $ .79
It also stated:
Cisco reported fiscal first quarter EPS of $0.18, which exceeded ... the consensus expectation of $0.17. The EPS upside was due to higher than expected revenues .... Guidance for the upcoming year is for revenue growth of 50%-60% .... After another solid quarter, we are raising our EPS estimates to $0.79 ... for fiscal 2001 .... http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 153 of 223
* * * The balance sheet remained strong as AR DSOs were 40 days, compared to 37 days last quarter .... We believe that collections were on track, but as product lead times improved toward the end of the quarter a corresponding change in shipment linearity adversely affected DSOs.... Cisco continues to build inventory primarily due to investment in key components under constrained supply, support for new product introductions, and continued stocking to reduce lead times to customers....
The company elaborated more on vendor financing. For Cisco Capital as a whole, the funded financing activity for 01 was approximately $625M. Of this amount, approximately 2/3 was related to operating and financial leases to quality enterprises and tier 1 service provider accounts. The remaining 1/3 was related to structured loans offered to higher risk service providers. Since inception of their financing program, structure loan commitments through Cisco capital to date totaled approximately $2.4B. Of this amount Cisco capital has funded approximately $600M. Cisco expects to fund the remaining $1.8B to be over next 2-3 years [sic], provided their customers meet the requirements that Cisco has established. Of the $600M in structured loans that have been funded to date, the company has deferred or reserved approximately 65% of that balance.
On a geographical basis, Cisco stated that the balance in geographical strength is the best in five years, with all major regions performing well.... It is this continued balance of the strength in the business which we believe was a key reason why Cisco maintains that revenues should grow in to 50%-60% range in 2001 ....
242. On 11/7/00, Deutsche Banc Alex. Brown issued a report on Cisco by Wade, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.79 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .22 Year $ .79
It also stated:
*** Cisco ... bests Wall Street consensus again. Book-to-bill above 1 and linearity was good.
* * * *** Cisco allays fears that financing could lead to problems due to CLEC concerns. Vast majority of $625 [million] is operating or finance leases with majority of structure leases in deferred revenue.
*** Guidance from Cisco is strong and consistent with prior guidance. Management http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 154 of 223
expects FY01 revenue growth of between 50% and 60% over FY00 and expects operating expense levels and operating margins to remain stable.
*** We are increasing our FY01 revenue and EPS estimates from $28.5 billion and $0.74, respectively, to $30.3 billion and $0.79, respectively....
Details:
Cisco Systems reported another strong quarter which we believe should help calm investors who believe that Cisco could suffer from the same problems that have plagued Lucent and Nortel. The quarter was, as advertised, excellent and offered no decreased guidance as in the recent cases of other telecom giants .... EPS for the quarter were ... a penny ahead of ... the consensus estimate.
* * * Cisco also spent a great deal of time detailing its financing operations to make sure investors understood that recent financing problems at some CLECs would not be reflected by material changes in write-offs or restatements. During the quarter, Cisco financed $625 million, a majority of which were operating or finance loans. Most of the revenue was deferred and Cisco has no material exposure to CLEC funding problems in Cisco Capital Corp. We foresee no problems for Cisco due to is financing subsidiary and view its practices as very conservative versus the rest of the industry.
... Cisco predicted that FY01 revenues would increase between 50% and 60%, a very bullish statement ....
243. On 11/7/00, Chase Hambrecht & Quist issued a report on Cisco by Neiberg, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.78 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .21 Year $ .78
It also stated:
Diversification Saves the Day; Estimates Revised Upwards
* Revenues and EPS ... exceeds our estimate ....
* * * * The overall outlook remains bright, based on global and product diversification, and the lack of dependence on legacy products.
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* Raising FY01 revenue and EPS estimate to $29.6 billion/$0.78 from $28.1 billion/ $0.75.
* * * Cisco['s] ... fiscal first quarter ... EPS of $0.18 was a penny ahead of ... consensus of $0.17 .... Inventory turns were about 5x, down from 6.7x, as the company holds more inventory to offset strong demand and component constraints. Overall, the quarter's results were again exceedingly strong, and reflect the company's broad product line, geographic diversity and various customer mix.
* * * Cisco's advantage is its lack of dependence on legacy products
In light of the recent results reported by Lucent Technologies and Nortel Networks, it is clear that one of Cisco's main advantages is its lack of dependence on legacy equipment, giving us a greater level of confidence that it can continue to grow rapidly, with many products growing well in excess of 50%.
244. On 11/7/00, First Union Securities issued a report on Cisco by Koffler, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.79 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .21 Year $ .79
It also stated:
- Cisco's 1Q01 results surpassed high-end expectations.... This is the 11th quarter in a row of year-over-year acceleration.
- Orders to the Service Provider market grew in the high single digits sequentially, below the corporate sequential revenue growth rate of 14%. The company cited issues in the U.S. service provider market, notably the CLECs. The company expects service provider order growth to re-accelerate to double digits in the 2Q01.
* * * - Raising EPS for F2001 from $0.75 to $0.79 .... Raising revenue for F2001 from $28.5 billion to $29.9 billion .... * * * Balance sheet results.... Inventory turns declined ... reflecting the need to keep more product on hand to fulfill customer demand as well as the need to reduce lead times in a supply-constrained environment. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 156 of 223
245. On 11/7/00, ABN/AMRO issued a report on Cisco by Leon, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.81 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .21 4th $ .23 Year $ .81
It also stated:
- Enterprise and small to medium business (SMB) segment revenues were stronger than expected while service provider revenues from access products was below expectations.
- Cisco reported bookings greater than 20% sequential growth for enterprise and SMB bookings while service provider bookings were high single digit. Management is intent on renewing double digit service provider growth next quarter.
- We are raising our FY2001 est from $0.74 to $0.81 ....
* * * Balance sheet metrics were strong .... [T]he book to bill ratio was greater than one....
What about vendor financing?
The financial data suggests this is not a big issue. Cisco maintains a conservative vendor financing business model, with operating leases and financing leases accounting for 2/3 of total financing. These leases usually last 2-3 years in duration and are usually given to top tier service providers and larger enterprise customers. The remaining 1/3 are structured loans. These are loans made to more risky service providers. Revenue from these loans is deferred at the time of shipment and revenue is recognized as cash payments from customers are received. Cisco also takes reserves for these loans. To date, Cisco has about $2.4 billion in structured loans, $600 million of which has been financed. During the quarter total vendor financing from Cisco Capital was about $625 million, or roughly 10% of total revenue.
246. On 11/7/00, McDonald Investments issued a report on Cisco by Rubicam, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.78 and stated:
CSCO reported F1Q01 EPS of $0.18, a penny above ... consensus of $0.17.... This represents the eleventh consecutive quarter in which CSCO's year-over-year revenue growth accelerated. The company raised its guidance for F2Q01 and full-year FY01 revenue growth, and we have accordingly raised our FY01 EPS estimate to $0.78 from $0.74 .... With all the concern that has recently focused on prospects for reduced growth http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 157 of 223
in capital spending by telecomm service providers, it was not surprising that much of last night's conference call was consumed by this issue. While CSCO management did, predictably, include the risk of such a slowdown in its quarterly list of concerns, the bulk of the commentary tended to confirm our view that spending on IP-based solutions is likely to remain robust. Service provider budgets may stay flat or grow more slowly, but this will be due to sharply lower spending on older circuit-based solutions that CSCO does not provide, and this mitigates the risk for CSCO.
* * * The optical business increased 40% sequentially and 500% year-over-year, and CSCO began accepting orders for the 15900 (acquired with Monterey Networks) in the quarter.
* * * Book-to-bill in the quarter was greater than 1.0.
* * * Financed deals in the first quarter again accounted for about 10% of revenue, including third party financing. Two-thirds of financing is for large enterprise customers and Tier 1 carriers, with the remainder being structured loans to CLECs and ISPs. These loans carry more risk, and are accounted for on a cash basis, with revenue only being recognized when payment is received. We continue to believe that CSCO's financing practices and accounting is very conservative, and do not expect this to be a source of concern.
* * * CSCO cited the usual list of concerns, including competition from start-ups and telco equipment vendors, the threat of continuing component constraints, the need to continue to be vigilant about lead times, and the risk of slowing economic growth. There was also a great deal of discussion centered on the recent slowdown in telecom service provider spending that has caused several of CSCO's peers to stumble. This is certainly a valid concern, since about 40% of CSCO's revenue comes from the service provider segment. However, we believe that CSCO's focus on IP-based solutions and other advantages will largely insulate the company from any ill effects stemming from reduced growth in service provider spending. CSCO's strategy is based on building the future communication infrastructure, not on preserving and transitioning legacy systems. An acceleration in the movement to IP-based solutions favors CSCO, while hurting its large telco equipment competitors. CSCO has a unique product portfolio that will ultimately address the needs of both service providers and end users, and has a huge installed base of enterprise customers that can be leveraged to drive its penetration of the service provider market. We also believe that service providers cannot afford to stop spending on the next-generation IP solutions that CSCO provides, and that spending on these solutions will remain robust even as spending on circuit-based solutions goes into decline.
247. On 11/7/00, J.P. Morgan issued a report on Cisco by Geiling, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.79 and stated:
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• Cisco reports Q1 EPS of $0.18, beating ... consensus by $0.01....
• Management reiterated their positive outlook despite rising concerns surrounding service provider spending.
• We are raising our 2001 EPS estimate to $0.79 from $0.75.
* * * Cisco posted its 11th consecutive quarter for accelerating year over year revenue growth .... Though sequential revenue growth of 14% was slightly slower than in the previous quarter, this is normal given the seasonal weakness normally experienced in the first quarter.
* * * In the optical front ... [t]he company also booked its first orders for the ONS 15900 platform (Monterey) in the quarter and expects trials of its Qeyton product in Q2 to be followed by commercial deployment in Q3. The division added 118 new customers in the quarter. Cisco also reported seeing a general shift in business toward tier one carriers versus CLECs.
* * * Moving to the balance sheet, accounts receivable grew $588 million to $2.9 billion, bringing DSO's up a further 3 days to 40 days, while inventory turns have come down to 6.0 from 7.8. Inventories rose $724 million to $1.96 billion, with the majority of the increase coming from raw materials which grew by $486 million to $631 million. The company attributed this significant rise in inventory levels to investment in key components to support new products as well as in an effort to bring down lead times, all while fighting an uphill battle with component supply shortages. Going forward, the company expects inventories will not begin to come down from their current level until the company is able to address its lead times which may take another quarter or two.
* * * Vendor Financing: Cisco went through their vendor financing status in great detail, addressing a topic that is of increasing concern to investors. Management explained they extend financing in one or three ways:
* Financial leases, where a sale is recognized and payment is received over a period of up to 3 years
* Operating leases, effectively rentals, where revenue is recognized on a pro rata basis over 2-3 years
* Structured leases, or loans, where the customer buys the equipment and then pays back a loan to Cisco. Revenue is generally deferred over the life of the loan and recognized as the loan is repaid. Structured leases are mostly to higher risk service providers, and as a result, Cisco has deferred and/or taken a reserve against 65% of these revenues as a conservative stance. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 159 of 223
Cisco has extended a total commitment of $2.4 billion as of the end of the October quarter, of which only $625mm has been drawn against. Of the $625mm, 2/3 can be classified as either financial or operating leases, with the remaining 1/3 being structured leases. Cisco feels they are being extremely conservative in their policy towards financing, but that given the market opportunities and Cisco's balance sheet, that extending vendor financing has both a strategic as well as a fiscally prudent component to it.
* * * As a result of its healthy performance in the quarter and positive outlook going forward, we have raised our EPS estimate to $0.79 from $0.75 for 2001. On the top line, we are now estimating revenues of $29.7 billion for 2001 (versus $28 billion previously).
248. On 11/7/00, Thomas Weisel Partners issued a report on Cisco by Edelen, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 and F02 EPS for Cisco to $.77 and $.92 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .20 Year $ .77
It also stated:
* ... We are raising our 2001 revenue estimate to $29.9 billion from $28 billion with our EPS estimate moving to $0.77 from $0.72.
* * * Summary of the Quarter
Cisco reported solid fiscal Q1 results yesterday .... EPS ... were $0.18 versus our estimate of $0.17 .... Visibility continued to be solid as book-to-bill came in above unity.
* * * Well Positioned to Combat Slowing CLEC Spending
The weakness of the CLEC spending cycle on communications equipment was very evident over the past months and on the Cisco call yesterday. Although this dynamic cannot be said to have passed by Cisco, we believe Cisco has done extremely well to insulate itself on the whole and position itself correctly overall in the marketplace. Cisco's service provider bookings grew 9% sequentially, versus the 20% witnessed last quarter, [due] in large part to the slowing CLEC marketplace. However, during the quarter, Cisco had an impressively balanced mix of products across geographies, product lines and business segments.... Our confidence in Cisco's ability to execute in this storm http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 160 of 223
stems from its momentum with incumbent service providers.... Cisco has an expansive product offering with multiple segments witnessing strong incremental growth in service provider accounts, especially as its optical platforms being to gain traction and represent more than 10% of revenues.
Inventory Built to Meet Demand
In the quarter, Cisco's inventory grew 59% in total dollars to land at $1.95 billion. Included in the increase is a $431 million increase in Raw Materials inventory, a $262 million increase in Work In Progress inventory, and a $122 million increase in Finished Goods inventory. We believe that the substantial aggregate sequential increase is largely a function of Cisco continuing to manage the supply chain to come in line with end demand. As such, we believe Cisco was very focused in the quarter and will continue to be very focused on bringing lead times down to more acceptable levels on the whole. In the quarter, Cisco made good progress on product lead times, but it is clear that more work needs to be done. We do not believe this trend of falling lead times and rising inventory is reflective of an end demand environment similar to that seen by Nortel, where some customers were double ordering to get product in an acceptable time frame. We expect inventory levels to remain at this level into the January quarter and then being to taper off in subsequent quarters.
249. On 11/7/00, Gerard Klauer Mattison issued a report on Cisco by Cristinziano, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.80 and forecast the following F01 and F02 quarterly results for Cisco:
EPS/2001 EPS/2002 QTR 1st $ .18A $ .24 2nd $ .19 $ .25 3rd $ .21 $ .27 4th $ .22 $ .28 Year $ .80 $1.04
It also stated:
• 1Q01 operating EPS, of $0.18 ... exceeded ... consensus by $0.01. Cisco reported revenue of $6.5 billion ... on strong sales across all lines of business and geographies. Revenue growth accelerated for the eleventh consecutive quarter and book-to-bill was again greater than one....
• Service provider bookings were weaker than expected, but confidence in rebound voiced by management.... Management confidently stated it expects a return to double-digit sequential service provider bookings growth in Q2.
• Company sheds light on its conservative leasing company, Cisco Capital. The company has committed $2.4 billion in structured loans to date. However, only $600 million has been funded to date and 65% of which has been reserved. Generally, Cisco only recognizes revenues on the product portion of such loans when payment is http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 161 of 223
received. In 1Q, the company had $625 million in financing arrangements, 2/3 of which were capital leases and operating leases to financial[ly] strong customers and 1/3 of which were of the more risky structured loan type. Only a "small portion" of the $625 million was recognized as revenue in the quarter, indicating there is minimal risk associated with Cisco Capital, in our opinion.
... We are increasing our revenue and EPS forecasts for FY01 due to better-than- anticipated execution during FY01 and a very positive outlook. Our new FY01 revenue and EPS estimates are $30 billion (from $29 billion) and $0.80 (from $0.75), respectively.
250. On 11/7/00, A.G. Edwards issued a report on Cisco by Andrew, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.80 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .22 Year $ .80
It also stated:
Cisco announced results ... that once again came in a penny above expectations.... The quarter was very strong and Cisco continues to execute amazingly well .... Overall, Cisco's outlook remains very bullish for the markets they address as they continue to experience strong demand for their products. The company is in fact guiding analysts higher in terms of revenue and earnings expectations.... [W]e are increasing anticipated revenues for fiscal 2001 to $29.8 billion up from $28.4 billion.... [W]e are raising our earnings estimates from $0.75 to $0.80 for fiscal 2001 ....
* * * Inventories increased $724 million to $1.96 billion due to investment in key components given supply constraints, support for new product introductions, and continued stocking to reduce lead times to customers. This resulted in 6.0 inventory turns versus 7.8 last quarter. Cisco stated that they will continue to carry higher inventory levels until lead times to customer return to acceptable levels which should occur for most of their products to within a quarter or two.
251. On 11/7/00, Wachovia Securities issued a report on Cisco by Hunt, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.79 and forecast the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 162 of 223
3rd $ .20 4th $ .21 Year $ .79
It also stated:
Cisco's Numbers Exceed Expectations; Future Prospects Remain Positive. Fiscal Q1: 2001 revenue of $6.52 billion ... and pro forma EPS of $0.18 ... exceeded expectations .... This past quarter represented the 11th consecutive quarter that Cisco has posted accelerating year over year revenue growth. Solid numbers were driven by strong growth in all lines of Cisco's business, exhibiting exceptional balance. In fact, bookings in all of its business lines grew in excess of 50% on a year-over-year basis....
Carrier Spending Should Remain Strong for Cisco's Products. Robust Internet growth continues to drive the demand for carrier IP services, IP plus optical networking, and content. Furthermore, the movement to mobilize the Internet is forcing carriers to embrace packet switching technologies. Altogether, as data growth continues to outpace that of voice, TDM spending has flattened or is declining as opposed to packet infrastructure spending that is growing or accelerating. Management also highlighted a point that we have made often made [sic] that actual carrier spending typically exceeds the preliminary budgeting forecasts that we are not seeing. On an international basis, Cisco's management also made clear that financing and capital spending growth are not expected to see any similar concerns with what has been publicized here domestically.
... We are raising our FY 2001 revenue estimates by $1.32 billion to $29.7 billion (+57% year over year) and raising our EPS estimates by $0.05 to $0.79 versus $0.53.
252. These statements were directly contrary to a report entitled "The Worldwide Channels Tier-2 Reserve Package," which top management (Chambers, Carter) had received in 10/00 that warned that customer demand was slowing; that large orders already placed by customers would likely be cancelled since Cisco's sales channels were already stuffed by this time with excess Cisco product; that "blanket" purchase orders which Chambers had caused to be issued to vendors in 6/00 would result in excess inventory and lead to a huge write-off in the future; that a high amount of returned product would come in from overstocked customers; and that Cisco was building inventory the market did not want. The report forecast F01 revenues of $26 billion. Rather than advise the market of this adverse news, Cisco's top management told the financial staff to increase revenue forecasts by 25% even though there was no justification to do so.
253. On 11/10/00, UBS Warburg issued a report on Cisco by Theodosopoulos, after discussions with Chambers and Carter, which was based on and repeated information provided by them. The report increased the forecasted F01 EPS for Cisco to $.79 and also stated:
Cisco reported fiscal first quarter EPS of $0.18, which exceeded ... the consensus expectation of $0.17. The EPS upside was due to higher than expected revenues ....
* * * The balance sheet remained strong, with AR DSOs of 40 days compared with 37 days in the prior quarter.... [C]ollections were on track, but as product lead times improved http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 163 of 223
toward the end of the quarter, a corresponding change in shipment linearity adversely affected DSOs. Inventory turns declined to 4.9 from 6.7 last quarter, as Cisco continues to build inventory primarily due to investment in key components under constrained supply, support for new product introductions, and continued stocking to reduce lead times to customers.
