RULE MAKER PORTFOLIO

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Cisco Keeps on Keepin' On

By Phil Weiss (TMF Grape)

TOWACO, NJ (May 18, 1999) -- Tonight, I'm going to review last week's earnings report from one of the top-performing companies in our portfolio -- Cisco Systems (Nasdaq: CSCO). If you haven't already, check out the company's earnings press release and conference call replay.

I ran our networking company's third quarter results through the paces of the Rule Maker spreadsheet, giving the company its routine quarterly check-up. Let's take a look at how John Chambers and company scored versus rivals Lucent Technologies (NYSE: LU), Nortel Networks (NYSE: NT) and 3Com Corp. (Nasdaq: COMS) -- click here for my analysis.

As you can see from these results, Cisco had yet another top-notch quarter, achieving an impressive Top Tier score of 53 points. What I find most amazing is the way that Cisco trounced its competition in the Monopoly Status test with a perfect score of twenty points. If you look closely at these numbers, it's relatively easy to conclude that our networker's lead over its competitors is unlikely to disappear anytime soon.

In the gross margin race, Cisco has left the competition in the dust with this quarter's 65% gross margins versus 46-48% for the competition. Cisco's edge in terms of net margins is even more astounding, though it fell a few notches to 20.5%. The best of its competitors, 3Com, musters a net margin of only 6.4%. Although Cisco's margins fell slightly last quarter, it's easy to see that it has a significant advantage over its competitors in terms of pricing power.

The decline in Cisco's margins is pretty minor and not all that surprising. Cisco executives frequently warn that gross margins will fall slightly due to shifts in product mix and on-going competitive pricing pressures. The nice thing is that Cisco's gross margins are more than 30 percent better than that of the competition. With this comfortable lead, it's relatively painless for a company like Cisco to slightly lower its prices so as to increase overall sales revenue and put pressure on the competition. This is an example of the flexibility that a high-margin Rule Maker can have in terms of pricing.

Interestingly, during the conference call, Cisco CEO John Chambers said "Cisco's toughest competition continues to come from hundreds of new start-up companies." This statement dovetails nicely with Cisco's preference to buy the technology it needs in small-scale acquisitions as opposed to transactions such as Lucent's purchase of Ascend Communications and Nortel's purchase of Bay Networks.

A more detailed look at the income statement tells us that the decline in net profit margin was primarily related to the fact that both selling, general, and administrative expenses (SG&A) and research and development (R&D) expenses increased more rapidly than revenues. This can primarily be attributed to Cisco's expanding presence in Asia, where over the last 18 months headcount for Cisco Asia has grown from 175 to 575.

The company's existing office in Singapore has been expanded and now serves as the regional headquarters. Offices have also been opened in three additional towns in China, two in India, and one each in Taiwan and Vietnam. It seems pretty logical to assume that these efforts were behind Cisco's 40% year-over-year revenue growth in Asia. The growth in these expenses is evidence of Cisco's commitment to investing in its future.

During normal circumstances, Cisco targets expense growth at a level about 5% lower than sales growth. However, the company will "overinvest" in its future based upon its assessment of growth opportunities. Our company's CFO, Larry Carter, said he expects expenses to grow in-line with sales over the next few quarters.

The thing that I like best about Cisco's margin advantage is that I suspect it may even be larger than reflected by the numbers in the spreadsheet. This is because Cisco has conservative revenue-recognition policies, as I confirmed in a recent discussion with the company about its financial statements. One look at all the inventory writedowns that 3Com has taken over the last few years is a strong sign that not all of our company's competitors are as conservative in their accounting policies.

Now, let's move on to the balance sheet, where Cisco has loads of cash and not a single cent of debt -- none, notta, zilch. On the other hand, Lucent's cash position is down to only 11% of its interest-bearing debt. And while 3Com has very little debt, its net cash falls $500 million short of Cisco's $1.8 billion in liquid securities. Including long-term and restricted investments, Cisco is now sitting on a horde of $8.3 billion.

Looking at the Flow ratio, Cisco's balance sheet dominance becomes even more evident. The company's Flowie fell by about 20% year-over-year and now sits at only 1.05. In stark contrast, the average score for Cisco's competitors is 1.68. Clearly, Cisco's balance sheet is a lot stronger than that of its competition.

