RULE MAKER PORTFOLIO

Rule Maker Portfolio
Cisco Continues to Shine

By Phil Weiss (TMF Grape)

TOWACO, NJ (Nov. 11, 1999) -- If you check out the historical performance of the stocks in our portfolio, you'll find that one company stands head and shoulders above the others. Not surprisingly, it's Cisco Systems (Nasdaq: CSCO), a company that has matched or beaten the expectations of the Wise in each of the 39 quarters that it has been a public company. On Tuesday night, Cisco released its earnings results for the first quarter of its fiscal year 2000. It should hardly be a surprise that the "Kid" kept this string alive.

Interestingly enough, the conversation over on our Cisco Message Board over the last few weeks centered around unfound rumors that Cisco was going to pre-announce an earnings shortfall. Hopefully, at least some of you joined me in using the price decline that came about along with these rumors as an opportunity to add a few more shares of this stalwart company to your portfolio.

Before we get to some of the details for the quarter, I thought I'd highlight what impressed me the most while I listened to the quarterly conference call. First and foremost, Cisco's management continues to impress. It's particularly encouraging to know that this company operates its business with the same focus I have when I invest. Our company's CEO, John Chambers, said, "We will continue to make decisions on the basis of the long-term best interest of our customers, shareholders, employees and partners." This is exactly the kind of philosophy I want to hear from my company's top management.

As an investor that focuses on the Rule Maker criteria, it's also encouraging to hear how much attention Cisco pays to its margins, its accounts receivable, its inventory, and the amount of cash its business generates. It comes as no surprise that our company once again turned in a Top Tier Rule Maker score of 54 this quarter. (Want to know how to score Rule Makers? Check out our spreadsheets page.)

Here are the financial highlights for the quarter:

• Revenues of $3.88 billion, beating estimates of $3.80 billion
  
• Net income of $0.24 per share, beating estimates for $0.23
  
• Year-over-year sales growth of 49%
  
• Quarter-to-quarter sales growth of 9% (the 7th straight quarter that Cisco has had this type of growth)
  
• Gross margins of 64.8%
  
• Net margins of 21.6%
  
• Cash of $1.8 billion (excludes investments of $8.9 billion and restricted investments of $1.1 billion)
  
• No debt
  
• Flow Ratio of 1.03
  

What I'd like to do now is take Cisco through the ten basic Rule Maker criteria that we look for in our Rule Making investments and see how things shake out. Then, I'll wrap things up with a few of the other highlights from the conference call.

1. Dominant Brand -- Cisco's goal is to be #1 or #2 in each product line, a goal that it continues to achieve.
   
   
2. Repeat Purchase Business -- The growth rate of Cisco's industry is in the range of 30 to 50 percent, and Cisco has been growing at the top end of this range. That kind of growth requires strong, mutually beneficial customer relationships. Cisco generates repeat business by knowing and serving its customers' top needs: product capability, support and service, and strategic concerns.
   
   
3. Convenience -- During the call it was said that Cisco transacts approximately 83% of its orders -- $37 million per day -- over the Internet. That sounds pretty convenient to me.
   
   
4. Expanding Possibilities -- Cisco expects that its market will grow at a rate of 30 to 50 percent over the next several years in those countries with a growing economy. Provided solid execution, the company should be able to grow within this range. In addition, the company regularly offers new products, based on internal development, partnerships, and acquisitions. It was also interesting to note that Chambers said nearly two-thirds of Cisco's business relates to products developed internally. To me, these are all good indicators of continued future success for this Rule Maker.
   
   
5. Your Familiarity and Interest -- One of my favorite parts of investing is the opportunity it provides to learn about the characteristics of great businesses. The fact that I have a good deal of respect for Cisco's management team makes the company particularly interesting for me to follow.

The next five steps take us through the numbers.

6. Sales Growth of 10% or more on a comparable quarter basis -- Cisco's October 1998 sales were $2.6 billion. This quarter they were $3.9 billion, an increase of 49%. 'Nuff said.
   
   
7. Gross Margins of 50% or more -- Cisco's gross margin for the quarter was a healthy 64.8%, which was down from last year's 65.5%, but up slightly from last quarter's 64.7%. The biggest factors affecting gross margins are ongoing cost reductions, product mix, and continued pricing pressure from competitors. Management's guidance is that it expects gross margins to fall from its present level. However, it's still well above our target, and light years ahead of its major competitors who all have gross margins below 50%.
   