254. On 11/14/00, Cisco executives Ammar Hanafi and Blair Christie appeared at the Deutsche Banc Alex. Brown Tech 2000 Conference. In a formal presentation and in break-out sessions, they told the assembled analysts, money and portfolio managers, institutional investors, brokers and stock traders that:
• The Company was on track to achieve its goals in the optical market.
• The Company's growth rate and prospects continued to be extremely positive.
255. On 11/14/00, Deutsche Banc Alex. Brown issued a report on the Cisco presentation at the Tech 2000 Conference, stating:
* Ammar Hanafi (VP Business Development) and Blair Christie (Manager of Investor Relations) spoke at our Tech 2000 Conference and reiterated their bullish outlook on the future prospects of the company.
* Cisco's plans to be the "number one or two vendor in any sector in which it competes" was reiterated. Although many once doubted that Cisco could achieve this goal in the optics market, it now seems likely that management could achieve this goal in one or two years - a remarkable feat considering the relatively small optics base from which the company started in the not so distant past.
* We believe that Cisco is likely to continue its strategy of growing through acquisition where necessary, however, the strategy will increasingly target companies in the earlier stages of their development. Cisco has one of the highest acquisition success rates in the industry, with more than 3 in 4 being successful and a similar percentage of CEO's staying on board after integration.
256. On 12/1/00, the following ran on Bloomberg:
Cisco Systems Inc., the world's largest maker of Internet equipment, expects its Asian sales for the fiscal year ending July 2001 to grow faster than elsewhere, as phone companies in the region spend more on networking products.
The region accounted for about 10 percent of Cisco's revenue in the fiscal year ended July 31 and grew by an average of 80 percent in the past two years as against 50 percent in the U.S.
"In Asia, we continue to see very aggressive numbers," said Gary Jackson, vice- president of the San Jose, California-based company's Asian operations in an interview. "Asia is our fastest growing piece of business."
257. Each of the statements made between 11/6/00-12/1/00 were false or misleading when issued. The http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 164 of 223
true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 1stQ F01 revenues, net income and EPS through several accounting tricks in violation of GAAP, including the following:
(i) When certain products were in short supply and Cisco could not ship as much fully manufactured and functioning product as was necessary to meet its internal revenue goals, at the end of the quarter Cisco would ship empty shells of those products, i.e., plastic casings which did not contain internal working parts, recording and reporting the revenue on such shipments in that quarter, then providing customers functional working product in the following quarter;
(ii) Via the so-called "yellow line" scheme, Cisco improperly recorded and reported revenue when product in its warehouses or shipment centers was moved across a "yellow line" in the facility, but not actually shipped to a customer;
(iii) By closing a quarter "early" when sufficient revenue had been created to enable Cisco to beat the consensus Street EPS forecast for that quarter by $.01, thus carrying revenue over into, and inflating, the next quarter's results, thereby manipulating its results to mislead the market;
(iv) By improperly recording and reporting revenue on shipments of products to uncreditworthy customers where Cisco had loaned 100% of the sales price of the products and which customers would likely never repay in full the loans made by Cisco;
(v) In connection with making vendor-financed loans to uncreditworthy customers to purchase Cisco equipment, Cisco frequently required customers to purchase significant additional amounts of equipment the customers did not need and did not want, which Cisco knew would reduce demand for Cisco's products in the future. Some of this equipment was not working and had expired warranties;
(vi) By not adequately reserving for vendor financing loans it had made or recording revenue on shipments of product to uncreditworthy customers who Cisco knew would likely be unable to repay in full their loans from Cisco;
(vii) Cisco frequently shipped products at the end of the quarter to warehouses in order to make their quarterly numbers. The product would sit in warehouses for an indeterminate amount of time or, for customers like Xerox, the product went directly to the customer who did not want it and would return it. As an example, at the end of 2ndQ F01, Cisco shipped millions of dollars of equipment from its San Jose facility to a Federal Express warehouse facility in San Jose for storage;
(viii) By recognizing revenue on shipments to distributions prior to end-user customers being identified;
(ix) Duplicate orders from customers were recorded as sales throughout 00, but product was returned leading to inventory build-up;
(x) Cisco utilized third-party intermediaries, such as Sunrise Capital, Deutsche Bank, GE Capital, American Express, and Silicon Valley Bank, to facilitate sales to customers who were not tier-one customers. Cisco guaranteed payments to these entities in case these customers defaulted on their loans; and http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 165 of 223
(xi) Cisco booked large deals before quarter-end to CVAPs and CVARs without required terms completed. The Special Handling Deals List set forth those transactions. For example, Cisco booked orders from CVAP Timebridge, even though the ultimate customer (Nextel) was not ordering the product.
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶257(a)(i)-(xi).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues detailed above in ¶257(a)(i)-(xi).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customers did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(v) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vi) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) The growth in Cisco's inventory of component parts, work in progress and finished goods during the 3rdQ and 4thQ F00 was not the result of any deliberate decision on the part of Cisco to increase its inventories to secure necessary supplies of custom-made component parts or to build more finished http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 166 of 223
goods to attempt to reduce lead times on customer shipments due to continuing strong demand for Cisco's products. Rather, it was due to a slowdown in demand for Cisco's products which was resulting in a sharp build-up in component parts inventory which Cisco could not control or halt because Cisco had secretly entered into several long-term, non-cancellable supply contracts for over $3 billion in component parts; as a result, Cisco was rapidly accumulating hundreds of millions of dollars of excess, unusable, unsaleable and over-valued inventory of component parts, work in progress and finished goods.
(f) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa Four switch product had substantial technical defects and quality problems that were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(g) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(h) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. For example, Cisco loaned approximately $40 million to Onetel, Limited, a company losing money that eventually went bankrupt. ICG, Comindigo and Resilient were other uncreditworthy companies to which Cisco provided funds. Cisco also loaned money to Vectris Communications and continued to sell equipment to Vectris in 00 despite knowing that Vectris was in financial distress, which resulted in its filing bankruptcy. Cisco's senior management, including Cisco's Credit Board, was aware on a weekly basis during 00 of the severe problems with the vendor financed loan portfolio as a result of a Deloitte & Touche review. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. One customer, AMC, received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(i) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipment to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor financed loans, as represented. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 167 of 223
(j) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(k) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(l) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(m) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey, PixStream, Cerent and Pirelli) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(n) The statement that Pirelli gave Cisco the industry leading DWDM equipment was false as the equipment was behind competitors' products and the statement about a customer base of 300 for these products was false. In fact by 7/20/01, the Pirelli product would only have 25 customers which would include those who Cisco helped finance.
(o) Cisco's Pirelli acquisition was a failure as it has been unable to develop new technology to increase the capacity of fiber optic networks and has been eclipsed by Nortel and Ciena. In fact, Cisco's sales of Pirelli products in 00 was $180 million, less than Pirelli's pre-acquisition sales of $218 million in 99.
(p) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 168 of 223
(q) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s.
(r) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps.
(s) The proposed PixStream acquisition was a failure and would within months result in a huge write- down of $300 million.
(t) Contrary to Cisco's representations that the decline in its stock price would not hurt its acquisition program, by 10/00, the decline in Cisco's stock price meant that Cisco's pace of acquisitions would slow dramatically, if not come to a halt, which would adversely impact Cisco's ability to achieve the growth it had forecast or obtain the new technology it needed to remain competitive.
(u) Contrary to Cisco's representations that a decline in service provider capital expenditures would hurt it less than its rivals, in fact, it would hurt Cisco as much if not more because Cisco had already shipped out more product than its customers desired, which customers had accepted so that they could get Cisco-backed financing. Thus, not only would the cutbacks hurt future sales, but they would result in defaults and returns.
(v) Contrary to Cisco's representations that an economic slowdown would benefit it, that Cisco would actually be better off if the market stayed tough for the next 12-18 months and that Cisco would grow in good times and bad because most of Cisco's revenues came from commodity router products, demand for which was very much dependent on and impacted by macro-economic growth, an economic slowdown, tough market and bad timing would very adversely impact Cisco's business and growth.
(w) Contrary to Cisco's representation that product prices were stable and it was not seeing pricing pressure from Lucent, in fact, by Fall 00 there was severe price-cutting in the marketplace due to weakening demand and intensified competition with Lucent and Nortel, which was adversely impacting Cisco's revenues and profitability.
(x) The decline in the order and sales rate for the SP part of Cisco's business and for Cisco overall in the 1stQ F01 ended 10/28/00 was not due to seasonal factors and was not temporary as represented; in fact, it represented a fundamental drop-off in demand and was an extremely negative development and trend which was continuing and was having a very adverse impact on Cisco's growth, revenues and profits. In fact, Cisco's 1stQ F01 results were inflated by "pull-ins" of orders from 2ndQ F01.
(y) Contrary to Cisco's assurances that its Asian markets, including Japan, were recovering from prior slowness and that Cisco was seeing strengthening sales there, in fact, demand for Cisco's products in Asia and Japan remained soft and was not improving in any material way.
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(z) Cisco's sales representatives pressured resellers/CVAPS (such as SBC Datacom, Bay Data Consultants, Solarcom, Ameritech, and G.E. Capital IT Solutions) to place orders in advance of end- user commitments.
(aa) Cisco executives had knowledge of declining sales to telecommunications companies because these entities made purchasing commitments 6-12 months in advance. Cisco was experiencing a sales shortfall in Summer 00 in various regions. Order Status Reports for the Central Region showed declining sales from Spring 00 forward. Cisco's Professional Services Group was experiencing declining numbers in Summer 00. By Fall 00, software revenues were 20%-30% below projections for 1stQ F01. Cisco was reducing and cancelling orders from suppliers (such as Insight Electronics) in 8/00-9/00 due to weakening demand.
(bb) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(cc) Cisco's acquisition of Infogear, a maker of an Internet appliance product, was a disaster. Cisco was shipping product even though the product did not work. One major customer - Big Planet - eventually returned a significant amount of product due to product defects. Cisco eventually discontinued the whole product line.
(dd) In 10/00, Chambers and Carter received a worldwide forecast report which was based on forecasts from each sector in the world which indicated that F01 and F02 revenues would be much lower than published forecasts.
(ee) Because of Cisco's improper sales practices, it was required to reduce reported revenue by the expected amount of returns and non-collectibility. Cisco offered unlimited return rights for defective products and at least 10% of shipments for any reason. Additionally, Cisco would accept returns as a matter of practice to protect relationships with customers. During mid-00, Cisco's internal financial staff calculated a reserve of 22% on invoiced shipments to distributors. Because of the adverse effect this would have had on earnings (i.e., Cisco would not beat projections by one penny), Cisco's financial management (under Carter) told the staff that the reserve could not be more than 20%. Ultimately due to the under-reserving, after the Class Period the reserve needed to be increased to 35%, which was included in the charges taken in the $2.5 billion write-off in 4/01.
(ff) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-60% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
258. Despite Cisco's bullish presentation after releasing its 1stQ F01 results and bullish presentation at the Tech 2000 Conference in mid-11/00, Cisco's stock continued to decline from $57-5/8 on 11/7/00 to as low as $45-3/16 on 11/30/00. This sharp decline in Cisco stock exacerbated the problems Cisco was having in continuing its vitally important acquisition program and on which its business plan was largely dependent. This decline was also wiping out hundreds of millions of dollars of value in the http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 170 of 223
stock options of Cisco's top executives, managers and employees. Chambers and Cisco's other top executives were desperate to halt the decline in Cisco's stock. To make matters worse, rumors were now circulating that demand for Cisco's products was weakening and that Cisco was accumulating excess inventory. Cisco's executives knew they had to dispel these rumors to stabilize Cisco's stock and push it back up to higher levels. Cisco's annual Analyst Conference was scheduled for 12/4-5/00 - a tremendously important event attended by hundreds of analysts. To do this, they knew they had to present a very positive picture of Cisco's business and prospects at its 12/4-5/00 Analyst Conference and assure analysts and investors that Cisco's acquisition program and growth prospects were intact.
259. On 12/2/00, the following ran on Bloomberg:
Cisco Expected to Give Upbeat Presentations at Analyst Meeting
... Cisco Systems Inc. Chief Executive John Chambers and other top officials likely will give upbeat presentations at the company's analyst meeting Monday and Tuesday, analysts said.
* * * Investors will listen for hints as to whether Cisco's business of selling equipment to telecommunications equipment is recovering ....
Orders in that business for the quarter ended Oct. 28 increased from the previous quarter by a percentage in the "high single digits," while revenue rose 15 percent. Chambers said last month he "would be surprised and disappointed" if the order rate doesn't return to double digits this quarter.
"If they can show people that they are on target for that, I think that will really help them a lot," Lauria said.
When Cisco reported fiscal first-quarter results on Nov. 6, Chief Financial Officer Larry Carter said the company expects fiscal 2001 revenue to grow 50 percent to 60 percent. Fiscal second-quarter revenue will rise from the first by a percentage in the "high single" or "low double" digits, he said.
260. On 12/4/00, Cisco executives Chambers, Carter and Volpi appeared at the Cisco Analyst Conference in San Jose, California. In formal presentations and break-out sessions, they told the assembled analysts, money and portfolio managers, institutional investors, brokers and stock traders that:
• Cisco had never been more bullish on the market opportunities for Cisco; Cisco had never been more optimistic.
• Cisco was not changing its prior forecasts of 50%-60% annual revenue growth, sequential quarterly revenue growth of 10+%, F01 revenues of $30 billion and F01 EPS of $.78-$.81.
• Cisco was continuing its rapid acquisition program which would continue at or near the 00 pace of two per month.
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• Cisco was seeing strong growth in Europe and Asia.
• Cisco's optical business was enjoying exceptionally strong growth.
• Any downturn in the economy would probably help Cisco as companies would spend more on technology to cut costs. Cisco would grow in good times or bad.
• The prior quarter's slowdown in SP orders was temporary and due to the timing of new product launches, not weakening demand. Cisco was now enjoying stronger than plan results in the optical and service provider business lines. Upcoming results would show reaccelerating growth.
• Cisco's inventories were up due to the Catalyst 4000 and 6000 products which continued to experience tremendous demand, requiring Cisco to increase component part supplies and finished goods inventory. Cisco expected its inventory situation to normalize in two quarters. The rise in inventories had been planned and expected.
• Cisco had seen no adverse changes in conditions despite the emerging economic slowdown.
• Cisco's vendor financing program continued to be prudently administered and conservatively accounted for.
• Cisco's business was not only strong but improving. Cisco was not seeing any price- cutting.
• Cisco's unique Executive Information System gave its top executives the ability to continually monitor critical business information and data, such as sales, discounts, and channel inventory by product and region. This gave Cisco exceptional visibility into its current business conditions and its future results.
261. On 12/4/00, Chambers was interviewed on CNBC:
MARIA BARTIROMO, CNBC ANCHOR, STREET SIGNS: ... Cisco ... executives are meeting with analysts in San Jose, California....
Let's find out what Cisco is telling the analyst community. We're joined now by the company's CEO, John Chambers.... What's going [on] in that meeting?
CHAMBERS: Well, it's a chance for us to outline where we see the market and what Cisco's strategy is over the next three to five years and why we think there's a chance for us to break away if we execute properly. So it is a chance really to exchange views.
MARIA: OK. And what is the viewpoint for the next three to five years as far as revenue growth?
CHAMBERS: Well, I think the market has never been more bullish in terms of the opportunity for Cisco if we execute properly. The business drivers from the CEOs of http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 172 of 223
both enterprise customers and service providers are extremely strong.... Our geographic balance is very, very good....
MARIA: So are you still looking for revenue growth of 50 or 60 percent like you have been delivering?
CHAMBERS: Well, I think that's where the industry analysts have it. Over the long term we've always said 30 to 50, but we had the analysts go up on us this last quarter after our quarterly conference call. I think my CFO, Larry Carter said high single digits for this next quarter to low double digits. Our guidance has not changed at all. I'm probably more optimistic about the market going forward than I've ever been.
262. On 12/4/00, Bloomberg reported:
Cisco Systems CEO Chambers Says Acquisition Pace Won't Slow
... Cisco Systems Inc. Chief Executive John Chambers said a slumping market for computer networking stocks won't slow the No. 1 Internet equipment maker's acquisition strategy.
"We are the white knight in many ways," Chambers said, speaking to a packed ballroom at the company's analyst meeting in San Jose, California.
In his remarks, Chambers tried to emphasize that Cisco has an opportunity to "break away" from its competition. The company has made 22 acquisitions this year.
Chambers also took pains to spell out that the company was not changing its financial forecasts in any way.
Before the meeting began, investors speculated that the company might surprise analysts with lower forecasts. That proved to be unfounded.
"We aren't changing guidance, nor should you interpret any comment as changing guidance," Chambers said.
263. On 12/5/00, The Wall Street Journal reported:
Cisco Holds to Bullish Growth Projections Despite Cloudy Skies for Tech Industry
Cisco Systems Inc. reaffirmed its bullish projections of rapid growth, despite ... new economic clouds.
"I have never been more optimistic," said John Chambers, Cisco's chief executive, before roughly 500 analysts at a Cisco-sponsored conference in San Jose, Calif. "There are no changes to the guidance."
That guidance to analysts a month ago indicated that Cisco's revenues will increase about 10% for the current fiscal quarter ending in January, as compared with the preceding quarter, and will rise more than 50% for the fiscal year ending July. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 173 of 223
* * * Reductions in capital spending by businesses? "We are not immune," Mr. Chambers said, "but we will not be affected as much as others."
* * * The "law of large numbers," which makes it progressively hard[er] for $20 billion-a-year titans such as Cisco to keep growing at the same rate? "The size of a company does not affect your ability to grow," Mr. Chambers said. "Our challenge is more what markets we don't go into than which one we do go into."
264. On 12/5/00, USA Today reported:
Cisco CEO reassures as concerns about growth percolate
... Despite the stock-market swoon and a slowing economy, Cisco Systems CEO John Chambers told analysts Monday that the networking behemoth would dominate more new markets, keep buying companies and continue its strong yearly revenue growth of 50% or more.
* * * Chambers said any downturn could be good for Cisco as companies try to cut costs and increase productivity by upgrading their computer networks.
* * * Chambers also said that Cisco would keep surging into Asia, Europe and Latin America, which are starving for technology. Cisco's growth rates in countries abroad already are running about 50% a year.
265. On 12/5/00, J.P. Morgan issued a report on Cisco by Geiling, which was based on and repeated information provided by Cisco at its 12/4-5/00 analyst meeting. The report forecast F01 EPS of $.79 for Cisco and stated:
CISCO HOSTS ANNUAL ANALYST MEETING - DAY 1 SITUATION NORMAL - ALL SYSTEMS GO
* * * * Cisco management hosted the first day of their annual analyst conference yesterday. The tone of the meeting was one of confidence and reassurance.
* ... [T]he company did reaffirm its previous revenue and EPS guidance for the current quarter and FY01.
* * * [T]his confidence stems from their traction with the greatest breadth of customers as well as Cisco's exposure to the fastest growing segments of the industry, namely IP and metro Optical systems, with no exposure to slower growing legacy businesses. We believe that this diversity in revenue sources, on a product, customer, and geographic basis, should enable the company to meet and exceed their guidance for 50-60% revenue http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 174 of 223
growth and over 50% EPS growth in FY2001.