The cash-generating capabilities of Cisco's business are becoming increasingly obvious. The company said that its operations are currently generating about $300 million per month in positive cash flow. During the call, Cisco also mentioned that despite the fact that sales grew 11% sequentially, accounts receivable actually fell by 14%. This led to a significant decline in days sales outstanding (DSO). The reasons given for the positive developments in terms of receivables collection were the excellent "linearity" of sales during the quarter as well as continued process improvements in the collection process.

On the other hand, inventory increased by about 32% from last quarter. The increase was due to such factors as Cisco's need to retain flexibility to meet customer ordering patterns, product mix, and new product ramps. While we don't like to see inventory increasing faster than sales, management's justification for the rise seems reasonable. Nevertheless, we'll keep our eye on this one.

One thing that really surprised me during the call was how optimistic the company seemed to be about the future. This was particularly true during the discussion of the Year 2000 (Y2K) issue. Cisco noted that there have been substantial improvements in this area over the past few quarters as CIOs are now much more optimistic about their ability to successfully manage this issue. Cisco has been through three tests of Y2K compliance for its own systems, and at this point, the company's focus is on its suppliers and partners.

Finally, I should also point out that these terrific results are in what typically has been a tough quarter for the company. So far this year, Cisco's revenues are up by 30% or more in 13 of its top 15 countries. Japan is one of the few areas in which the company is not optimistic in the short term. Cisco does not expect to see a turnaround in Japan until at least calendar year 2000.

All in all, this was a great quarter for Cisco. As John Chambers put it, "There are very few quarters as smooth as this one." For more on Cisco's quarter, check out TMF Verve's conference call notes.

See ya on the boards.

Fool on!

Phil Weiss (TMFGrape)

05/18/99 Close
Stock Change    Bid
AXP   +2 3/4    124.38
CHV   -3 1/4     92.63
CSCO  -  1/4    116.19
EK    -2 5/8     74.13
GM    +  11/16   81.00
GPS   +  5/16    61.38
INTC  -  1/2     58.94
KO    +1 5/8     68.75
MSFT  -  7/16    78.69
PFE   -  13/16  113.56
SGP   -1 1/8     45.94
TROW  +  7/16    38.13
XON   -1 1/4     77.75
YHOO  -5        156.81


                  Day     Month  Year    History
        R-MAKER  -0.54%  -3.79%   7.83%  36.45%
        S&P:     -0.46%  -0.14%   8.79%  34.57%
        NASDAQ:  -0.14%   0.61%  16.68%  54.78%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     78.69   101.07%
   6/23/98   34 Cisco Syst    58.41    116.19    98.92%
    5/1/98   55 Gap Inc.      34.37     61.38    78.57%
   2/13/98   44 Intel         42.34     58.94    39.21%
    2/3/98   22 Pfizer        82.30    113.56    37.99%
   2/17/99   16 Yahoo Inc.   126.31    156.81    24.15%
   5/26/98   18 AmExpress    104.07    124.38    19.51%
    2/6/98   56 T. Rowe Pr    33.67     38.13    13.22%
   2/27/98   27 Coca-Cola     69.11     68.75    -0.52%
   8/21/98   44 Schering-P    47.99     45.94    -4.28%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     77.75    20.85%
   3/12/98   20 Eastman Ko    63.15     74.13    17.38%
   3/12/98   17 General Mo    72.41     81.00    11.87%
   3/12/98   15 Chevron       83.34     92.63    11.14%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
   6/23/98   34 Cisco Syst  1985.95   3950.38  $1964.43
    2/3/98   48 Microsoft   1878.45   3777.00  $1898.55
    5/1/98   55 Gap Inc.    1890.33   3375.63  $1485.30
   2/13/98   44 Intel       1862.83   2593.25   $730.42
    2/3/98   22 Pfizer      1810.58   2498.38   $687.80
   2/17/99   16 Yahoo Inc.  2020.95   2509.00   $488.05
   5/26/98   18 AmExpress   1873.20   2238.75   $365.55
    2/6/98   56 T. Rowe Pr  1885.70   2135.00   $249.30
   2/27/98   27 Coca-Cola   1865.89   1856.25    -$9.64
   8/21/98   44 Schering-P   2111.7   2021.25   -$90.45

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1555.00   $268.30
   3/12/98   20 Eastman Ko  1262.95   1482.50   $219.55
   3/12/98   17 General Mo  1230.89   1377.00   $146.11
   3/12/98   15 Chevron     1250.14   1389.38   $139.24

                              CASH     $70.09
                             TOTAL  $32828.84

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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