   
8. Net Margins of at least 7% -- Cisco rang in with a solid 21.6%. This is unchanged from the first quarter of last year and three times our target. It shouldn't be too surprising that this figure is also in a different league than its competitors, none of whom hit double digits. Cisco's advantage in gross margins also gives it a big edge in net margins. Net margin increased from 20.5% last quarter. The primary driver behind this increase was a decline in Cisco's effective tax rate 33% to 30%. This decline was partially offset by increases in selling and marketing expenses.
   
   
9. Cash-to-Debt of 1.5 or greater -- Cisco continues to have a debt-free balance sheet. Its two largest competitors in terms of size continue to sport negative net cash on their balance sheets.
   
   
10. Flow Ratio of 1.25 or less -- Cisco's flow ratio fell from 1.13 in the first quarter of last year to 1.03 this quarter. The only disappointment was that this result was higher than last quarter's 0.87. At first blush this sounds like at least a bit of a disappointment. So, let's look at the numbers a little more carefully and see what we learn.
    

The first test is to compare the growth rates of accounts receivable and sales. Ideally, receivables (uncollected bills) will grow less quickly than sales. Cisco's accounts receivable balance on a year-over-year basis increased by a measly 4%, compared to robust sales growth of 49%. Good so far. But, on a quarter-to-quarter basis, receivables increased by 12%, which is ahead of the 9% sequential growth in revenues.

Another way to look at the level of receivables is days of sales outstanding (DSO), which is the amount of time it takes to collect cash payment for sales -- the faster the better. Cisco's DSO was 32.6 days this quarter versus 31.9 days last quarter. When you take into consideration that typical sales terms require payment within 30 days, this figure is impressive even with the slight increase. It's also down significantly from 52 days a year ago and well under the company's target of 50 days or less. So, accounts receivable appear to be in check, so let's next take a look at inventory.

Inventory management improved nicely from last quarter, but it was not as strong as a year ago. Cisco expects inventory to expand slightly as the company must provide flexibility in order to satisfy its customers' overall expectations, especially with regard to lead times and product availability. Cisco anticipates that its inventory turnover will remain at current levels over the near term.

All in all, there are no big problems with receivables or inventory. So, why did the flow ratio increase from last quarter? If you look at the balance sheet, you'll see that cash and equivalents fell 6% year-over-year and by 14% quarter-to-quarter. Initially, that looks disappointing, as we'd prefer to see cash on the rise. But, in the long-term section of the balance sheet, investments increased from $7.0 billion last quarter to $8.9 billion this quarter. So, it looks like all that happened was that some cash was moved from the current asset section of the balance sheet to the long-term section. If the mix between current and non-current had been the same as in the past, the flowie would have been better. To me, this is a reasonable explanation, so I have no concerns.

As promised, here is a summary of some of the other impressive facts I heard and/or learned while listening in on the conference call:

• Once again during the quarter Cisco's orders were greater than its shipments, meaning that its book-to-bill ratio is greater than one. This is a good sign for the future.
  
  
• The sum of all cash (short term, long term, and restricted investments) increased by approximately $0.6 billion from last quarter. In addition, our company is now generating approximately $300-$400 million of cash flow from operations every month.
  
  
• Cisco breaks its sales into four geographic regions. EMEA (primarily Europe), the Americas, Asia, and Japan. All but Japan showed at least 45% year-over-year growth led by Asia Pacific's 60%. Japan rang in at 12% growth.
  
  
• Our company has three primary concerns going forward: Worldwide economic conditions, Y2K challenges, and competition. Y2K is still being viewed as a one quarter phenomenon, and if anything, Cisco is a bit more optimistic about its impact than it was last quarter.
  

Related Links:

• Earnings Release
  
• Conference Call Replay (available thru 11/18)
  
• Cisco's Q1 Ranker, versus Lucent, Nortel, and 3Com
  

Finally, our Rule Making retailer Gap Inc. (NYSE: GPS) reported its third quarter results this morning. Most interesting perhaps is that Gap opened up its conference call to the public for the first time ever -- bravo! Earnings per share of $0.35 beat the consensus estimate by a penny. Apparently, the market had already anticipated this outcome as Gap shares barely moved today, rising only $1/16. Get the low-down on Gap's results from today's Fool News story, Gangbusters at Gap.

What do you think?
Come post your thoughts about tonight's report on our Rule Maker Strategy board. Alternatively, if you have ideas, analysis, or questions about a particular Rule Maker company, take a seat at the roundtable discussion on our Rule Maker Companies board. Finally, if you're new to all this stuff, the Rule Maker Beginners board is the place to get your questions answered.