266. On 12/5/00, McDonald Investments issued a report on Cisco by Rubicam, which was based on and repeated information provided by Cisco at its 12/4-5/00 analyst conference. The report forecast F01 EPS of $.78 for Cisco and stated:
We attended the first day of CSCO's two-day analyst conference yesterday, and we would describe the overall tone of the session as very positive.
267. On 12/5/00, Wachovia Securities issued a report on Cisco by Hunt, which was based on and repeated information provided by Cisco at its 12/4-5/00 analyst conference. The report forecast F01 EPS of $.79 and the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18 2nd $ .19 3rd $ .20 4th $ .21 Year $ .79
It also stated:
No Change in Guidance - Outlook Remains Bullish. We are in attendance this week at Cisco's annual two-day analyst meeting, which highlights the company's product lines and overall business strategy. Cisco yesterday, led by its CEO, John Chambers, reaffirmed its growth targets and also mentioned that it will not ease up the pace of its investments/acquisitions. Specifically, the company was making no change to its projection of sequential revenue growth of 10% or more in the current quarter and annual growth of between 50 and 60%. Accordingly, our estimates remain unchanged as the company's outlook remains, in our opinion, very bright. Our estimates call for FY 2001 revenue of $29.7 billion ... producing an EPS estimate of $0.79 versus $0.53 ....
Meeting Highlights:
* Cisco Believes It Can Grow in Good Times or Bad. The company also highlighted that two to three percent GDP growth is fine for them to succeed and that the company can grow in good times or bad. Specifically, the company mentioned that they liked negative inflection points because it allowed them to gain market share when the markets they serve are in a disruptive state....
* Size Is Not Regarded As An Obstacle For Growth. Cisco's size, which has come into question lately, was not an obstacle to maintaining its growth rate, according to management. The company specifically said that the size of the company does not dictate how fast it can grow and that it only determines how you empower your company for future growth.
268. On 12/5/00, Dain Rauscher Wessels issued a report on Cisco by Wadhwani, which was based on and repeated information provided by Cisco at its 12/4-5/00 analyst conference. The report forecast http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 175 of 223
F01 EPS of $.79 and F02 EPS of $1.00 for Cisco and stated:
UPBEAT CISCO ANALYST MEETING HIGHLIGHTS BULLISH OUTLOOK
* * * Chambers kicked off the meeting by reiterating that guidance for the fiscal January quarter has not changed and that Cisco remains bullish about outlook going forward.
* * * The afternoon question and answer session highlighted the following:
Inventories: A large portion of the inventories in the October quarter was to support the Catalyst 6000 product, which continues to experience tremendous demand. While lead-times for many products have come down, the situation has not yet returned to normalcy.
Outlook and Exposure to the CLEC market: The outlook remains very bullish. Cisco's total exposure to the CLEC market is about 20% of total service provider revenues.
269. On 12/6/00, Wadhwani of Dain Rauscher Wessels issued another report, stating:
* The inventory situation is expected to normalize during the next two quarters.
* * * Larry Carter, Senior Vice President and Chief Financial Officer: Larry Carter highlighted that information is key to differentiation. The continuous monitoring and analysis of critical information by management at Cisco is key to effectively running the business. Cisco's focus remains revenue growth, gaining market share, and profitability....
Inventory: On the inventory situation, Carter drove home the point that Cisco had in the early part of this year, eluded [sic] that it would build inventory. Essentially, lead times for components were increasing while at the same time business was accelerating. In order to continue to satisfy customer demand and reduce lead time for its products, Cisco had to build inventory. The situation in the October quarter was exasperated due to the fact that a couple of vendors decommitted; consequently, Cisco could not ship certain products despite having all the other components to manufacture the product. A large portion of the inventory in the October quarter was due to the Catalyst 4000 and Catalyst 6000 products, both of which are experiencing tremendous demand. Cisco hinted that during the time when it experienced long lead times from its component suppliers, it lost between 5%-10% market share in certain product categories. Cisco expects the inventory situation to normalize in approximately two quarters.
Vendor Financing: Vendor financing in the last quarter totaled $625 million, more than two-thirds of which was operating or sales leases. The remaining third was for structured loans, which are riskier investments. Nevertheless, revenues from structured loans are only recognized when Cisco is paid. Additionally, any time the structured loan includes products from third parties, reserves are taken immediately against that portion. Cisco capital grew 100% year over year, and for 2001, a similar growth rate is expected. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 176 of 223
Pricing Pressure: Cisco has not seen any recent pricing pressure in the market from Lucent.
270. On 12/5/00, Morgan Stanley Dean Witter issued a report on Cisco by Stix, which was based on and repeated information provided by Cisco at the 12/4-5/00 Analyst Conference. The report forecast F01 EPS for Cisco to $.79 and the following F01 quarterly results:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .21 Year $ .79
It also stated:
* Day One: Bullish High-Level Presentations
* * * * Financial guidance affirmed.
CSCO reaffirmed guidance of 50% revenue growth for 2001 and fiscal Q2 :01 sequential revenue growth in the low single/high double digits.
* * * Guidance Affirmed - Visibility Remains Strong
CSCO ... reaffirmed guidance of 50% to the high 50s Y/Y revenue growth for 2001, and sequential revenue growth in the high single/low double digits for Q2 :01. The company continues to have very strong visibility ....
* * * Continue To Be Aggressive With Financing
Cisco did not back off of its financing plans, and continues to view it as a very effective way to secure business. We believe that company will continue to finance young service provider companies. We also believe that the company will continue to fully reserve revenues very conservatively.
271. On 12/6/00, Merrill Lynch issued a report on Cisco by Ching, which was based on and repeated information provided by Cisco at its 12/4-5/00 Analyst Conference. The report forecast F01 EPS of $.79 for Cisco and stated:
Day 2 Just as Upbeat as Day 1
* * * Financial Review by CFO http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 177 of 223
Larry Carter highlighted the financial innovation within Cisco, namely the virtual close. The company is using its advanced IS systems to drive financial performance. For example, management has the ability to track revenue, discounts, and product margins on an hourly basis. Other variables such as expenses, headcount, and market share are tracked on a weekly, monthly, or quarterly basis.
* * * Further, Cisco's superior financial management ... includes management of inventory ....
Inventories - Increase Planned - Cisco cited two main reasons for the surging level of inventory: 1) desire to reduce cycle time for high demand products, and 2) shortages of key components, which force the rest of the bill-of-materials into inventory. The rise in inventories was planned and expected....
Vendor Financing - Conservative Accounting - Cisco uses three basic financial products: financial leases, operating leases and structured loans. Management believes they use conservative accounting to recognize revenues associated with these products: with financial leases, revenues are recognized when products ship; with operating leases, revenues are prorated over the duration of the lease; with structured loans, revenues are typically deferred. The structured loans make up about one-third of the $625 mil. in outstanding financing and carry more risk. A portion of the structured loans could also be applied to the purchase of non-Cisco equipment; in this case, the company takes a reserve against that portion of the loan.
272. On 12/6/00, ABN AMRO issued a report on Cisco by Leon, which was based on and repeated information provided by Cisco at its 12/4-5/00 Analyst Conference. The report forecast F01 EPS of $.81 for Cisco and the following F01 quarterly results:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .21 4th $ .23 Year $ .81
It also stated:
Larry Carter, CFO, on enhancing and managing growth
After 6 years, Mr. Carter['s] ... achievements in bringing financial information to line executives and bringing senior management data in hours, weeks is legendary. Today, Cisco is a case model reviewed by leading companies around the globe.
* * * So, what Mr. Carter presented was how the role of finance has changed from collecting financial data to having a system for continuous monitoring and analysis of critical http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 178 of 223
information. The Cisco Executive Information System can drill down to day, geography, line of business, product sales channel, or customer/partner all the way down to specific account managers.
* * * Obviously, there was no change in financial guidance ....
273. On 12/6/00, Salomon Smith Barney issued a report on Cisco by Henderson, which was based on and repeated information provided by Cisco at its 12/4-5/00 Analyst Conference. The report forecast F01 EPS of $.77 for Cisco and the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .21 Year $ .77
It also stated:
SUMMARY
* Comments from Cisco analyst meeting consistent with solid fundamental outlook ....
* Despite growing evidence of weakening economic conditions and increasing pressures on the Service providers, Cisco presented an upbeat and reassuring outlook at the annual analyst meeting held in San Jose on Monday ....
* According to Cisco CFO, pricing is holding relatively steady.
* * * * Strengths enough to offset issues in the Service Provider market and a modest slow down in domestic economic conditions.
* * * Cisco Also Suggests Pricing Conditions Holding Relatively Steady. There's no doubt prices are declining for Cisco products, they are after all a technology company and that's par for the course. However, Cisco is indicating it isn't seeing any material change in conditions despite the economic slowdown at hand. Cisco's CFO stated during his presentation yesterday that pricing conditions remain fairly stable and that pricing is not an issue for gross margins. John Chambers added to these comments that pricing is not even in the top five criteria for most of Cisco's customers.
* * * Optical Remains Robust - Cisco Indicates Its Optical Business Remains Healthy And Ahead of Target.... According to Carl Russo head of the optical unit, while there are pockets of weakness among some CLECs, overall demand remains robust and Cisco continues to gain substantial share in the optical market place. Mr. Russo expressed http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 179 of 223
considerable confidence that Cisco will continue to deliver exceptional results in the optical arena and could reach number two status in the broader optical market over the next several years eclipsing Lucent and Alcatel.
* * * Cisco ... Expressed Confidence In Its Service Provider Business - Cisco Expect[s] the Service Provider Business To Sharply Reaccelerate. We had considerable opportunity to ask questions one on one with the head of Cisco's service provider operations. Cisco believes the third quarter slow down in Service Provider orders was temporary and reflected the timing of new product launches as well as program deployments. In response to our questions, Mr. Kennedy, head of the Service Provider business unit, indicated he believed stronger than plan results in the optical and content aware business lines were offsetting weakness within the CLEC end market segment. Mr. Kennedy specifically stated that the weakness in the most recent quarter was temporary and results should reaccelerate in the current quarter and beyond.
274. On 12/6/00, Wit SoundView issued a report on Cisco by Slocum, which was based on and repeated information provided by Cisco at its 12/4-5/00 Analyst Conference. The report forecast F01 EPS of $.77 for Cisco and stated:
We attended Cisco's two-day analyst meeting earlier this week. The company gave upbeat presentations on its future as a provider of end-to-end networks and as expected, gave no change in guidance....
Cisco is optimistic about its outlook and we would agree that the company's prospects are very strong....
Our Thoughts on Inventories
... Inventories were up significantly in the quarter, with most of the rise in raw materials. The company echoed what it has said in the past in that it would increase its investment in key components for new product introductions and to decrease lead times going forward. Cisco's business complexion is changing to be more driven by telecommunications service providers and we believe this is an environment where a build up of component inventories to shorten lead times is justified. Cisco will continue to carry the higher inventory until lead times come down over the next few quarters and has said that turns are not expected to improve in the current quarter.
As the company has seen the shortage conditions for parts abate, there have been rumors that Cisco's business is slowing down because some suppliers have not seen the same order flow they saw earlier in the year. The company feels that as hard as it struggled to keep up with demand, and ended up growing 66% for the year compared to its earlier estimates of 30%, it felt as though it could have gained more market share in the areas where parts shortages caused lead times to lengthen. Cisco was determined not to let that happen again. The company has worked on its forecasting process and believes its supply chain is in good shape to be able to deliver its needs in the future.
275. On 12/7/00, Deutsche Banc Alex. Brown issued a report on Cisco by Wade, which was based on and repeated information provided by Cisco at its 12/4-5/00 Analyst Conference. The report forecast http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 180 of 223
F01 EPS of $.79 for Cisco and stated:
Cisco management delivered a very upbeat message to attending financial and industry analysts at the company's 2000 Analyst's Day on December 4th and 5th. Management reiterated confidence in previous financial guidance, as well as its view of strong growth in the markets that the company addresses.
Cisco's optics business continues to experience exceptionably strong growth .... We view this feat as particularly remarkable, given the nominal sales levels that the company's optics business contributed only a year ago....
We believe that investor concern over high raw material inventories is easing. We believe that buildups of strategic components with relatively long lead times is prudent as the contribution of additional sales associated with the availability of these components far outweighs any inventory holding costs.
* * * We believe that Cisco management continues to be very conservative in its accounting for the structured loan portion of its vendor financing agreements. Cisco has generated $2.4 billion in structured loan vendor financing, of which, only $600 million has currently been funded. Reserves have been placed on over 60% of this $600 million. The company ... requires stringent financial and operational metrics to be achieved before funding is granted.
* * * In summary, we believe Cisco's business is not only strong, but improving. Management is very optimistic about the future prospects of the company in the face of investor concerns over service provider demand. We believe that Cisco's very diverse customer base, both geographically and by product line, is a core advantage that is relatively difficult to replicate. We see particularly strong growth going forward in the optics sector ....
276. In reaction to Cisco's exceptionally bullish Analyst Conference, Cisco's stock jumped from $45 on 12/3/00 to $53-9/16 on 12/6/00, a market capitalization increase of over $56 billion. The statements made at the 12/4-5/00 Cisco analyst conference set forth above were false or misleading when issued. The true but concealed facts were:
(a) As detailed in ¶¶292-327, Cisco manipulated upward and artificially inflated its reported 1stQ F01 revenues, net income and EPS through several accounting tricks in violation of GAAP, including those described in ¶257(a)(i)-(xi).
(b) Cisco's consistent reporting of EPS of $.01 over the consensus forecasted level in quarter after quarter during the Class Period was not the result of the ongoing strength of its business or exceptionally strong demand for all of its products or its strong forecasting ability or the other positive factors claimed, but rather, the result of the accounting tricks and manipulations set forth above in ¶257(a)(i)-(xi).
(c) Cisco's quarterly sales linearity was not as consistent or smooth as claimed as, in fact, Cisco was engaging in the secret practices to manipulate and boost Cisco's recorded and reported revenues http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 181 of 223
detailed above in ¶257(a)(i)-(xi).
(d) Cisco was manipulating and artificially inflating its reported book-to-bill ratio to keep it above one and make it appear that demand for its products was stronger than it really was by secretly engaging in the following practices:
(i) Cisco was accepting double and triple orders from customers, which orders were cancellable at will by the customers, and thus including hundreds of millions of dollars of these duplicate orders which would never be fulfilled in computing its book-to-bill ratio;
(ii) Cisco was accepting hundreds of millions of dollars of orders from customers which Cisco knew were not creditworthy and to which Cisco knew it would likely never ship all of the ordered product and who would likely never repay in full the loans made to them by Cisco to pay for any product that actually was shipped;
(iii) In connection with agreeing to make vendor-financed loans to uncreditworthy customers to enable them to order Cisco equipment, Cisco required customers to order significant additional amounts of equipment the customers did not need and did not want - which artificially inflated Cisco's current period orders;
(iv) Cisco executives falsely told vendor-financed customers that there were long backlogs for equipment and they would need to take product right away. In many cases, Cisco delivered incomplete product to customers;
(v) Cisco inflated its revenues by engaging in "selling futures," which meant that Cisco sold customers products that Cisco had not yet manufactured, and in exchange for a purchase order from the customer, Cisco would ship a similar type of product, and when the desired unit was finally produced Cisco would "swap-out" the old unit for the new one; and
(vi) Cisco's use of CVAPs was simply a means to sell product to uncreditworthy customers through CVAPs.
(e) The growth in Cisco's inventory of component parts, work in progress and finished goods during the 1stQ F01 was not the result of any deliberate decision on the part of Cisco to increase its inventories to secure necessary supplies of custom-made component parts or to build more finished goods to attempt to reduce lead times on customer shipments due to continuing strong demand for Cisco's products. Rather, it was due to a slowdown in demand for Cisco's products which was resulting in a sharp build-up in component parts inventory which Cisco could not control or halt because Cisco had secretly entered into several long-term, non-cancellable supply contracts for over $3 billion in component parts; as a result, Cisco was rapidly accumulating hundreds of millions of dollars of excess, unusable, unsaleable and over-valued inventory of component parts, work in progress and finished goods.
(f) Cisco's acquisition of Summa Four was a disaster. Like other acquisitions, key personnel left the Company after Summa Four was acquired by Cisco, resulting in key products not being developed. Cisco falsely assured customers that the Summa Four switch had 4,000 ports which could handle 4,000 calls simultaneously, when, in fact, it needed two ports for each call which reduced capacity by 50%. The switch was marketed for both data and voice, but did not work for voice applications, with the product failing the 99.999% requirement, often falling to only 85%-90% reliability. Cisco's Summa http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 182 of 223
Four switch product had substantial technical defects and quality problems which were resulting in significant and continued failures of this product in the field which Cisco knew would require either replacement of the product or substantial remedial work at great expense; nevertheless, Cisco did not take any adequate reserve for this liability and continued to ship what it knew were defective Summa Four switches and record revenue on those shipments.
(g) In order to conceal the extent of problems with some of Cisco's products (including the Summa Four switch), Cisco concealed its settlement of product defect claims made by customers by making them appear to be and characterizing them as "acquisitions" of companies or technologies, including the AMC acquisition.
(h) Cisco was making large amounts of vendor financing loans to new and untested companies, even though they did not meet Cisco's stated internal criteria or standards for such loans, most of which companies were not creditworthy, on terms which Cisco knew made it likely the loans would never be repaid; loans were made in some instances with only two years of financial statements, in addition to providing 100% financing for the purchase of its product. Cisco was also secretly making large unsecured working capital loans to these new and untested companies which unsecured working capital loans carried an extremely high risk of loss for Cisco and both of which types of loans were not being adequately reserved for. Cisco's vendor financing involved loans to companies that had no ability to repay. For example, Cisco loaned approximately $40 million to Onetel, Limited, a company losing money that eventually went bankrupt. Chambers had even attended a 12/11/00 board meeting of Digital Broadband at which meeting it was decided that Digital Broadband would declare bankruptcy. ICG, Comindigo and Resilient were other uncreditworthy companies to which Cisco provided funds. Cisco also loaned money to Vectris Communications and continued to sell equipment to Vectris in 00 despite knowing that Vectris was in financial distress, which resulted in its filing bankruptcy. Cisco's senior management, including Cisco's Credit Board, was aware on a weekly basis during 00 of the severe problems with the vendor financed loan portfolio as a result of a Deloitte & Touche review. Cisco pressured cash-poor customers to inflate orders in order to obtain more financing, including working capital, from Cisco Capital. One customer, AMC, received a $250 million credit facility despite the fact that AMC was insolvent and contemplating bankruptcy at that time (6/99), and was in violation of loan covenants.
(i) Cisco was treating customers (i.e., PSInet, ICG Communications, Flashcom, Rhythms NetConnections) receiving vendor financing that were, in fact, new, untested and uncreditworthy as tier-one/financially secure companies and thus recording revenue on product shipment to them (frequently by inserting an established reseller in between Cisco and the customers), rather than waiting until the receipt of cash payments on their vendor financed loans, as represented.
(j) Cisco's attempt to develop for commercial release the optical switch product it had acquired with Monterey for $500 million in 8/99 was failing due to substantial continuing technical difficulties and quality problems with the product; as a result, Cisco could not successfully complete the development of this optical switch product for commercial sale. Since this was to be Cisco's most expensive "top of the line" optical switch, Cisco's failure to develop this product, which was not commercially viable at the time of acquisition and never became so, meant that Cisco would not be able to successfully diversify into the large telecom SP market, or deliver the so-called "end-to-end" solution it claimed it could; therefore Cisco's F01-F02 revenues, net income and EPS would not grow at the rates forecasted.
