RULE MAKER PORTFOLIO

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What Happened to Cash-King?

Cisco vs. Lucent

By Phil Weiss (pweiss@homemail.com)

Towaco, NJ (Jan. 6, 1999) -- Tonight I thought that I'd visit a question that comes up regularly on Cisco's Message Board: Which is the better stock to own, Cisco (Nasdaq: CSCO) or Lucent (NYSE: LU), or both?

Before I get to the analysis I should disclose that I own shares of both of these companies in my portfolio; however, I don't treat them the same. I remember back in April of last year Al wrote a report about his thoughts on Lucent. He concluded that Lucent, which he had acquired when it was spun off from AT&T, was not a Rule Maker, so he sold his shares when he rotated his Foolish Four stocks. At the time I took the other side of the argument as I believed then (and still do by the way) that Lucent is a great company -- one that I thought could become a Rule Maker over time. However, based upon its performance over the last 9 months, I think that it is now much further away from Rule Maker status than it was at that time.

Sometimes, even though several of our stocks fall short on one or another of our criteria, it may seem that our approach can focus more on the numbers than anything else. To me, the numbers are important as a starting point in determining whether or not a company is a viable Rule Maker candidate. However, the numbers themselves are less important than their direction. This is where Lucent really falls short in my view.

Warning! Warning! Danger! Those of you that don't like to go through numbers too much may want to go through the next section of this report real quickly. But, I think that if you do take the time to look through it, you'll see some rather disturbing trends.

As of December 31, 1996, Lucent had $3.2 billion of cash on its balance sheet. By the first quarter of 1997 this number had fallen to 2.0 billion. As a matter of fact, with one exception, this number has fallen every quarter since then and as of September 30, 1998 cash represented only $685 million of Lucent's assets. This also means that its ratio of cash-to-debt has fallen from 1.92 to 0.28 - an 85% decrease. During this timeframe, long-term debt has also increased from $1.7 billion to $2.4 billion.

If you take a look at Lucent's flow ratio, you'll also see a similar trend. From December 31, 1996 to September 30, 1998, it has increased from 0.97 to 1.28 (though it has been relatively steady over the last year) a 32% increase. The trend here is what's most disturbing to me as the 1.28 value is really right in line with our minimum threshold of 1.25.

Now, let's look at Cisco's numbers for the same period. At the end of the quarter ended January 25, 1997 Cisco had $1.1 billion of cash and no long-term debt. As of the end of its October 1998 quarter, Cisco had $1.9 billion of cash and still had no long-term debt. During this same period our company's flow ratio has fallen from 1.59 to 1.13.

So, if we take an isolated look at the balance sheets of these two companies, Cisco looks much stronger. Even more telling is the fact that Cisco's balance sheet has been getting stronger every quarter while Lucent's has been getting consistently weaker. In my view, Lucent has not shown any real evidence that it's been able to successfully pay off its long-term debt (or even wants to). Lucent is currently incurring a little more than $300 million of annual interest expense on its debt. Cisco is not paying a penny of interest expense.

You might ask what value this information has to me as an investor analyzing these two companies. Well, I know that many view these companies as potential competitors. They are certainly industry heavyweights. I'd expect that if Lucent continues trying to make inroads into the networking space the battle between it and Cisco could get nasty. Since it doesn't have Lucent's heavy debt load, I think Cisco is in much better shape to do battle than Lucent.

A look at the income statements of these two companies only serves to strengthen my conviction that Cisco currently has a strong leg up in any competition with Lucent. Cisco's gross margins have been around 65% during the period that I mentioned above; Lucent's have ranged from 41% to 48%. Cisco's net margins are consistently above 20%. On the other hand, Lucent's are generally less than 10% (for more information on gross and net margins, you can check through our 6th Step).

These superior margins also leave Cisco in better position to survive a competitive situation. Cisco could much more easily cut prices in order to win new business while still staying more profitable than Lucent. And Cisco doesn't have to pay $300 million in interest expense either.