(k) Cisco was not successfully penetrating the large telecom SP market as claimed because Cisco sold http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 183 of 223
cash-poor vendor financed customers product that did not work. Customers such as AMC ($55 million), HarvardNet ($75 million), and Caprock ordered product they could not afford that did not work. For CLECs, the Cisco products did not meet the technical requirements of the telecommunications industry - many of Cisco's products were not NEBS compliant and failed to meet other RBOC specifications.
(l) Cisco did not provide an "end-to-end" solution as it represented because the products it acquired either did not work as promoted, were not commercially viable or could not be upgraded to the levels promised by Cisco.
(m) Cisco's acquisition program was not nearly as successful as claimed as, in fact, several acquisitions had failed or were failing (Monterey, PixStream, Cerent and Pirelli) and several executives of acquired companies had left Cisco (i.e., Michael Zadikian and Zareh Baghdasarian, the founders of Monterey), leaving Cisco with serious management and leadership problems with those entities.
(n) The statement that Pirelli gave Cisco the industry leading DWDM equipment was false as the equipment was behind competitors' products and the statement about a customer base of 300 for these products was false. In fact by 7/20/01, the Pirelli product would only have 25 customers which would include those who Cisco helped finance.
(o) Cisco's Pirelli acquisition was a failure as it has been unable to develop new technology to increase the capacity of fiber optic networks and has been eclipsed by Nortel and Ciena. In fact, Cisco's sales of Pirelli products in 00 was $180 million, less than Pirelli's pre-acquisition sales of $218 million in 99.
(p) Cisco's Cerent acquisition was not nearly as successful as Cisco was representing and its revenues were far short of the levels internally forecasted and necessary for Cisco to achieve the levels of growth being forecast. Also, the Cerent switch was not upgradeable to OC-192, a fact that Cisco misrepresented to customers and to the market. OC-192 refers to the ability to transfer 10 gigabits of data per second. OC-192 was an increase in broadband capacity from the then-standard OC-48, which could only transfer 2.5 gigabits per second. The Cerent switch had never been designed by Cerent to be OC-192 capable. It had originally been designed as an "ADM replacement," a use for which it was adequate. The fundamental problem was heat, as adding speed capabilities to the switch caused excessive heat, making OC-192 speeds impossible. Cisco engineers told members of Cisco's marketing department that Cisco would never be able to deliver OC-192 capability in the Cerent switch. Because of these open protests from engineering personnel, nobody at Cisco believed the Cerent 454 switch was upgradeable to OC-192. Many former Cerent engineers simply quit when the claims of OC-192 capability were made because the architecture of the 454 would not support OC-192.
(q) Cisco's assertion that the Cerent 454 could handle 150,000 T1s, or 3.8 million phone calls, was blatantly false, as even if it were possible to put OC-48 cards in all 16 input-output slots of a Cerent 454 (which wasn't possible) this would still only result in 21,504 T1s. An OC-48 carries 48 DS3s, such that with 16 slots, a 454 could carry 768 DS3s (48 x 16 = 768). Each DS3 was made up of 28 DS1s (the equivalent of a T1), such that the maximum number of T1s that could be handled by the Cerent 454 was 21,504 (28 x 768 = 21,504), not the 150,000 asserted. As a result, the number of phone calls the 454 could handle was only 500,000 not 3.8 million since each DS1 (T1) is made up of 24 DS0s.
(r) Contrary to Cisco's assertion that the Cerent 454 had a 240Gbp backplane and could support a very high density of T1 lines, the actual switching capacity of the 454 was around 20Gbps. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 184 of 223
(s) The PixStream acquisition was a failure, resulting in a $300 million write-off.
(t) Contrary to Cisco's representations that the decline in its stock price would not hurt its acquisition program, by 10/00, the decline in Cisco's stock price meant that Cisco's pace of acquisitions would slow dramatically, if not come to a halt, which would adversely impact Cisco's ability to achieve the growth it had forecast or obtain the new technology it needed to remain competitive.
(u) Contrary to Cisco's representations that a decline in SP capital expenditures would hurt it less than its rivals, in fact, it would hurt Cisco as much if not more because Cisco had already shipped out more product than its customers desired, which customers had accepted so that they could get Cisco-backed financing. Thus, not only would the cutbacks hurt future sales, they would result in defaults and returns.
(v) Contrary to Cisco's representations that an economic slowdown would benefit it, that Cisco would actually be better off if the market stayed tough for the next 12-18 months and that Cisco would grow in good times and bad because most of Cisco's revenues came from commodity router products, demand for which was very much dependent on and impacted by macro-economic growth, an economic slowdown, tough market and bad timing would very adversely impact Cisco's business and growth.
(w) Contrary to Cisco's representation that product prices were stable and it was not seeing pricing pressure from Lucent, in fact, by Fall 00 there was severe price-cutting in the marketplace due to weakening demand and intensified competition with Lucent and Nortel, which was adversely impacting Cisco's revenues and profitability.
(x) The decline in the order and sales rate for the SP part of Cisco's business and for Cisco overall in the 1stQ F01 ended 10/28/00 was not due to seasonal factors and was not temporary as represented; in fact, it represented a fundamental drop-off in demand, and was an extremely negative development and trend which was continuing and was having a very adverse impact on Cisco's growth, revenues and profits. In fact, Cisco's 1stQ F01 results were inflated by "pull-ins" of orders from 2ndQ F01.
(y) Contrary to Cisco's assurances that its Asian markets, including Japan, were recovering from prior slowness and that Cisco was seeing strengthening sales there, in fact, demand for Cisco's products in Asia and Japan remained soft and was not improving in any material way.
(z) Cisco's sales representatives pressured resellers/CVAPS (such as SBC Datacom, Bay Data Consultants, Solarcom, Ameritech, and G.E. Capital IT Solutions) to place orders in advance of end- user commitments.
(aa) Cisco executives had knowledge of declining sales to telecommunications companies because these entities made purchasing commitments 6-12 months in advance. Cisco was experiencing a sales shortfall in Summer 00 in various regions. Order Status Reports for the Central Region showed declining sales from Spring 00 forward. Cisco's Professional Services Group was experiencing declining numbers in Summer 00. By Fall 00, software revenues were 20%-30% below projections for 1stQ F01. Cisco was reducing and cancelling orders from suppliers (such as Insight Electronics) in 8/00-9/00 due to weakening demand.
(bb) In exchange for arranging financing from Cisco Capital, Cisco executives received special benefits http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 185 of 223
from customers (such as Megs INet, Inc., Convergent Communications, Rhythms NetConnections, Covad Communications, USInternetworking, Inc.), including warrants and stock in those companies. These practices created a conflict of interest and caused Cisco to lend money to, or do business with, uncreditworthy customers.
(cc) Cisco's acquisition of Infogear, a maker of an Internet appliance product, was a disaster. Cisco was shipping product even though the product did not work. One major customer - Big Planet - eventually returned a significant amount of product due to product defects. Cisco eventually discontinued the whole product line.
(dd) In 10/00, Chambers and Carter received a worldwide forecast report which was based on forecasts from each sector in the world which indicated that F01 and F02 revenues would be much lower than published forecasts.
(ee) Because of Cisco's improper sales practices, it was required to reduce reported revenue by the expected amount of returns and non-collectibility. Cisco offered unlimited return rights for defective products and at least 10% of shipments for any reason. Additionally, Cisco would accept returns as a matter of practice to protect relationships with customers. During mid-00, Cisco's internal financial staff calculated a reserve of 22% on invoiced shipments to distributors. Because of the adverse effect this would have had on earnings (i.e., Cisco would not beat projections by one penny), Cisco's financial management (under Carter) told the staff that the reserve could not be more than 20%. Ultimately due to the under-reserving, after the Class Period the reserve needed to be increased to 35%, which was included in the charges taken in the $2.5 billion write-off in 4/01.
(ff) As a result of the foregoing, Cisco knew that it would not be able to obtain or achieve the levels of growth it was forecasting. In light of these negative and undisclosed conditions which were adversely affecting Cisco's business, Cisco would not be able to sustain or achieve 30%-60% revenue growth going forward and its F01-F02 revenue, net income and EPS growth would be substantially less than the levels being forecast.
277. On 12/12-13/00, Cisco revealed in an SEC filing that it had established a $275 million reserve for uncollectible accounts receivables and over-valued/excessive inventories - much larger than anticipated or earlier disclosed! On 12/15/00, Bloomberg publicized this filing, reporting:
CISCO RAISES LOSS RESERVES TO $275 MLN IN 1ST QUARTER
* * * Cisco Systems Inc. ... set aside $275 million during its first fiscal quarter to cover losses from unpaid customer bills and other items, more than tripling the amount earmarked a year earlier.
The bigger loss reserve ... reinforces concerns by some analysts that Cisco and other equipment makers, such as Nortel Networks Corp. and Lucent Technologies Inc., could suffer because of cash shortages at telecommunications carriers and Internet service providers on which they rely for sales.
* * * Loss Reserves Grow With Sales
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Claudia Ceniceros, a Cisco spokeswoman, said the reserve covers losses on inventories, investments and accounts receivable. She said these losses increased because Cisco is doing more business than last year, while declining to specify how much of the reserve pertains to the various categories.
* * * Creditworthiness Concern
"It certainly just raises the issue again of the creditworthiness of their customers," said Walter Casey, an analyst with Banc One Investment Advisors, which owns Cisco shares. "It's a concern - no question about it."
278. These increased reserves indicated to investors and analysts that Cisco's vendor financing activities contained larger than previously disclosed losses and that Cisco had over-valued and excessive inventories - suggesting that demand for Cisco's products was weaker than Cisco had disclosed. As a result, Cisco stock fell from $55-1/4 on 12/13/00 to $35-5/32 on 12/21/00, losing over $150 billion in market capitalization in just six trading days on trading volume of over 650 million shares! However, Cisco continued to falsely assure investors and analysts, inter alia, that demand for its products remained strong and that Cisco's revenues and EPS would continue to achieve the previously forecasted levels of growth during the balance of F01 and F02. As a result, despite this sharp decline in Cisco's stock price, the stock continued to trade at artificially inflated levels.
279. On 12/20/00, Unterberg, Towbin issued a report "initiating coverage" on Cisco by Pyykkonen. Because this was Unterberg, Towbin's first report on Cisco, it was issued only after Pyykkonen had extensive discussions with Chambers and Carter and was based on and repeated information provided by them. Chambers or Carter reviewed this report before it was issued and assured Pyykkonen it was accurate. The report forecast F01 and F02 EPS of $.78 and $.98, a 30% long-term EPS growth rate and the following F01/F02 quarterly results for Cisco:
EPS/2001 EPS/2002 QTR 1st $ .18A $ .22 2nd $ .19 $ .24 3rd $ .20 $ .25 4th $ .21 $ .27 Year $ .77 $ .98
The report also stated:
The accelerating trend toward a higher percentage of Internet protocol (IP)- based equipment in service providers' capital spending plans clearly benefits Cisco. IP equipment will be an increasing percentage of service providers' total capital spending and traditional voice equipment suppliers have not yet achieved a comparable base in IP technology.
Cisco's diversified and balanced revenue base by products and geographies is a key factor in our outlook for sustainable revenue and EPS growth above the networking equipment industry average. While several factors are in their favor, Cisco's growth is increasingly a function of global macroeconomic conditions. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 187 of 223
Cisco's year/year revenue growth has accelerated for 11 consecutive quarters, most recently by 66% in Cisco's first (October) fiscal period to $6.5 billion. Our model shows a gradual, rational deceleration in estimated total revenue growth (to 59% for fiscal 2001).
The company's competitive stronghold in the corporate enterprise market reinforces our overall growth outlook, as Cisco is in a strong product cycle position and its end-to-end strategy has made it more difficult for enterprise market competitors to gain critical mass.
While Cisco has suffered some competitive encroachment in specific product lines (most notably Juniper Networks' high-end IP routing), we believe its overall competitive position is sound and perhaps even better than in the past few years.
* * * Just Feed Me More Packets; Initiating Coverage with a Buy
Corporate Enterprise Market Still Critical
Amid all the recent focus on the service provider market, the corporate enterprise market - at about 60% of revenue - remains a critical one for Cisco. Its dominant competitive position (stable pricing), end-to-end sales strategy success and promotion of its own use of networking technology are positive factors in our outlook for enterprise market growth. The enterprise market has been accelerating for Cisco in recent quarters, with bookings up more than 65% year/year [in] its latest (October) quarter.
The strong mix of enterprise market business - with gross margins more favorable than in the service provider market - is another plus factor. This generally is due to a higher software content in the enterprise router/switch product lines than for high-growth (optical and access) products in the service provider market.
* * * Vendor Financing Exposure Prudently Managed So Far
For now, at least, we are comfortable with Cisco's vendor financing exposure. In its latest quarter, vendor financing commitments were about 9.5% of revenue, about two-thirds of it in the form of financial and operating leases to high-quality/low-credit-risk enterprise and service provider customers. The remaining one-third was structured loans to lower credit quality customers, including CLECs; with these, revenue is recognized only as payments are received and Cisco reserves against conservatively [sic] these loans.
280. On 1/10/01, Chambers made a presentation to the Morgan Stanley Dean Witter Conference in Scottsdale, Arizona, during which he stated that Cisco's 2ndQ F01 had been "a little bit more challenging" than expected because of a slowdown in customer spending, Cisco was "slowing" its hiring pace and "our visibility isn't as good as it normally is." Analysts described Chambers' comments as "incrementally more cautious." On 1/11/01, Deutsche Banc Alex. Brown issued a report on Cisco by Wade, based on Chambers' 1/10/01 presentation. The report continued to forecast a 30% three-year EPS growth rate for Cisco, F01 EPS of $.79, with the following F01 quarterly results for Cisco: http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 188 of 223
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .20 4th $ .22 Year $ .79
The report also stated:
No change in Cisco's growth rate guidance, 30%-50% annually, but visibility decreased in near term.
* * * DETAILS:
Cisco President and CEO John Chambers spoke yesterday at an investment banking conference .... His comments come with just less than three weeks left in Cisco's 2Q01 (Jan.) quarter. His comments were, as usual, very well measured to be optimistic about Cisco's future yet cognizant of the unsettled economic environment. Summaries of the incremental changes in his comments since the last analyst's meeting are as follows:
While Mr. Chambers did not back off his traditional 30%-50% growth rate over the next several years, he did say that the visibility has decreased for the next few quarters. He anticipates that this range could widen at times due to the lack of visibility. Some newswires incorrectly inferred that Cisco was changing its guidance for the January quarter.
281. On 1/28/01, Chambers briefed analysts at the World Economic Forum in Davos, Switzerland. He told them that "[b]usiness in January was a little bit slow," as the "business momentum" of most of Cisco's customers "was very tough in December and equally tough in January."
282. On 1/30/01, Bloomberg reported:
Cisco's Chambers Lowers Forecast, Avoids Sell-off, WSJ Says
Cisco Systems Inc. Chief Executive John Chambers has made several public appearances in what appears to be a move to reduce expectations for the company without openly admitting as much, The Wall Street Journal reported in its "Heard on the Street" column.
During one recent appearance, Chambers signaled concern about Cisco's growth forecast for the fiscal year. Although he never explicitly told analysts to reduce estimates, at least 10 did exactly that, the paper said. Chambers said that analysts are "reading to much into" his statements, while repeating his uncertainty about the company's outlook ....
The tactic can be effective in a volatile market, where missing estimates by a penny can provoke a stock sell-off .... Chambers has been successful in reducing expectations, and the shares are little changed from before he began making his http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 189 of 223
public remarks ....
283. On 1/30/01, Gruntal & Co. issued a report "initiating coverage" on Cisco by Perica. Because this was Gruntal's first report on Cisco, it was issued only after Perica had extensive discussions with Chambers and Carter and was based on and repeated information provided by them. Chambers or Carter reviewed this report before it was issued and assured Perica it was accurate. The report forecast F01 and F02 EPS of $.77 and $.94, a 28% five-year EPS growth rate and the following F01 quarterly results for Cisco:
EPS/2001 QTR 1st $ .18A 2nd $ .19 3rd $ .19 4th $ .21 Year $ .77
The report also stated:
Cisco's Acquisition Strategy
We believe Cisco Systems will continue its pace of acquiring 20-25 companies a year. During calendar 2000 Cisco announced 23 acquisitions. Cisco's acquisition strategy is a key component of its ... strategy to supplement its internal development efforts....
Despite the recent slide in Cisco's stock price and the general market place, we believe this is a near-term benefit for Cisco. While this may seem counter-intuitive given that the company's primary acquisition currency is its common equity, we note that even the best capitalized technology start-ups are finding it very difficult to access the public equity markets. We believe that this provides Cisco with a window to purchase key technologies and development teams that otherwise would have remained independent.
* * * Cisco's balance sheet is very strong.... Receivables of $2.89 billion yielded a day's sales outstanding (DSOs) figure of 40, which leads the industry .... Inventories increased $724 million sequentially to $1.96 billion while turns decrease to 6 from 7.8 in the prior quarter. The sharp increases in inventory balances and corresponding turns reduction reflects a conscious decision by management to stockpile key components and finished goods to ensure customer obligations are met. We believe inventory turns should improve during the second half of fiscal 2001 as components shortages ease.
Moving on to vendor financing, Cisco Capital, the company's financing arm that was established in 1996, offers three types of financing arrangements. These include financing leases (revenues are recognized upon the shipment of equipment but the customer pays over the lease period), operating leases (revenues are recognized pro rata over the lease period of 2-3 years), and structured loans (customer pays for equipment by establishing associated debt with Cisco Capital). Of the $625 million Cisco Capital funded during the first fiscal quarter, two-thirds was related to leasing arrangements extended to Cisco http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 190 of 223
Corporation's largest enterprise and service provider customers. We believe there is very little credit risk associated with these financing arrangements. With regard to the remaining one-third allocated to structured loans, these are typically extended to emerging service providers, including CLECs. Since inception, Cisco Capital has extended structured loan commitments totaling $2.4 billion with $600 million funded. Cisco has reserved or deferred 65% of the $600 million thereby only recognizing $210 million as revenue over the life of this program. Overall, while [we] believe it is quite likely that some of its structured loan customers may not survive, we do not believe this will materially erode Cisco's financial position nor do we believe this issue should lead to a revenue or earnings disappointment during fiscal 2001.
284. On 1/31/01, Chambers was quoted in a Bloomberg report as follows:
Cisco CEO Chambers on Hiring, Sales Outlook; Company Comment
Chambers talked with reporters after he spoke to the Swiss-American Chamber of Commerce in Zurich:
On whether parts of Cisco have a hiring freeze:
"I don't have a hiring freeze on the company as a whole, but we are very selective about where we are hiring...."
On Cisco's sales outlook:
* * * "I still see growth rates of 30 to 50 percent per year in the segment of the information technology industry where we are involved - the network.
285. On 2/6/01, Cisco reported its 2ndQ F01 results with EPS of $.18 - $.01 below forecasted levels, on revenues well below forecasted levels - and revenue growth of just 3.5% - the lowest quarter-over- quarter revenue growth in Cisco's history as a public company. Cisco's inventory soared by $600 million in the 2ndQ - doubling in just months to $2.5 billion. Cisco also revealed that its accounts receivable had also soared - growing much faster than sales. In addition, Cisco revealed it had imposed a hiring freeze and cut back sharply on new financing commitments by Cisco Capital. Cisco also revealed that its 3rdQ F01 revenues would decline from 2ndQ F01 levels - which would be the first quarter-over-quarter revenue decline in Cisco's history as a public company. As a result, analysts slashed revenue and EPS forecasts for Cisco. Cisco's stock plunged on these revelations, falling from $36-3/16 on 2/6/01 to $29-7/8 on 2/7/01, a 17% drop on trading volume of 279 million shares - the second largest one-day trading volume in the history of the United States securities markets - a staggering one-day wipe-out of over $42 billion in Cisco's market capitalization!
286. Analysts and investors were furious over the deception that had been practiced by Cisco, as the following comments show:
• Bloomberg, 2/6/01:
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said Ed Dowd, an analyst at Independence Investment Associates, which owns about 13 million Cisco shares. "I don't feel comfortable about anything."
• The New York Times, 2/7/01:
"I've followed the company since it went public, and I've never seen a down sequential revenue quarter," said Paul Johnson, a financial analyst at Robinson Stephens. "That took me by surprise."
* * * "The numbers are worse than we had expected, that's clearly a cause for concern," said Michael Ching, a financial analyst at Merrill Lynch.
• The Washington Post, 2/7/01:
Steve Kamman, an executive director at CIBC World Markets who recently downgraded Cisco shares from "buy" to "hold," said the results were even worse than his lowered estimates based on warnings the company had given earlier about a tough market.
"They have a clockwork-like regularity when it comes to earnings - they always do well - and that's why everyone had so much confidence in the company. I think this news points to some very bad times ahead," he said.
• The Wall Street Journal, 2/7/01:
The speed of the reversal in Cisco's fortunes is startling. As recently as November, Cisco urged analysts to increase their financial targets for the current fiscal year. Then, in two January speeches, Mr. Chambers said Cisco's business had slowed significantly in mid- December. Many analysts trimmed their forecasts for the remainder of the fiscal year, but few anticipated yesterday's results.
* * * The rising payroll and rising inventory prompted some analysts to question how well Cisco is reacting to the slowdown. "I was shocked by the inventory," said Nikos Theodosopoulos of UBS Warburg.
• Sanford C. Bernstein & Co., 2/7/01:
* Cisco missed consensus EPS for the first time in its history, breaking a 14-quarter streak of beating by exactly a penny. There is evidence that Cisco stretched mightily even to reach $0.18. The 7-day increase in receivables DSOs suggests significant business closed in the last days of the quarter.
* * * * Inventory days on hand have almost doubled YoY to 79, the result of over-optimistic business projections and long-term supply agreements. Cisco suggests inventory levels will get worse before they get better, taking 3 quarters to reach target levels. This will bring down gross margins until the situation is resolved. It also increases risk of inventory obsolescence. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 192 of 223
287. During the balance of 2/01 through 4/01, Cisco continued to reveal further horrible problems with its business, including:
• Cisco's sales in Asia, Europe and the U.S. were all very slow.
• Cisco was laying off some 8,000 workers - 17% of Cisco's workforce - resulting in a $300-$400 million charge.
• Cisco was completely abandoning its most expensive optical networking product - the Monterey ONS 15900 series wave length router, which it had paid $500 million for in 99, because the product had never been successfully developed for commercial use.
• Cisco was taking an astonishing $2.5 billion inventory write-off during the 3rdQ F01 - likely the largest inventory write-off in the history of the world. Cisco also revealed $500-$800 million in write-offs of fixed assets and goodwill, the value of which had become impaired.
• Cisco was halting its acquisition program and has only acquired two small companies in 2001.
• Cisco's 3rdQ F01 revenues would decline by at least 30% from its 2ndQ F01 revenue. Cisco's 3rdQ F01 sales would be $4.0-$4.2 billion, not the $9 billion forecast. Cisco would suffer a huge 3rdQ F01 loss of $2.5-$3 billion, which would wipe out all of its purported earnings during F00.
Later, Cisco reported a 3rdQ F01 loss of $2.69 billion wiping out all the profits it claimed to have earned in its F00, on sales of just $4.7 billion, below even Cisco's 3rdQ F00 sales of $4.9 billion.
288. In addition to the massive size of Cisco's 3rdQ F01 inventory write-off, its timing provided further evidence of Cisco's deceptive practices. On 5/01, Fortune magazine reported:
Cisco claims that the excess inventory will be obsolete within 12 months because manufacturers keep improving their components - a scenario affirmed by some suppliers. If that's the case, though, the question becomes, Why hadn't Cisco written down some of its inventory in earlier quarters? By the end of the January quarter, inventory levels had reached $2.5 billion, up $1.2 billion from a year earlier. Yet the company didn't disclose any write-downs, which implies that Cisco expected to be able to use the gear. How did so much of it become impaired in a three-month period? the Securities and Exchange Commission has recently expressed concerns over the timing of such write-offs. A company might know that it was holding impaired inventory, so the worry goes, and fail to share this information [with] investors.
289. In 8/01, Cisco reported dismal 4thQ F01 results - net income down a whopping 99% from a year earlier. Cisco earned pro forma income of $163 million, or $0.02 per share, compared with $1.2 billion, or $0.16 per share, in the same period the previous year. Of this $163 million in earnings, Cisco's operations - its business - generated a paltry $28 million in operating income. Almost all of Cisco's profit came from the bank via interest payments on its cash balances, an activity purely ancillary to the Company's main business. Moreover, Cisco's margins fell through the floor. Cisco's http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 193 of 223
operating profit margins came to just 0.7% - an amazing number considering Cisco's operating profit margin was 25.5% in the quarter that ended in 10/00. In 11/01, Cisco announced that 1stQ F02 earnings plunged 77% from the same period a year earlier and posted a net loss of $268 million. The results included a write-off of $858 million for bad investments.
290. As these negative revelations continued, Cisco's stock continued to plummet, falling to as low as $11.04 from its Class Period and all-time high of $82, meaning its market capitalization had fallen from $555 billion to under $100 billion - a wipe-out of some $450 billion for Cisco's public shareholders! However, Cisco's insiders named as defendants did not do nearly so poorly. As detailed in ¶¶353-372, during the Class Period they sold 11.8 million shares of their Cisco stock, pocketing $626 million in illegal insider trading proceeds.
291. A 1/21/02 Business Week article highlighted the "Hype" behind Cisco's purported success and is detailed in ¶34(d).
CISCO'S FALSE FINANCIAL STATEMENTS
292. In order to inflate the price of Cisco's stock, defendants caused the Company to falsely report its results for at least the 4thQ F99, 1stQ, 2ndQ, 3rdQ and 4thQ F00 and the 1stQ F01 through several methods. In fact, Cisco's ability to report EPS of $0.01 above forecasts in quarter after quarter was not so much due to its visibility of future results as its practice of improperly manipulating sales cut- offs and its earnings manipulation. Cisco also falsified its financials through improper revenue recognition, including recording as sales the shipment of shell units of products not yet developed, recording revenue on financing arrangements with certain of its customers, including CLECs who could not pay for product shipped to them, and failing to adequately accrue reserves for bad debts and excess inventory, thereby materially overstating its revenue and net income during the Class Period. Ultimately, Cisco admitted that its results for F01 would be adversely affected due to a deterioration in the economy and it has become apparent that Cisco will have billions of dollars in charges to account for the inability of many of its customers to pay the amounts owed, and to write off inventory, including returned product purchase commitments. In fact, much of Cisco's growth reported during the Class Period was due to its practice of using Cisco Capital to lend money to noncreditworthy customers to buy Cisco product, which practice it can no longer continue, which is contributing to its poorer than expected results.
293. Cisco reported the following amounts for the 4thQ F99, 1stQ, 2ndQ, 3rdQ, and 4thQ F00, and the 1stQ F01 (before charges for purchased research and development, payroll tax on stock option exercises, and gains realized on minority investments):
7/31/99 10/31/99 1/29/00 4/29/00 7/29/00 10/28/00
Revenue $3.55B $3.88B $4.35B $4.92B $5.72B $6.52B Net Income $ 727M $ 837M $ 906M $1.03B $1.20B $1.36B EPS $.11 $.12 $.13 $.14 $.16 $.18
294. Cisco included its 4thQ F99 and 4thQ F00 results in Form 10-Ks which were filed with the SEC. The Form 10-Ks were signed by Chambers and Carter. The interim results were included in Form 10- Qs signed by Carter and filed with the SEC. The Form 10-Qs represented that as to the accompanying financial statements, "[i]n the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present a fair statement of financial position" and "results of http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 194 of 223
operations ... have been made."
295. These representations were false and misleading when made, as Cisco's financial statements for the 4thQ F99, 1stQ, 2ndQ, 3rdQ and 4thQ F00 and the 1stQ F01 were not a fair presentation of Cisco's results and were presented in violation of GAAP and SEC rules.
296. GAAP are those principles recognized by the accounting profession as the conventions, rules and procedures necessary to define accepted accounting practice at a particular time. SEC Regulation S-X (17 C.F.R. §210.4-01(a)(1)) states that financial statements filed with the SEC which are not prepared in compliance with GAAP are presumed to be misleading and inaccurate, despite footnote or other disclosure. Regulation S-X requires that interim financial statements must also comply with GAAP, with the exception that interim financial statements need not include disclosure which would be duplicative of disclosures accompanying annual financial statements. 17 C.F.R. §210.10-01(a).
297. The Individual Defendants caused Cisco to falsify its reported financial results through its improper revenue recognition on Cisco's transactions involving Cisco Capital in which Cisco Capital would extend loans to customers to buy Cisco products even where the customers did not meet the loan covenants. These loans actually went way beyond the amounts customers needed to acquire Cisco products, as many customers were granted financing well in excess of the purchase price as incentive to purchase Cisco products. Often, customers were granted more than one-third of the invoice price as additional financing so long as they would agree to purchase the product. The customers, including many ISPs and CLECs were start-ups and unable to pay back even the invoice amounts. Thus, the extension of additional credit was extremely risky. Cisco granted its sales personnel authority to grant credit and extend payment terms (Cisco Capital personnel acquiesced to sales personnel) so as to accelerate sales and income reporting. Pursuant to GAAP, Cisco should have deferred recognition of revenue on such shipments, but did not in order to inflate its reported results. Moreover, pursuant to GAAP, Cisco was required to adequately accrue losses for uncollectible accounts receivable, but did not in order to report growing EPS during the Class Period.
298. GAAP, as described by FASB Statement of Concepts ("Concepts") No. 5 provides that the recognition of revenue should occur only where two fundamental conditions are met: The revenue has been earned and the amount is collectible. Concepts No. 5, ¶¶83-84.
299. Cisco's Form 10-K for F99, issued on 9/28/99, sets forth the Company's revenue recognition policy:
REVENUE RECOGNITION
The Company generally recognizes product revenue upon shipment of product unless there are significant post-delivery obligations or collection is not considered probable at the time of sale. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. Revenue from service obligations is deferred and generally recognized ratably over the period of the obligation. The Company makes certain sales to partners in two-tier distribution channels. These customers are generally given privileges to return a portion of inventory and participate in various cooperative marketing programs. The Company recognizes revenues to two-tier distributors based on management estimates to approximate the point that products have been sold by the distributors and also maintains appropriate accruals and allowances for all other programs. The Company accrues for warranty costs, sales returns, and other allowances http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 195 of 223
at the time of shipment based on its experience.
300. In fact, during the Class Period, Cisco had not earned revenue it recognized as it failed to ship working units to customers. Cisco would send placeholder products so that revenue could be recognized and then the products could be exchanged for functional units in later quarters. In the Summer of 99, Cisco shipped 14 switches to World Wide Web in Miami, recognizing sales of approximately $400,000 each. When technicians tried to turn on the switches, they would not light up. They ultimately determined that Cisco had shipped only shells of the switches and the switches were not ready yet. Cisco agreed to replace the shells with actual switches in a subsequent quarter.
301. GAAP, as set forth in FASB Statement of Financial Accounting Standard ("SFAS") No. 5, Accounting for Contingencies, requires that the estimated portion of uncollectible accounts receivable be accrued in the period it becomes evident that receivables or some portion of the receivables will not be collected. SFAS No. 5, ¶22, states in part:
Losses from uncollectible receivables shall be accrued when both conditions in paragraph 8 [it is probable that an asset has been impaired and the amount of loss can be reasonably estimated] are met. Those conditions may be considered in relation to individual receivables or in relation to groups of similar types of receivables. If the conditions are met, accrual shall be made even though the particular receivables that are uncollectible may not be identifiable.
302. Despite knowing that certain of its customers, including CLECs, did not meet Cisco Capital's required loan covenants, Cisco extended credit to the customers so that Cisco could make sales and improperly recognize the revenue and then failed to adequately accrue losses for uncollectible receivables in order to inflate its reported results, contrary to GAAP. One of these CLEC customers was American MetriComm ("AMC") which was essentially insolvent at the time Cisco started dealing with it and was actually insolvent when Cisco extended additional credit in 9/99. Other problematic customers included Digital Broadband, HarvardNet, PSINet, Onetel, Comindigo and Vectris.
303. In fact, Cisco had a practice of continuing to sell product to customers who could not pay, which this partial list of bankrupt Cisco borrowers confirms:
CUSTOMER DATE/TYPE OF DATE OF ULTIMATE RESOLUTION FINANCING BANKRUPTCY Advanced Radio 2/00 4/20/01 Secured claim of $10.7 million sold Telecom for $6 million. Big Words, Inc. Lease 11/00 Big Words never even paid down- payment on equipment lease. CAIS 6/30/99 10/01 Cisco bought assets of CAIS $50 million line of Software Solutions for $102 credit. million. Convergent 7/99 4/01 Convergent owed Cisco $11.5 $103.5 million million and a Cisco VAR $11.8 credit facility. million at the time of bankruptcy.
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Darwin Networks 12/99-10/00 11/01 $20 million in equipment still in Equipment warehouse. financing of $15.9 million. Digital Broadband $85 million in 12/00 Cisco had unliquidated $70 million vendor financing. claim. ICG Multi-million dollar 11/00 ICG owed $17.9 million loan. (unsecured) to Cisco and $14 million (unsecured) to Cisco Capital. Internet Connect, Inc. 4/00 5/01 Cisco unsecured for $4.9 million. Lease Agreement Microcast, Inc. 5/00 11/00 Cisco unsecured for $13.2 million. Lease Agreement Pacific Gateway 12/00 Pacific Gateway Exchange Exchange defaulted on $2.7 million loan. Pathnet 4/01 $43.9 million owed at time of Telecommunications bankruptcy. PSI Net 5/01 $81 million (unsecured) owed at time of bankruptcy. Rhythms 2/00 8/01 $25 million (unsecured) owed at NetConnections time of bankruptcy. Vectris 3/00 1/01 $20 million owed at time of bankruptcy. Winstar 11/00 4/01 $500 million commitment
304. Note the trend in Cisco's outstanding financings:
Outstanding Financing (000's) Customer: 1/29/00 4/29/00 7/29/00 10/28/00 1/27/01 4/28/01 7/28/01 1 Convergent 103.50 9,500 N/A 12,600 14,100 N/A N/A N/A 2 ICG 180.00 - 11,500 99,100 N/A N/A N/A N/A 3 Pathnet 50.00 - - - 30,500 N/A N/A 4 Netvoice 25.00 - - - 7,000 14,617 16,235 17,202 5 AMC 250.00 N/A N/A N/A 6 Harvardnet 120.00 - 7 CTC 25.00 25,000 ------8 Rhythms 75.00 - - 10,000 25,000 9 hte 8 60.00 - 10 Digital Broadband 85.00 11 ILD 10.00 12 MegsINet 25.00 13 Vectris 60.00 14 Pacific Gateway 15.00 - 2,700 2,700 2,700 N/A N/A N/A 15 CAIS 50.00 24,700 26,500 26,500 N/A http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 197 of 223
16 Viatel 50.00 - - - - 17 Nucentrix 16.25 - 18 Advanced Radio 175.00 7,800 19 Winstar 500.00 - - - - 20 Looking Glass 100.00 - - - - - 1,974.75
305. These customers had warned Cisco of their problems prior to filing for bankruptcy. The national SP customers (including ISPs, CLECs and wireless telephone companies) would periodically send written reports to Cisco of their dire financial situation.
306. For certain of Cisco's structured loans, Cisco represented that it only recognized revenue upon payment, such that its revenue recognition was conservative in light of the loans. This was false in two ways. First, Cisco would in fact recognize revenue from entities receiving structured loans despite not being paid. Second, Cisco set up its end-user customers to buy through resellers who paid Cisco with monies received from end-user customers using Cisco Capital or Sunrise Capital funding. Third, because Cisco Capital would lend in excess of the amount required to purchase the equipment, Cisco was frequently being paid back with funds loaned for working capital purposes. Essentially, the customers who were paying were paying with Cisco monies.
307. During the year ended 7/28/01, Cisco significantly increased its reserves for uncollectable lease receivables. This is clear from the material increase in "unearned income and other reserves" by $701 million from 7/29/00 to 7/28/01, while gross lease receivables increased by only $244 million. A $244 million increase in gross lease receivables should have resulted in an increase of approximately $38 million, principally representing the interest factor inherent in the lease. While Cisco did not disclose the increase in its reserves for uncollectable lease receivables it appears that the increase occurred as follows:
Total Est. Reserves Recorded Q1 $ 150 $ 135 Q2 $ 100 $ 100 Q3 $ 125 $ 110 Q4 $ 326 $ 305 $ 701 million $ 650 million
308. GAAP requires the following information with respect to leases shall be disclosed in the financial statements or footnotes thereto pursuant to SFAS No. 13, Accounting for Leases (as amended by SFAS No. 91, ¶25(d)):
a. For sales-type and direct financing leases: [FAS13, ¶23]
i. The components of the net investment in sales-type and direct financing leases as of the date of each balance sheet presented:
(a) Future minimum lease payments to be received, with separate deductions for (i) amounts representing executory costs, including any profit thereon, included in the minimum lease payments and (ii) the accumulated allowance for http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 198 of 223
uncollectible minimum lease payments receivable.
(b) The unguaranteed residual values accruing to the benefit of the lessor.
(c) For direct financing leases only, initial direct costs ...
(d) Unearned income ....
ii. Future minimum lease payments to be received for each of the five succeeding fiscal years as of the date of the latest balance sheet presented.
iii. [Deleted]
iv. Total contingent rentals included in income for each period for which an income statement is presented. * * *
c. A general description of the lessor's leasing arrangements.
Cisco failed to disclose separately its accumulated allowance for uncollectible minimum lease payments receivable.
309. Because of Cisco's improper sales practices, it was required to reduce reported revenue by the expected amount of returns and non-collectibility. Cisco offered unlimited return rights for defective products and at least 10% of shipments for any reason. Additionally, Cisco would accept returns as a matter of practice to protect relationships with customers. During mid-00, Cisco's internal financial staff calculated a reserve of 22% on invoiced shipments to distributors. Because of the adverse effect this would have had on earnings (i.e., Cisco would not beat projections by one penny), Cisco's financial management (under Carter) told the staff that the reserve could not be more than 20%. Ultimately due to the under-reserving, after the Class Period the reserve needed to be increased to 35%, which was included in charges taken in the $2.5 billion write-off in 4/01.