Can Lucent win a battle for supremacy with Cisco? Yes. Do I think that it's likely that it will? No. Lucent has chosen to take on a large amount of debt in an attempt to grow its business. There is nothing that says this strategy can't be successful. However, if given a choice between one company with a heavy debt burden and another that is lean and mean, I'll take the lean, mean fighting machine any day. The latter company has a lot more margin for error. But, this also doesn't mean that I can't be wrong. After all, I'm simply a Fool.

I also like the fact that, while neither company is small, Cisco's revenues are less than a third of Lucent's. This gives it a lot more room to grow. As a matter of fact, for what it's worth, according to Zacks, the Wise currently estimate that Cisco will grow earnings per share by approximately 28% over the next 5 years. The estimate for Lucent is only 22%.

I did say up front, though, that I own shares in both companies. You might ask why I would choose to do so when I believe that one is much stronger than the other. There are really two reasons for this. The first is that in my view there really isn't a reason to sell my Lucent stock right now. It's been executing its business model well. I won't sell unless I think that's changing. The other is that holding onto Lucent allows me to hedge my bet a little bit. But, whenever I invest new money in a company in this industry it is much more likely that I will add more Cisco stock rather than Lucent stock.

Do you agree or disagree with my views? Do you think that you can convince me otherwise? Do you have any other questions? I'd be happy to continue the discussion on our Companies Board. Phil Weiss, Fool

01/06/99 Close
Stock  Change    Bid
AXP   +4 1/16  103.63
CHV   +2 3/8   83.25
CSCO  +3 3/16  100.13
KO    +1 5/8   70.25
GPS   +4 9/16  63.13
EK    +1 11/16 73.19
XON   +2 15/16 74.88
GM    +3 7/16  78.06
INTC  +6 1/4   129.50
MSFT  +4 3/4   151.25
PFE   +2 7/16  126.31
SGP   +  3/4   57.00
TROW  -1 3/16  37.44

                   Day   Month    Year  History
        R-MAKER  +3.20%   6.14%   6.14%  38.12%
        S&P:     +2.22%   3.51%   3.51%  26.48%
        NASDAQ:  +3.09%   5.85%   5.85%  39.28%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    151.25    93.24%
    5/1/98 55.5 Gap Inc.      34.06     63.13    85.33%
   6/23/98   34 Cisco Syst    58.41    100.13    71.42%
    2/3/98   22 Pfizer        82.30    126.31    53.48%
   2/13/98   22 Intel         84.67    129.50    52.94%
   8/21/98   44 Schering-P    47.99     57.00    18.77%
    2/6/98   56 T. Rowe Pr    33.67     37.44    11.18%
   2/27/98   27 Coca-Cola     69.11     70.25     1.65%
   5/26/98   18 AmExpress    104.07    103.63    -0.42%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     74.88    16.38%
   3/12/98   20 Eastman Ko    63.15     73.19    15.90%
   3/12/98   17 General Mo    72.41     78.06     7.81%
   3/12/98   15 Chevron       83.34     83.25    -0.11%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3630.00  $1751.55
    5/1/98 55.5 Gap Inc.    1890.33   3503.44  $1613.11
   6/23/98   34 Cisco Syst  1985.95   3404.25  $1418.30
   2/13/98   22 Intel       1862.83   2849.00   $986.17
    2/3/98   22 Pfizer      1810.58   2778.88   $968.30
   8/21/98   44 Schering-P   2111.7   2508.00   $396.30
    2/6/98   56 T. Rowe Pr  1885.70   2096.50   $210.80
   2/27/98   27 Coca-Cola   1865.89   1896.75    $30.86
   5/26/98   18 AmExpress   1873.20   1865.25    -$7.95

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1497.50   $210.80
   3/12/98   20 Eastman Ko  1262.95   1463.75   $200.80
   3/12/98   17 General Mo  1230.89   1327.06    $96.17
   3/12/98   15 Chevron     1250.14   1248.75    -$1.39

                              CASH    $120.62
                             TOTAL  $30189.75
  
Note: On 8/4/98 $2,000 cash was added to the
portfolio. $2,000 will be added every six months.


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