310. Cisco's finance arm, Cisco Capital, was a tool for Cisco to force its sales growth and was used to conceal a lack of demand for Cisco's products by customers who could actually pay for them. Despite its enormous lending operations, it was not set up with controls and procedures to safeguard Cisco's (and its shareholders') assets. For example, when Cisco customer ICG went bankrupt in late 00, Cisco Capital had not completed its security interest in the Cisco equipment ICG held. While Nortel and Lucent had also provided financing to ICG, those two equipment providers had a security interest in the equipment they sold. Cisco did not.
311. While Lucent was also aggressive in lending, it had controls in place to protect itself to some extent. Thus, Lucent was able to sell its loans to customers to financial institutions, relieving itself of some of the risk. Cisco was not able to do this.
312. Cisco Capital's policies were non-existent. In 12/99, Chambers started seeing problems on the horizon with consumer demand and wanted Deloitte & Touche to do a special review of Cisco and Cisco Capital. When Deloitte personnel requested the loan policy to compare it to what Cisco Capital was actually doing, Cisco Capital personnel had nothing but a draft of a proposed policy to give them. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 199 of 223
In 5/00, Deloitte started the initial review of what was internally called the "$2 billion problem," where the total exposure in 5/00 was $2 billion. Cisco had asked Deloitte to look at the entire portfolio. Deloitte came in with 1100-1200 "findings" or problem documentation. The goal when Deloitte first arrived was to clean up the loan files and sell the loan portfolio in 60 days. It was eventually discovered that the portfolio was not worth nearly as much as its face value - it would have to be deeply discounted. Almost half the time Cisco Capital could not even provide Deloitte with credit records. The reason for this was the various signature authorities at Cisco and Cisco Capital. A typical scenario was that a Cisco Capital credit manager would turn down a financing request. The business manager or sales person would go to a Cisco executive and get a signature overriding the Cisco Capital person. The push was to get the sale - even if the financing made no sense.
313. Moreover, when new customers would begin the process of securing financing from Cisco, Cisco frequently required that the customer submit an order for Cisco product. Whether the customer actually needed or wanted the product ordered was beside the point. The reason for the order was to help Cisco "make its numbers" in exchange for securing funding from Cisco. One example of this occurred in Houston, Texas where an ISP was seeking more than $50 million in funding from Cisco Capital. Cisco sales personnel approached the ISP and told them to make a nearly $3 million purchase of fixed broadband wireless products as a show of good faith. This was much more product than the ISP needed as its annual sales were barely that much. Moreover, the ISP wanted point to multipoint solutions and the product was only point to point but agreed to issue the purchase order based on Cisco's representations (1) that once the point to multipoint product was released in late 00 the customer could swap out the product, and (2) that the order was a show of "good faith" by the customer to secure the subsequent funding. Based on these representations, the customer issued a purchase order to a Cisco reseller who then paid Cisco. Cisco then recognized the revenue from the sale as it had been sold through to an end user. Not only did this practice inflate sales and earnings, it also permitted Cisco to report a favorable book-to-bill ratio exceeding 1.0 in each quarter during the Class Period.
314. Unfortunately for investors, Cisco's results, and the representations concerning them, were false. Ultimately, Cisco's results have been adversely affected by the customers having financial problems, including bankruptcy. As the Financial Times reported on 4/3/01:
On Tuesday PSINet, one of the oldest internet access providers in the US and a prominent customer of Cisco, warned it was likely to face bankruptcy and delisting from the Nasdaq after a sharp fall in business.
Other internet and telecom providers are thought to be on the brink of such announcements in the next few weeks.
* * * Although Cisco's vendor financing deals are thought to be significantly lower than its largest competitors, including Lucent and Nortel, it is nevertheless expected to take write-offs as bankruptcies mount.
315. The Financial Times also reported on 4/4/01:
Several companies in which Cisco has almost Dollars 200m in cumulative financing commitments - including Digital Broadband, HarvardNet and Vectris - have recently gone bankrupt, releasing millions of dollars worth of Cisco equipment into the used equipment http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 200 of 223
auction market.
"Cisco's equipment is being auctioned off at 10 to 20 per cent of its catalogue price," says Matt Sousa, an equipment reseller on the East Coast. "Cisco is effectively competing against itself at prices it cannot possibly match."
* * * The company's equity exposure to private companies has also increased sharply. For example, "minority investments" in non-listed companies have risen more than fivefold to dollars 765m in the past 12 months. These investments are recorded at cost and do not reflect the collapse in valuations in recent months.
"Cisco has been acting as a banker to its customers and it will pay a price for that," says Jack Whelan, at Fechtor Detwiler, a brokerage firm in Boston.
A brief tour of Cisco's website illustrates the zeal with which the group has been pursuing customers. It offers support on "terms which mean less documentation than traditional bank financing", and which offer "off-balance sheet financing."
Customers need only two years of financial statements ("auditing is preferred"). In addition, "Cisco Capital can tailor your financing to include equipment obtained from sources other than Cisco."
316. Cisco's results were also misstated due to its failure to accrue reserves for excess inventory, both inventory on hand or committed through purchase commitments. Cisco ultimately had to record a charge for excess inventory of $2.25 billion, more than Cisco's total inventory on hand just months earlier. In fact, much of this inventory charge was for inventory returned to Cisco from customers who either had never wanted the product and refused to pay for it or who were unable to pay for it.
317. GAAP, as set forth in Accounting Research Bulletin ("ARB") No. 43, Chapter 4, requires a loss be recorded when the value of goods decreases to less than cost, whether due to pricing declines, obsolescence or other causes.
318. Cisco delayed making such a charge until it could not be avoided and then took an enormous charge of $2.25 billion in 4/01. This represented more than one-third of Cisco's reported net income during the Class Period, spanning seven quarters.
319. Moreover, the practice by Cisco of providing financing to financially troubled companies to purchase its own equipment creates inflated product demand (leads to oversupply of inventory) and inflated product revenue being reported by Cisco.
320. According to Silicon Valley.com, 70% of the write-off in excess inventory was for products to be sold to SP businesses, namely phone and net access companies who were also recipients of these financing programs. As such, these companies were experiencing significant operating problems in late calendar 00 and began a rash of bankruptcy filings. For example, ICG Communications, Inc., Winstar Communication and North Point Communications Group, Inc. filed for bankruptcy. Phone and Internet companies made up about 40% of Cisco's annual revenue in 00. Cisco's close relationships with these companies would have put it on early notice of their financial problems, which was leading to a drop off in customer orders. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 201 of 223
321. Even as current inventory levels were ballooning out of control, from $1.956 billion at 10/28/00 to $2.533 billion at 1/27/01, Cisco kept increasing its purchase of raw materials as a result of purchase commitments it made with its suppliers. A Wall Street Journal article dated 4/18/01 stated that by 12/00 Cisco knew that its actual sales would fall short of its overly optimistic forecasts. They even acknowledged that its customers had been double and triple ordering products, once from Cisco and then again from Cisco's distributors. Accordingly, Cisco knew or should have known that its forecasts on which it based its inventory purchasing plans were significantly overstated. Accordingly, Cisco knew it would be left with massive amounts of inventory that it knew it would not need or could not use.
322. Defendants also failed to disclose all of the related-party transactions as set forth above in ¶72.
323. These relationships were not adequately (if at all) disclosed in Cisco's filings. GAAP, as set forth in SFAS No. 57, Related Party Disclosures, requires that financial statements include disclosures of material related-party transactions, including the nature of the relationships, a description of transactions, the dollar amount of transactions and amounts due from or to related parties. See SFAS No. 57, ¶¶2-3. SFAS No. 57 defines related parties as affiliates of the enterprise, principal owners of the enterprise, management of the enterprise and other parties with which the enterprise may deal if one party controls or can significantly influence the management or operating policies of the other. See SFAS No. 57, ¶24.
Cisco's Earnings Manipulation
324. Cisco also violated GAAP and SEC rules by manipulating its cut-off for sales. In some quarters, when Cisco's sales were below expectations, Cisco would move inventory across the yellow line in one of its warehouses and it was considered shipped and revenue would be recognized. Pursuant to GAAP, as set forth in FASB Statement of Concepts No. 5, revenue is not recognized until earned, which for products generally means upon shipment.(3) In quarters where Cisco's sales exceeded expectations, the quarter would be cut-off prematurely so that excess sales could be used to meet sales and earnings goals the following quarter. This number manipulation was "standard operating procedure" engaged in throughout the Company at the direction of upper management as a way to keep revenues up.
325. Such manipulation is a violation of GAAP which the SEC has reiterated. In a 9/98 speech, former SEC Chairman Arthur Levitt stated:
Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation.
As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; Integrity may be losing out to illusion.
Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 202 of 223
obscure actual financial volatility. This, in turn, masks the true consequences of management's decisions. These practices aren't limited to smaller companies struggling to gain investor interest. It's also happening in companies whose products we know and admire.
326. Cisco also manipulated its earnings presentation through the use of "pro forma" earnings in its press releases and other public statements announcing its quarterly earnings. Cisco abused the definition of pro forma earnings by excluding legitimate operating expenses in order to inflate its pro forma earnings results. Whereas historically there was some justification for excluding large one-time only expenses and goals as part of pro forma earnings, Cisco abused this process, excluding items which were occurring on a regular basis. For example, in 1/01 Cisco reported pro forma earnings of $1.4 billion, nearly $600 million over its net income. Cisco excluded such ordinary and important costs as acquisition expenses and payroll taxes on stock option exercises. The SEC recently stated that issuance of pro forma results by companies was misleading and warned companies that they could face civil-fraud lawsuits.
327. Due to these accounting improprieties, the Company presented its financial results and statements in a manner which violated GAAP, including the following fundamental accounting principles:
(a) The principle that interim financial reporting should be based upon the same accounting principles and practices used to prepare annual financial statements was violated (APB No. 28, ¶10);
(b) The principle that financial reporting should provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit and similar decisions was violated (FASB Statement of Concepts No. 1, ¶34);
(c) The principle that financial reporting should provide information about the economic resources of an enterprise, the claims to those resources, and effects of transactions, events and circumstances that change resources and claims to those resources was violated (FASB Statement of Concepts No. 1, ¶40);
(d) The principle that financial reporting should provide information about how management of an enterprise has discharged its stewardship responsibility to owners (stockholders) for the use of enterprise resources entrusted to it was violated. To the extent that management offers securities of the enterprise to the public, it voluntarily accepts wider responsibilities for accountability to prospective investors and to the public in general (FASB Statement of Concepts No. 1, ¶50);
(e) The principle that financial reporting should provide information about an enterprise's financial performance during a period was violated. Investors and creditors often use information about the past to help in assessing the prospects of an enterprise. Thus, although investment and credit decisions reflect investors' expectations about future enterprise performance, those expectations are commonly based at least partly on evaluations of past enterprise performance (FASB Statement of Concepts No. 1, ¶42);
(f) The principle that financial reporting should be reliable in that it represents what it purports to represent was violated. That information should be reliable as well as relevant is a notion that is central to accounting (FASB Statement of Concepts No. 2, ¶¶58-59);
(g) The principle of completeness, which means that nothing is left out of the information that may be http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 203 of 223
necessary to insure that it validly represents underlying events and conditions was violated (FASB Statement of Concepts No. 2, ¶79); and
(h) The principle that conservatism be used as a prudent reaction to uncertainty to try to ensure that uncertainties and risks inherent in business situations are adequately considered was violated. The best way to avoid injury to investors is to try to ensure that what is reported represents what it purports to represent (FASB Statement of Concepts No. 2, ¶¶95, 97).
328. Further, the undisclosed adverse information concealed by defendants during the Class Period is the type of information which, because of SEC regulations, regulations of the national stock exchanges and customary business practice, is expected by investors and securities analysts to be disclosed and is known by corporate officials and their legal and financial advisors to be the type of information which is expected to be and must be disclosed.
PRICEWATERHOUSECOOPERS' PARTICIPATION IN THE SCHEME AND FRAUD
329. PWC, a firm of certified public accountants, was engaged by Cisco to provide independent auditing and accounting services throughout the Class Period. PWC's San Jose office was engaged to examine and opine on Cisco's financial statements for fiscal 99 and fiscal 00, to perform review services on Cisco's interim F00 and F01 results, and to provide significant consulting, tax and due diligence services from F99 through F01. As a result of the far-reaching scope of services provided by PWC, they were intimately familiar with Cisco's business, including its vendor financing to non- creditworthy customers, its earnings manipulation and Cisco's (and its executives') undisclosed ownership interests in customers and vendors. PWC received large fees for its services to Cisco. These fees were particularly important to the partners in PWC's San Jose office as their incomes were dependent on the continued business from Cisco. For F01 alone, for example, PWC received $1.86 million in fees related to the audit of Cisco's F01 financial statements, another $3.67 million for financial information systems design and implementation and $13.13 million for other services and non-audit related work. Since audit fees represented less than 10% of the total fees generated from Cisco, PWC was highly motivated not to allow any auditing disagreements with Cisco management to interfere with its lucrative consulting business.
330. Moreover, PWC had almost lost Cisco as a client in early 00, since Cisco was one of the clients of PWC implicated in PWC's independence problems which led to an SEC investigation. As disclosed in a Cisco 3/01 prospectus:
PricewaterhouseCoopers LLP ("PCW"), our independent accountants, has notified us that PWC is engaged in discussions with the Securities and Exchange Commission following an internal review by PWC, pursuant to an administrative settlement with the Securities and Exchange Commission, of PWC's compliance with auditor guidelines. PWC has advised us that we are one of the companies affected by such discussions.(4)
331. Due to these independence violations, Cisco was encouraged by the SEC to retain a new auditor, threatening PWC's fees from this client. According to a 5/00 CFO Magazine article:
Other companies have found themselves more directly caught in the crossfire, even though none has been forced to restate its financial results. Compaq Computer Corp. replaced PwC as its auditor in February at the SEC's request, while Cisco Systems Inc. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 204 of 223
has opted to stick by the Big Five firm despite SEC pressure. "Our auditors are telling us that they're independent, and we believe them," says Dennis Powell, Cisco's corporate controller.
332. At the time, Cisco had the largest market capitalization of any company in the world. Moreover, Cisco was extremely active in acquisitions, leading to an enormous amount of work for PWC. Thus, PWC was concerned about possibly losing Cisco as a client and was more reticent than ever to raise audit issues with Cisco.
333. PWC falsely represented that Cisco's financial statements for F99 and F00 were presented in accordance with GAAP and that PWC's audits of Cisco's financial statements had been performed in accordance with Generally Accepted Auditing Standards ("GAAS"). PWC also consented to the incorporation of its false reports on Cisco's financial statements in Cisco's Form 10-Ks for those years and in Cisco's registration statements for the registration of millions of Cisco shares which were issued in Cisco's acquisitions made during the Class Period, which were filed with the SEC. PWC's issuance of and multiple consents to reissue materially false reports on Cisco's F99-F00 financial statements were themselves violations of GAAS.
334. The SEC has stressed the importance of meaningful audits being performed by independent accountants:
[T]he capital formation process depends in large part on the confidence of investors in financial reporting. An investor's willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest. The quality of information disseminated in the securities markets and the continuing conviction of individual investors that such information is reliable are thus key to the formation and effective allocation of capital. Accordingly, the audit function must be meaningfully performed and the accountants' independence not compromised.
Relationships Between Registrants and Independent Accountants, SEC Accounting Series Release No. 2961, 1981 SEC LEXIS 858, at *8-*9 (8/20/81).
335. GAAS, as approved and adopted by the American Institute of Certified Public Accountants ("AICPA"), relate to the conduct of individual audit engagements. Statements on Auditing Standards (codified and referred to as AU §___) are recognized by the AICPA as the interpretation of GAAS.
PWC's False Statements as to Cisco's F99-F00 Financial Statements
336. With respect to Cisco's financial statements for F00, PWC represented, in a report dated 8/8/00, the following:
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Shareholders of Cisco Systems, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 205 of 223
consolidated statements of operations and of shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Cisco Systems, Inc. and its subsidiaries at July 29, 2000 and July 31, 1999, and the results of their operations and their cash flows for each of the three years in the period ended July 29, 2000, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP ------San Jose, California
337. PWC issued nearly identical audit reports for F99 (issued 8/10/99).
338. PWC's reports were false and misleading due to its failure to comply with GAAS and because Cisco's financial statements were not prepared in conformity with GAAP, as alleged in detail in ¶¶292- 327, so that issuing the reports was in violation of GAAS and SEC rules. PWC knew its reports would be relied upon by the Company as well as by present and potential investors in Cisco's stock.
PWC Ignored the Audit Evidence It Gathered
339. GAAS, as set forth in AU §326, Evidential Matter, requires auditors to obtain sufficient competent evidential matter through inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit:
In evaluating evidential matter, the auditor considers whether specific audit objectives have been achieved. The independent auditor should be thorough in his or her search for evidential matter and unbiased in its evaluation. In designing audit procedures to obtain competent evidential matter, he or she should recognize the possibility that the financial statements may not be fairly presented in conformity with generally accepted accounting principles or a comprehensive basis of accounting other than generally accepted accounting principles. In developing his or her opinion, the auditor should consider relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements. To the extent the auditor remains in substantial doubt about any assertion of material significance, he or she must refrain from forming an opinion until he or she has obtained sufficient competent evidential matter to remove such substantial doubt, or the auditor must express a qualified opinion or a disclaimer of opinion.
AU §326.25 (footnotes omitted).
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340. PWC's responsibility, as Cisco's independent auditor, was to obtain "sufficient competent evidential matter ... to afford a reasonable basis for an opinion regarding the financial statements under audit" as to "the fairness with which they present, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles." AU §§110, 150.
341. In violation of GAAS, and contrary to the representations in its report on Cisco's financial statements, PWC did not obtain sufficient, competent, evidential matter to support Cisco's assertions regarding its income, receivables, and inventory for F99 and F00.
PWC's Audit Procedures with Respect to Cisco's Failure to Consolidate Its Non-qualifying SPEs Did Not Conform with GAAS
342. As one of the largest audit firms in the world, PWC was well aware of the strategies, methods and procedures required by GAAS to conduct a proper audit. Also, PWC knew of the audit risks inherent at Cisco and in the industries in which Cisco operated because of the comprehensive services it provided to Cisco over the years (PWC had been Cisco's auditor since 1988) and its experience with many other clients. PWC's intentional failure to comply with GAAS and PWC's performance on the Cisco audits rose to the level of deliberate recklessness, as the following paragraphs demonstrate.
343. PWC abandoned its role as independent auditor by turning a blind eye to each of the above indications of improper accounting, including Cisco's recognition of revenue from customers who could not pay, Cisco's manipulation of earnings, its undisclosed interests in customers and vendors and its uncollectible vendor receivables. Despite this knowledge, PWC did not insist upon adjustments to Cisco's audited financial statements. Pursuant to GAAS, PWC should have issued a qualified or adverse report, or it should have insisted that Cisco comply with GAAP.
344. In the Spring of 00, Cisco and Cisco Capital accumulated some $2 billion in finance and/or lease receivables from its customers. Defendants wanted to sell this paper to a bank or other entity so that the Company would not have to wait for (or worry about) the money to be collected. Cisco hired a separate accounting firm (Deloitte & Touche, LLP ("DT")) to perform assurance services on the paper so that it could be valued and sold to a third party. This engagement was in 5/00.
345. DT personnel were astounded at what they found. First, when they requested a copy of the loan policy to compare it to what had occurred in the loan files, they were told there was no such policy. Cisco Capital personnel eventually provided DT with a "draft" policy which had not been finalized. This is all DT had to work with as far as a policy was concerned to lay out the procedures and documentation required to loan money.
346. Second, when DT started going through loan files, so much documentation was missing (or had never existed) that it was impossible to tell what the customers owed and when. DT found more exceptions, or problems, than non-exceptions.
347. These problem loans became known internally at Cisco as the "$2 billion problem." DT and Cisco eventually concluded that it would be impossible to sell the paper due to the disastrous lack of documentation. DT made recommendations to Cisco and Cisco Capital on how to rectify the situation and how to clean up the files. DT then left. In 8/00, DT personnel returned and found that Cisco had http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 207 of 223
failed to implement DT's prior recommendations.
348. PWC had access to DT's findings and was charged with finding sufficient competent evidential matter to support Cisco's assertions regarding the amounts in Cisco's financial statements. Yet despite having access to the same problems that DT uncovered (in fact better access), PWC did not insist on a large write-down of these unrecoverable assets as of 7/29/00, nor did PWC issue a qualified opinion. PWC was required to design its audit to test management's assertions.
349. AU §311.06 states:
.06 The auditor should obtain a level of knowledge of the entity's business that will enable him to plan and perform his audit in accordance with generally accepted auditing standards. That level of knowledge should enable him to obtain an understanding of the events, transactions, and practices that, in his judgment, may have a significant effect on the financial statements. The level of knowledge customarily possessed by management relating to managing the entity's business is substantially greater than that which is obtained by the auditor in performing his audit. Knowledge of the entity's business helps the auditor in:
a. Identifying areas that may need special consideration.
b. Assessing conditions under which accounting data are produced, processed, reviewed, and accumulated within the organization.
c. Evaluating the reasonableness of estimates, such as valuation of inventories, depreciation, allowances for doubtful accounts, and percentage of completion of long-term contracts.
d. Evaluating the reasonableness of management representations.
e. Making judgments about the appropriateness of the accounting principles applied and the adequacy of disclosures.
350. In fact, PWC either did not find the problems DT found, which would amount to a departure from GAAS, or ignored the problems it did find, and did not require any change in the way Cisco accounted for the problems. Moreover, PWC accountants actually received copies of DT's reports.
351. Cisco was also engaging in a practice where it would provide financing to an end-user who could not pay. The end-user would then purchase product through a reseller who would be paid by the end- user with Cisco-provided monies and the reseller would pay Cisco and Cisco would recognize the revenue. Despite having DT's findings of thousands of problem accounts, PWC failed to determine the revenue generated and recognized by these bad loans. As a result, PWC failed to exercise professional skepticism as required by GAAS, as described in AU§230.07-.09.
352. Due to the problems with loans and inventory, PWC should have either substantially increased its testing procedures to determine the true value of these assets or issued a qualified opinion. See AU§326.25.
353. Due to PWC's false statements and failure to identify and modify its reports to identify Cisco's http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 208 of 223
false financial reporting, PWC violated the following GAAS standards:
(a) The first general standard is that the audit should be performed by persons having adequate technical training and proficiency as auditors.
(b) The second general standard is that the auditors should maintain an independence in mental attitude in all matters relating to the engagement.
(c) The third general standard is that due professional care is to be exercised in the performance of the audit and preparation of the report.
(d) The first standard of field work is that the audit is to be adequately planned and that assistants should be properly supervised.
(e) The second standard of field work is that the auditor should obtain a sufficient understanding of internal controls so as to plan the audit and determine the nature, timing and extent of tests to be performed.
(f) The third standard of field work is that sufficient, competent, evidential matter is to be obtained to afford a reasonable basis for an opinion on the financial statements under audit.
(g) The first standard of reporting is that the report state whether the financial statements are presented in accordance with GAAP.
(h) The second standard of reporting is that the report shall identify circumstances in which GAAP has not been consistently observed.
(i) The third standard of reporting is that informative disclosures are regarded as reasonably adequate unless otherwise stated in the report.
(j) The fourth standard of reporting is that the report shall contain an expression of opinion or the reasons why an opinion cannot be expressed.
DEFENDANTS' INSIDER TRADING
354. During the Class Period defendants sold the following amount of their Cisco stock despite adverse information about Cisco's business which they knew had not been disclosed to the public:
Insider Date Shares Price $ Value
Bartz 8/16/99 400 $31.66 $ 12,662 8/19/99 40,000 $31.25 $ 1,250,000 8/14/00 20,000 $64.13 $ 1,282,600 60,400 $ 2,545,262
Carter 8/13/99 284,400 $31.53 $ 8,967,132 8/16/99 200,000 $32.02 $ 6,404,000 8/17/99 150,000 $32.00 $ 4,800,000 8/18/99 500,000 $31.93 $ 15,965,000 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 209 of 223
8/19/99 500,000 $31.105 $ 15,552,500 8/17/00 300,000 $63.45 $ 19,035,000 8/18/00 200,000 $64.00 $ 12,800,000 2,134,400 $ 83,523,632
Chambers 2/11/00 2,300,000 $65.875 $ 151,512,500 2,300,000 $ 151,512,500
Daichendt 8/13/99 100,000 $31.25 $ 3,125,000 8/13/99 49,874 $31.22 $ 1,557,066 8/13/99 55,126 $31.315 $ 1,726,271 8/13/99 50,000 $31.28 $ 1,564,000 8/13/99 13,308 $32.815 $ 436,702 8/13/99 22,372 $31.22 $ 698,454 8/13/99 100,000 $31.22 $ 3,122,000 8/13/99 126 $31.22 $ 3,934 8/13/99 97,628 $31.22 $ 3,047,946 8/13/99 120,000 $31.28 $ 3,753,600 8/13/99 104,064 $31.25 $ 3,252,000 8/13/99 143,436 $31.25 $ 4,482,375 8/13/99 112,500 $31.25 $ 3,515,625 2/11/00 61,288 $66.50 $ 4,075,652 2/14/00 140,626 $64.605 $ 9,085,143 2/14/00 150,000 $64.605 $ 9,690,750 2/14/00 84,378 $64.605 $ 5,451,241 2/14/00 34,340 $64.605 $ 2,218,536 2/14/00 66,656 $64.605 $ 4,306,311 8/11/00 140,625 $62.59 $ 8,801,719 8/11/00 213,332 $62.59 $ 13,352,450 8/11/00 25,000 $62.59 $ 1,564,750 8/11/00 47,812 $62.59 $ 2,992,553 8/11/00 150,000 $62.59 $ 9,388,500 8/11/00 50,000 $62.59 $ 3,129,500 8/11/00 84,375 $62.59 $ 5,281,031 2,216,866 $ 109,623,108
Estrin 8/13/99 80,000 $31.225 $ 2,498,000 11/12/99 50,000 $41.84 $ 2,092,000 2/11/00 337,500 $65.89 $ 22,237,875 2/11/00 328,126 $65.89 $ 21,620,222 2/11/00 20,000 $65.89 $ 1,317,800 2/11/00 18,000 $65.89 $ 1,186,020 2/11/00 225,000 $65.89 $ 14,825,250 1,058,626 $ 65,777,167
Kozel 8/13/99 40,000 $31.25 $ 1,250,000 8/13/99 80,000 $31.375 $ 2,510,000 8/13/99 30,000 $31.50 $ 945,000 8/13/99 120,000 $31.315 $ 3,757,800 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 210 of 223
12/6/99 110 $49.125 $ 5,404 12/8/99 1,580 $49.969 $ 78,951 2/17/00 40,000 $64.325 $ 2,573,000 2/17/00 40,000 $64.33 $ 2,573,200 2/17/00 40,000 $64.00 $ 2,560,000 2/17/00 40,000 $64.745 $ 2,589,800 2/17/00 40,000 $64,485 $ 2,579,400 2/17/00 40,000 $64.55 $ 2,582,000 2/17/00 40,000 $64.72 $ 2,588,800 2/17/00 20,716 $64.57 $ 1,337,632 2/17/00 19,284 $64.64 $ 1,246,518 2/17/00 40,000 $64.87 $ 2,594,800 2/17/00 40,000 $64.74 $ 2,589,600 8/11/00 50,000 $64.00 $ 3,200,000 8/11/00 50,000 $64.50 $ 3,225,000 8/14/00 20,000 $63.76 $ 1,275,200 8/14/00 10,000 $63.71 $ 637,100 8/14/00 20,000 $63.67 $ 1,273,400 8/14/00 10,000 $63.94 $ 639,400 8/14/00 40,000 $63.63 $ 2,545,200 8/14/00 50,000 $64.25 $ 3,212,500 8/14/00 50,000 $64.00 $ 3,200,000 8/18/00 22,000 $64.13 $ 1,410,860 993,690 $ 54,980,565
Listwin 8/16/99 56,248 $31.91 $ 1,794,592
Puette 3/21/00 30,000 $70.00 $ 2,100,000 3/21/00 20,000 $70.13 $ 1,402,600 3/21/00 30,000 $70.06 $ 2,101,800 3/21/00 30,000 $70.03 $ 2,100,900 3/24/00 60,000 $80.24 $ 4,814,400 3/24/00 20,000 $80.24 $ 1,604,800 190,000 $ 14,124,500
Redfield 8/13/99 50,000 $31.22 $ 1,561,000 8/13/99 50,000 $31.75 $ 1,587,500 8/17/99 50,000 $31.795 $ 1,589,750 8/18/99 30,000 $32.00 $ 960,000 8/18/99 20,000 $32.00 $ 640,000 8/19/99 100,000 $31.095 $ 3,109,500 2/17/00 490,000 $64.815 $ 31,759,350 8/11/00 155,000 $64.44 $ 9,988,200 8/18/00 165,000 $63.76 $ 10,520,400 1,110,000 $ 61,715,700
Valentine 8/13/99 40,000 $31.25 $ 1,250,000 8/13/99 360,000 $31.21 $ 11,235,600 8/13/99 540,000 $31.22 $ 16,858,800 http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 211 of 223
940,000 $ 29,344,400
Volpi 8/11/00 3,750 $64.50 $ 241,875 8/11/00 562 $64.50 $ 36,249 8/11/00 75,688 $64.50 $ 4,881,876 8/18/00 137,688 $64.00 $ 8,812,032 8/18/00 32,312 $64.00 $ 2,067,968 11/28/00 140,000 $52.04 $ 7,285,600 390,000 $ 23,325,600
West 2/11/00 10,000 $65.655 $ 656,550 2/11/00 45,000 $65.655 $ 2,954,475 2/11/00 45,000 $65.785 $ 2,960,325 100,000 $ 6,571,350
TOTAL: 11,550,230 $604,838,376
355. As demonstrated above, the stock sales of the Individual Defendants constituted 22% of the Cisco stock they actually owned or acquired by exercise of stock options during the Class Period. These sales were unusual in amount. None of the defendants acquired any stock during the Class Period by option exercise or otherwise and continued to own that stock. They sold 22% of the stock they already owned or acquired because they knew the stock was artificially inflated and would decline sharply in price when the true facts, which they were concealing, became public.
356. While the Individual Defendants held vested stock options to purchase Cisco stock during the Class Period which they did not exercise to acquire stock and then sell it, they actually took this action to help further and perpetuate the fraudulent scheme they were pursuing. First of all, none of these defendants wanted to acquire any Cisco stock during this period and continue to hold it because they knew the stock was artificially inflated and would collapse when the true facts became known. Thus, none of them exercised any of their vested stock options for the purpose of acquiring and continuing to hold and own Cisco stock. In addition, none of these Individual Defendants were willing to exercise more vested stock options to acquire Cisco stock and immediately sell that stock for several reasons. First of all, each of the Individual Defendants realized that their stock sales would become known to the public, either through public reporting of their Form 144's or Form 4's they had to file with the SEC to disclose their sales. This public reporting and disclosure acted as a significant market force restraint on the amount of stock the Individual Defendants could actually sell. Many sophisticated investors and several insider stock selling or short-selling stock newsletter services closely track insider selling by corporate executives at major corporations and then quickly publicize that information as a sign that something is likely seriously wrong at a corporation that has not yet been disclosed - negative publicity which can result in analyst inquiries and often a decline in the stock price. Therefore, while the Individual Defendants wanted to unload significant amounts of the stock they actually owned or could acquire by stock option exercise, they realized that they had to exercise some restraint and not exercise all their vested stock options and sell the stock acquired thereby because of the negative consequences outlined above. Thus, the Individual Defendants sold only as much of their Cisco stock and vested stock as they thought they could without generating trouble and negative publicity.
357. The Individual Defendants each also had an economic motive for behaving in this way, i.e., not exercising all of their vested stock options and selling off the stock, even though they knew that Cisco http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 212 of 223
stock was selling at artificially inflated prices and would likely shortly decline sharply in price. First of all, their vested options would remain vested for several years and thus even a sharp decline in Cisco stock in the near term would not completely eliminate the value of these options. These Individual Defendants had the option of holding onto these options hoping the stock would later recover and they could then exercise these options and sell the stock. Also, these defendants knew that they always had the option after the negative information they were concealing became public and Cisco's stock price declined sharply, to take their unexercised vested stock options and get Cisco's Board of Directors to re-price them downward with much, much lower exercise prices and longer exercise lives, to immediately restore the value in those unexercised vested stock options. Or defendants could get Cisco's Board of Directors to issue additional options at lower exercise prices to restore the value lost from the stock decline. In fact, in 5/01 and 8/01, after the stock price decline, Cisco's Board issued a significant amount of new options at very low strike prices ($16.01 and $18.57) to Cisco's senior management. For example, Chambers received 4,000,000 new options, Carter received 400,000 new options, Volpi received 400,000 new options, Bartz received 210,000 new options, and Redfield received 300,000 new options. As a result of the foregoing, each of the Individual Defendants actually sold during the Class Period all of the shares of stock of Cisco which they actually owned by way of existing actual ownership or exercise of vested stock options and all or nearly all they rationally could sell via the exercise of vested stock options without generating adverse publicity and inquiry, which might result in the premature disclosure of their fraudulent scheme and cause a decline in and negative impact on the stock price of Cisco.
358. The Individual Defendants' stock sales were also very unusual in their timing. These stock sales occurred during the time period when Cisco was supposedly enjoying a period of exceptional business success and was pointed to achieve strong revenue, net income and EPS growth, not only in the next quarter or two, but during the next few years at least. As a result, if these exceptionally favorable present conditions and future prospects actually existed, Cisco stock should have been poised for a major advance over the next few years as was being predicted by several prominent investment firms that followed Cisco and whose analysts were relying upon the information provided them by the Individual Defendants as to these strong business conditions that would result in the forecasted strong growth and revenue, net income and EPS for Cisco. Nevertheless, the Individual Defendants unloaded 11.5 million shares of Cisco stock -- 22% of the stock they actually owned - for $604 million in illegal insider trading proceeds at the beginning or during the early stages of this supposed exceptionally favorable period for Cisco's business, which should logically have resulted in a strong increase in Cisco's stock price over the next few years. The Individual Defendants did this because they knew their statements about the current strong condition of and successes with Cisco's business, as well as its strong future prospects, were false and were concealing the serious negative conditions in Cisco's business detailed herein. By selling off large amounts of Cisco stock when they did, the Individual Defendants not only personally profited from the artificial inflation in the price of Cisco stock that their false and misleading statements and manipulations had created, they also avoided losing millions of dollars which would have been the case had they waited until the true facts they were concealing were known to the market before they sold their stock at much lower levels.
359. While the Individual Defendants also owned vested stock options which were not exercised, their stock sales were still significant in amount and unusual in timing. Ownership of stock options is considerably different from ownership in stock.
360. A stock option is a right to purchase a security for a pre-determined price (the exercise price) on or before a specified expiration date. It is common for publicly traded companies to compensate their management, in part, by granting them long-term stock options which vest over time. No money http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 213 of 223
changes hands at the time these options are granted. Since stock options are a "free ride," there is no fundamental economic incentive to exercise options before they expire unless a holder expects to see poor stock performance.
361. Cisco used stock options as part of its compensation package for the Company's management. These stock options were typically 9 years in length and became vested at a rate of 20%-25% after the first year and ratably in monthly increments over the succeeding three to four years and lapsed after 9 years, thus providing a 5-year "free ride" to Cisco management.
362. Ownership of stock options is considerably different from ownership of common stock. First, stock options have no capital at risk. The exercise price is not paid until the option is exercised. Thus, an option has substantial upside potential without the downside risk. Second, owners of stock options do not have voting rights. Consequently, stock option holders cannot vote in matters of corporate governance. Third, stock options do not receive dividends. Fourth, stock options are not "marginable" the way stock is. Fifth, stock options issued by a company are not freely tradeable. Because of this, they have to be held to maturity to realize their full economic value. Because of these significant differences, one cannot and should not lump an insider's stock ownership together with an insider's vested options to determine the insider's "total holdings" of stock in the company. In fact, none of the insider trading services that collect and disseminate information about securities by corporate insiders include vested stock options in their calculation of the insider's "total holdings" of stock.
363. Vested stock options do not carry the same economic risk as actual stock ownership. If a stock's price declines, the owner of the stock suffers a real economic loss of the money paid for the stock. The holder of a vested stock option does not lose any invested money; at worst, the option holder suffers a reduced expectancy of profit in the future. Thus, vested options are not the equivalent of common stock owned because stock actually owned is owned - no further action or expenditure is required. The owner's invested cash is actually at risk to any market price decline. The holder of a vested stock option has no invested cash and no money at risk until that person actually purchases the stock, i.e., pays the exercise price. To actually own the stock, the option holder must put capital at risk. Thus, the failure of the Individual Defendants in this Cisco suit to exercise any more of their vested options, i.e., their failure to purchase more Cisco stock, is consistent with plaintiffs' theory of their case - these defendants were getting out of their Cisco stock, not buying more. Exercising more options would be investing in Cisco, while these defendants were divesting themselves of their Cisco stock.
364. Executives do not face the same risk of loss in stock options as they do with common stock - because they did not pay for the options, and because a company can always lower the exercise price of the options if the price of the stock falls:
Directors simply lower the options' exercise prices to the stock's current price level. Presto! the options can soon be back in the money again. It doesn't matter if the stock ever returns to the levels where the options were originally issued.
E.S. Browning & Laura Jereski, In the Money: Firms With Sagging Stocks Set New 'Repricings' of Executive Options, Wall St. J., 6/11/97, at C1; see Adam Levy, The New Math of CEO Pay, Bloomberg, 7/99, at 24-25:
CEOs, already richly compensated, now get stock options that reward them even when they don't deliver for their shareholders. The practice is called repricing. http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 214 of 223
* * * Options - grants that let executives buy stock at a certain price during a set period of time - were supposed to tie CEO pay to company performance. If the stock went up, the options were worth a bundle. Now, companies are repricing options to give executives a shot at cashing in even though their stocks have sunk. In short, options have become an entitlement rather than an incentive.
365. Because stock options are not freely tradeable, they cannot simply be sold on the open market at a price approximating their value. For the holder to make a disposition, the stock option first has to be exercised, i.e., the holder pays the exercise price in return for the underlying stock. Then the stock can be sold at the market price. Absent transaction costs, the proceeds to the stock option holder thus equals the price received for the sale of the stock, less the exercise price paid. This is also known as an option's intrinsic value. However, the economic value of a stock option equals the intrinsic value, plus a premium reflecting the substantial upside potential of the option. This is similar to the option premium that an investor pays when he buys options in the open market.
366. As a stock option approaches its expiration date, the economic value and intrinsic value converge. Therefore, a stock option has to be held until expiration to realize its full economic value. Ownership of stock has no such considerations.
Black-Scholes Options Valuation as Evidence of Scienter
367. An analysis of the timing of an insider's exercise of stock options and sale of the underlying shares can provide clear and convincing evidence that these transactions were either irrational or based on non-public information. The analysis is based on the common sense foundation that executives will not irrationally, and needlessly, waste large amounts of their wealth. If the finder of fact is unwilling to believe that financially sophisticated executives, privy to all of a company's non-public information, would engage in dramatically irrational personal financial decisions, then a strong inference can be drawn that transactions were based on non-public information, and therefore were illegal.
368. The analytical tool used here is the universally accepted method for calculating the value of stock options, named for its authors, Black and Scholes, who earned the Nobel Prize for this now well- established methodology.(5) Options are valuable rights because the option allows its owner to preserve the opportunity for upside gain without any capital commitment and without any risk of loss. The Black-Scholes formula calculates the expected market value of any option based on several factors: stock price; exercise price of the option; expiration date of the option; volatility of the stock; and the risk-free rate of return. At any time prior to its expiration date, the market value of any option has two components: (1) "intrinsic value," the amount of money that one could obtain by exercising the option as of today (stock price less the strike or exercise price of the option); and (2) "time value," the value from any potential increase in the stock price during the term of the option. The formula demonstrates that a rational investor in an environment of efficient markets, relying solely upon public information, will be hesitant to exercise an option to purchase a non-dividend paying stock prior to the expiration date of the option. The reason for this conclusion is that an early exercise of an option to purchase forfeits the time value of the option between the date of exercise and the date the option expires.
369. Holding the option rather than exercising the option 5-8 years prior to expiration maximizes the holder's wealth, assuming that the holder makes transactions based only on public information. The http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 215 of 223
rational executive will never forfeit more than a de minimis amount of this value because it is unnecessary to do so. Any desire for asset liquidity or diversification can be achieved by any number of financial instruments readily available and commonly used by executives. For example, executives commonly protect themselves from risk by the use of put options, call options, zero cost collars, and equity swaps. All these instruments are readily available, are commonly used, and can be obtained by a simple phone call to a broker. Similarly, information regarding these financial instruments is readily available to these executives through financial advisors and is part of the course work involved in obtaining business degrees. Further, such instruments are commonly used by executives in performing their official duties.
370. Should the holder of an executive option exercise these options early, the Black-Scholes formula quantifies the resulting loss to the executive. The premature exercise of vested options, and its associated dollar cost to the Individual Defendants (as calculated by the Black-Scholes formula), can be explained as rational, i.e., to maximize the returns on their asset only if the Individual Defendants were in possession of material adverse undisclosed inside information. Those Individual Defendants would be willing to forego the time value of the option because they know that the value is based upon an artificially inflated stock price - a price that does not yet reflect the non-public adverse information on which the executive is basing his or her decision to exercise and sell his or her stock.
371. Cisco itself uses the Black-Scholes formula to value its employee stock options in its 01 Annual Report filed with the SEC, stating at page 39 "the fair value of each [employee] option grant is estimated on the date of grant using the Black-Scholes option pricing model."
372. Using the Black-Scholes equation, we can analyze those options which defendants did not exercise which should not be considered part of their total holdings in determining the percentage of stock sold. For example, on 11/28/00, the same day he exercised and sold 140,000 shares at $52.04, Volpi chose not to exercise a different option for 100,000 shares at a strike price of $39.75. However, the fact that he chose not to exercise these options in no way defeats scienter in this case. In particular, the value of these options on that day was $3,909,733. Had he exercised and sold these options he would have obtained only $1,428,100, a loss of over 63% in the value of these options. No rational investor, basing his decision only on public information, could be expected to conduct his affairs in this manner. Further, Volpi's decision not to exercise this option makes sense even if he had based his decision on the insider information as the value of the options after the bad news was revealed was $2,565,447 or almost $1,121,894 more than he would have obtained by early exercise. Because no executive, honest or dishonest, would ever exercise such an option under these circumstances, this option was not in any informative way part of Volpi's holdings available for sale.
373. As a boundary, it is a reasonable inference that a lawful rational executive would not normally exercise an option in which he or she would incur a 20% loss. The following chart details the options for which there is a reasonable inference that these options were not part of defendants' true "available holdings":
No. of Options Value Proceeds by Class Wealth Lost if Penny Per Dollar Options @ 11/28/00 Period Sale on 11/28/00 Exercised Obtained if Sold West: 15,000 $ 577,953 $ 168,750 $ 409,203 $0.29 40,000 $ 1,731,598 $l,388.120 $ 348,478 $0.80 Volpi: http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 216 of 223
100,000 $ 3,909,733 $1,428,100 $2,481,633 $0.37 100,000 $ 3,672,086 (-$ 90,060) $3,762,686 >$0.00 146,667 $ 5,884,424 $3,284,021 $2,600,403 $0.56 30,000 $ 1,184,590 $ 545,610 $ 638,980 $0.46 Redfield: 220,000 $ 8,826,562 $4,925,800 $3,900,762 $0.56 130,000 $ 4,773,712 (-$117,780) $4,891,492 >$0.00 Puette: 40,000 $ 1,731,598 $1,388,120 $ 343,478 $0.80 Estrin: 50,000 $ 1,954,867 $ 714,050 $1,240,817 $0.37 Carter: 150,000 $ 6,248,566 $3,757,050 $2,491,516 $0.60 Bartz: 7,000 $ 269,711 $ 78,750 $ 190,961 $0.29
These figures we calculated as of 11/28/00, the last day any of the defendants sold stock during the Class Period. Similar figures were obtained when using other dates during the Class Period. If these options are not considered part of these defendants' total holdings, the percentage of holdings sold during the Class Period would be as follows: West 44%, Volpi 26%, Redfield 30%, Puette 100%, Estrin 52%, Carter 50%, and Bartz 22%.
CLASS ACTION ALLEGATIONS
374. This is a class action on behalf of purchasers of Cisco common stock between 8/10/99 and 2/6/01, excluding defendants (the "Class"). Excluded from the Class are officers and directors of the Company, as well as their families and the families of the defendants. Class members are so numerous that joinder of them is impracticable.
375. The members of the Class are so numerous that joinder of all members is impracticable. While the exact number of Class members is unknown to the plaintiffs at this time and can only be ascertained through appropriate discovery, plaintiffs believe there are, at a minimum, hundreds of members of the Class who traded during the Class Period.
376. Common questions of law and fact exist as to all members of the Class and predominate over any questions affecting solely individual members of the Class. The questions of law and fact common to the Class include whether defendants: (i) violated the 1934 Act; (ii) omitted and/or misrepresented material facts; (iii) knew or recklessly disregarded that their statements were false; and (iv) artificially inflated Cisco's stock price, and the extent of and appropriate measure of damages.
377. Plaintiffs' claims are typical of the claims of the members of the Class as plaintiffs and members of the Class sustained damages arising out of defendants' wrongful conduct in violation of federal law as complained of herein.
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378. Plaintiffs will fairly and adequately protect the interests of the members of the Class and have retained counsel competent and experienced in class actions and securities litigation. Plaintiffs have no interests antagonistic to or in conflict with those of the other Class members.
379. A class action is superior to other available methods for the fair and efficient adjudication of the controversy since joinder of all members of the Class is impracticable. Furthermore, because the damages suffered by the individual Class members may be relatively small, the expense and burden of individual litigation make it impossible for the Class members individually to redress the wrongs done to them. There will be no difficulty in the management of this action as a class action.
380. Class members were damaged. In reliance on the integrity of the market, they paid artificially inflated prices for Cisco stock.
381. Plaintiffs will rely, in part, upon the presumption of reliance established by the fraud-on-the- market doctrine in that:
(a) defendants failed to disclose material facts during the Class Period that would have corrected prior misrepresentations that became materially false and misleading as a result of subsequent events;
(b) the omissions and misstatements were material;
(c) the securities of the Company traded in an efficient market;
(d) the omissions and misstatements alleged would tend to induce a reasonable investor to misjudge the value of the Company's securities; and
(e) plaintiffs and members of the Class purchased their Cisco stock between the time the defendants failed to disclose material facts and the time the true facts were disclosed, without knowledge of the omitted facts.
FIRST CLAIM FOR RELIEF
Violation of §10(b) of the 1934 Act Against All Defendants
382. Defendants violated §10(b) and Rule 10b-5 by:
(a) Employing devices, schemes and artifices to defraud;
(b) Making untrue statements of material facts and omitting to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; and
(c) Engaging in acts, practices and a course of business that operated as a fraud or deceit upon the Class in connection with their purchases of Cisco stock.
383. Class members were damaged as they paid artificially inflated prices for Cisco common stock in reliance on the integrity of the market.
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SECOND CLAIM FOR RELIEF
Violations of §20(a) of the 1934 Act Against the Defendants Chambers and Cisco
384. Plaintiffs repeat and reallege each and every allegation contained in the foregoing paragraphs as if fully set forth herein.
385. Defendant Chambers acted as a controlling person of the Company within the meaning of §20(a) of the 1934 Act, 15 U.S.C. §78t(a), as alleged herein. By virtue of his high-level position, and participation in and/or awareness of the Company's operations, defendant Chambers had the power to influence and control and did influence and control, directly or indirectly, the decision-making of the Company, including the content and dissemination of the various statements that plaintiffs contend are false and misleading. Defendant Chambers was provided with or had unlimited access to copies of the Company's reports, press releases, public filings and other statements alleged by plaintiffs to be misleading prior to and/or shortly after these statements were issued and had the ability to prevent the issuance of the statements or cause the statements to be corrected.
386. In particular, the defendant Chambers had direct and supervisory involvement in the day-to-day operations of the Company and, therefore, is presumed to have had the power to control or influence the particular transactions giving rise to the securities violations as alleged herein, and exercised the same. Cisco controlled the Individual Defendants and all of its employees.
387. By reason of such wrongful conduct, defendants Cisco and Chambers are liable pursuant to §20 (a) of the 1934 Act. As a direct and proximate result of the wrongful conduct, plaintiffs and other members of the Class suffered damages in connection with their purchases of the Company's stock during the Class Period.
THIRD CLAIM FOR RELIEF
Insider Trading Under §20A of the 1934 Act Against the Individual Defendants
388. Plaintiffs repeat and reallege each of the allegations set forth in the foregoing paragraphs.
389. This claim is asserted by plaintiffs under §20A of the 1934 Act against the Individual Defendants, on behalf of all persons who purchased Cisco common stock contemporaneously with the sale of Cisco common stock by these defendants.
390. During the Class Period, each of the Individual Defendants occupied a position with Cisco which made him or her privy to confidential information concerning the Company, its operations, finances, financial condition and future business prospects, including, but not limited to, the material adverse information concerning orders and demand for Cisco's products, the reasons for and the impact of the growth of its inventories, the quality of and accounting for its vendor financing program, the development and sales of its new Monterey fiber optic switch, its success in penetrating the customer service software market, its success in penetrating the telecommunications SP market with new fiber optic products, the success and continuation of Cisco's acquisition program, and Cisco's forecasted growth and its F01-F02 revenues, net income and EPS, as well as Cisco's actual reported financial http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 219 of 223
results throughout the Class Period. Defendants' public representations on these subjects set forth herein were materially false and misleading.
391. Notwithstanding their duty to refrain from trading in Cisco common stock unless they disclosed the foregoing material adverse facts, and in violation of their fiduciary duties to plaintiffs and other members of the Class, the Individual Defendants sold in the aggregate millions of dollars worth of Cisco common stock during the Class Period contemporaneously with plaintiffs' and other Class members' purchases of Cisco common stock.
392. The Individual Defendants sold their shares of Cisco common stock, as alleged above, at market prices artificially inflated by the nondisclosure and misrepresentations of material adverse facts in the public statements released during the Class Period.
393. Sales that were made by the Individual Defendants contemporaneously with Cisco common stock purchases by at least one or more of the lead plaintiffs or plaintiff members of the Class are set forth in the Appendix A attached hereto.
394. The Individual Defendants knew that they were in possession of material adverse information which was not known to the investing public, including plaintiffs and other members of the Class. Before selling their stock to the public, they were obligated to disclose that information to plaintiffs and other members of the Class.
395. By reason of the foregoing, the Individual Defendants, directly and indirectly, by use of the means and instrumentalities of interstate commerce, the mails, and the facilities of the national securities exchanges, employed devices, schemes, and artifices to defraud, and engaged in acts and transactions and a course of business which operated as a fraud or deceit upon members of the investing public who purchased Cisco common stock contemporaneously with the sale of such stock by defendants.
396. Plaintiffs and other members of the Class who purchased shares of Cisco common stock contemporaneously with the Individual Defendants' sales of Cisco common stock: (1) have suffered substantial damages because they relied upon the integrity of the market and paid artificially inflated prices for Cisco common stock as a result of the violations of §10(b) and Rule 10b-5 alleged herein; and (2) would not have purchased Cisco common stock at the prices they paid, or at all, if they had been aware that the market prices had been artificially and falsely inflated by defendants' misleading statements and concealment. At the time of the purchases by plaintiffs and members of the Class, the fair and true value of Cisco common stock was substantially less than the prices paid by them.
397. This action was commenced within five years after the sales by the Individual Defendants while in possession of material, non-public information.
398. As a result of the foregoing, plaintiffs and the other members of the Class have suffered substantial damages.
PRAYER
WHEREFORE, plaintiffs, on behalf of themselves and the Class, pray for judgment as follows:
A. Declaring this action to be a class action properly maintained pursuant to Rule 23 of the Federal http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 220 of 223
Rules of Civil Procedure;
B. Awarding plaintiffs and other members of the Class damages together with interest thereon;
C. Awarding plaintiffs and other members of the Class costs and expenses of this litigation, including reasonable attorneys' fees, accountants' fees and experts' fees and other costs and disbursements;
D. Ordering defendants to disgorge their insider trading proceeds, including an accounting and constructive trust over those proceeds; and
E. Awarding plaintiffs and other members of the Class such equitable/injunctive or other and further relief as may be just and proper under the circumstances.
JURY DEMAND
Plaintiffs demand a trial by jury.
DATED: May 14, 2002 MILBERG WEISS BERSHAD HYNES & LERACH LLP WILLIAM S. LERACH DARREN J. ROBBINS SPENCER A. BURKHOLZ DANIEL S. DROSMAN
______SPENCER A. BURKHOLZ
401 B Street, Suite 1700 San Diego, CA 92101 Telephone: 619/231-1058 619/231-7423 (fax)
LEVIN, PAPANTONIO, THOMAS, MITCHELL, ECHSNER & PROCTOR, P.A. FREDRIC G. LEVIN J. MICHAEL PAPANTONIO TIMOTHY M. O'BRIEN
______TIMOTHY M. O'BRIEN http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 221 of 223
316 South Baylen Street, Suite 600 Pensacola, FL 32501 Telephone: 850/435-7000 850/436-6084 (fax)
Co-Lead Counsel for Plaintiffs
APPENDIX A
CONTEMPORANEOUS TRADES (8/11/99-2/6/01) Defendant Date of Defendants' Sales Plaintiff and Plaintiffs' Purchases Bartz 8/16/99 Gerald Benoit 8/14/00 Eric Wold Carter 8/13/99 John Orlando 8/16/99 Gerald Benoit 8/17/00 Robert Chmura 8/18/00 Carpenters Pension Fund Chambers 2/11/00 Philip Sutterlin Daichendt 8/13/99 John Orlando 2/11/00 Philip Sutterlin 2/14/00 Richard Chen 8/11/00 Carpenters Pension Fund Estrin 8/13/99 John Orlando 11/12/99 Miguel Arrunategui 2/11/00 Philip Sutterlin Kozel 8/13/99 John Orlando 12/6/99 Fredrick Freud 12/8/99 Plumbers & Pipefitters 8/11/00 Carpenters Pension Fund 8/14/00 Eric Wold 8/18/00 Carpenters Pension Fund Listwin 8/16/99 Gerald Benoit Puette 3/21/00 Plumbers & Pipefitters 3/24/00 Rachel Mosse Redfield 8/13/99 John Orlando 2/17/00 Carl Wilkinson, Jr. 8/11/00 Carpenters Pension Fund 8/18/00 Carpenters Pension Fund Valentine 8/13/99 John Orlando Volpi 8/11/00 Carpenters Pension Fund 8/18/00 Carpenters Pension Fund 11/28/00 Jo Daugherty http://securities.milberg.com/mw-cgi-bin/view_story?uid=filings&conf=/disk22/websites/MW.../3 8/7/02 Page 222 of 223
West 2/11/00 Philip Sutterlin 8/11/00 Carpenters Pension Fund 8/14/00 Eric Wold
DECLARATION OF SERVICE BY MAIL PURSUANT TO NORTHERN DISTRICT LOCAL RULE 23-2(c)(2)
I, the undersigned, declare:
1. That declarant is and was, at all times herein mentioned, a citizen of the United States and a resident of the County of San Diego, over the age of 18 years, and not a party to or interest in the within action; that declarant's business address is 401 B Street, Suite 1700, San Diego, California 92101.
2. That on May 14, 2002, declarant served the CONSOLIDATED COMPLAINT FOR VIOLATION OF THE FEDERAL SECURITIES LAWS by depositing a true copy thereof in a United States mailbox at San Diego, California in a sealed envelope with postage thereon fully prepaid and addressed to the parties listed on the attached Service List and that this document was forwarded to the following designated Internet site at:
http://securities.milberg.com
3. That there is a regular communication by mail between the place of mailing and the places so addressed.
I declare under penalty of perjury that the foregoing is true and correct. Executed this 14th day of May, 2002, at San Diego, California.
______Rika J. Ellis
1. Cisco's fiscal year ends on the last Saturday in July.
2. All share and per share amounts are adjusted to reflect 2-for-1 stock splits in 6/99 and 3/00.
3. While there are situations where revenue can be recognized prior to shipment, called "bill and hold," these situations require that numerous conditions exist before revenue recognition can occur, which conditions did not exist. See SEC Staff Accounting Bulletin No. 101.
4. As SEC chairman Arthur Levitt has stated:
The prohibition against members of a firm making a financial investment in a firm audit client is considered one of the "golden rules" of auditing. In today's technological and information-driven markets, an increased emphasis has been placed on information verified by third parties. With companies under increasing stress to meet their "numbers," the role and pressures on the independent auditor have significantly increased.
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5. See generally F. Black and M. Scholes, The Pricing of Options and Corporate Liabilities, J. Pol. Econ. (May/June 1973); S. Natenberg, Options Volatility & Pricing: Advanced Trading Strategies and Techniques (1994); V. Bhensali, Pricing and Managing Exotic and Hybrid Options (1998). ð
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