By Phil Weiss (TMF Grape)
May 10, 2000

Last night, Cisco Systems (Nasdaq: CSCO) released stellar earnings results for yet another quarter. The financial highlight of the quarter was probably Cisco's year-over-year revenue growth of 55%, which is pretty unbelievable considering that it recognized just shy of $5 billion of revenue in the quarter.

If you're a long-term Cisco shareholder like me that is interested in learning more about the company's business and getting some insight into the quality of its management team, you should also set aside some time to listen to the quarterly conference call, which is available until May 16. (Links provided at the end of the column.)

What I'm going to do first tonight is share some of the highlights from the conference call and the results for the quarter. If the negativity in the recent Barron's article on Cisco concerned you, then you should be happy to know that although, as always, Cisco did raise a few concerns, our CEO John Chambers is still quite optimistic about the company's future. As a matter of fact, he still expects expenses to grow more quickly than revenues over the next three to four quarters. The reason for this is that the market opportunities for Cisco right now are just too good to pass up.

The company actually sees many more opportunities available to it than it can fund at its current spending levels. Cisco still continues to expect that the market for its products will continue to grow in the 30-50% range for the next several years in those countries where the economy is strong. The execution by Cisco and its competitors is the primary factor that will determine if Cisco grows within or below its industry growth rate.

Before proceeding, I'd like to get back to the Barron's article for a second. My take on that article was that although it did raise some issues that could be of concern, it did a very poor job of examining the issues in detail and did not provide much in the way of valuable insights. Monday's Post of the Day did a great job of dissecting the article in more detail.

From a Rule Maker perspective, one of the most awesome results of the quarter is the growth in Cisco's cash balance -- 129% on a year-over-year basis. Our company is now generating cash flow from operations of approximately $500 million per month and its total balance of cash plus short and long-term investments is up to $16.2 billion!

According to the Rule Maker Ranker I put together for Cisco, this was actually its best quarter yet, as it registered a score of 57 -- the highest score we've seen on the Rule Maker Companies discussion board.

Here are the financial highlights for the quarter:

• Revenues of $4.92 billion, beating estimates of $4.67 billion
  
• Pro forma net income of $0.14 per share, beating estimates for $0.13
  
• Year-over-year sales growth of 55%
  
• Quarter-to-quarter sales growth of 13% (the ninth straight quarter of sequential growth)
  
• Gross margins of 64.5%
  
• Net margins of 20.9%
  
• Cash of $4.7 billion (excludes investments of $10.4 billion and restricted investments of $1.2 billion)
  
• No debt
  
• Flow Ratio of 0.87

What I'd like to do now is take Cisco through the quantitative elements of our five basic Rule Maker Criteria and see how things shake out. Then, I'll wrap up with a few more highlights from the conference call.

1. Sales Growth of 10% or more -- Cisco's April 1999 sales were $3.2 billion. This quarter they were $4.9 billion, an increase of 55%. It's hard for me to imagine that a company this size can grow sales at this pace. Clearly, with sales at this level, it's going to be quite difficult to sustain this level of growth over time.
   
   
2. Gross Margins of 50% or more -- Cisco's gross margin for the quarter was a healthy 64.5%, which was down slightly from last year's 64.9%. The biggest factors affecting gross margins are ongoing cost reductions and value engineering efforts by Cisco, product mix shifts, increasing levels of services, and continued pricing pressure from competitors. Management's guidance is that it expects gross margins will fall from their present level. However, they're still well above our target, and light years ahead of Cisco's major competitors who on average have a gross margin just below 49%.

Related to the subject of gross margins, John Chambers said on the conference call that the company was having trouble finding enough hardware to build corporate networks. "We've seen increasing component shortages," he said. Chambers added that Cisco could experience a "tight market" for components over the next two years. As the Rule Maker of the industry, you might think that Cisco would be able to call in favors from its suppliers in order to meet such shortages. One problem is that Cisco's sheer size relative to that of its competitors makes this increasingly difficult.

3. Net Margins of at least 7% -- On a pro-forma basis, Cisco rang in with a solid 20.9% net margin. This is up by 0.4 percentage points over the year-ago figure and by 0.1 percentage points over last quarter. Parallel to the gross margin situation, it shouldn't be too surprising that Cisco's net margin is in a different league than that of its competitors. Cisco has been able to lower its effective tax rate over the last year, which has offset the increase in expenses necessary to fund its future growth.

One other comment that I'd like to make here is that at first blush I disagree with Cisco's decision to not include the $25 million payroll tax paid on employee stock options as part of pro forma earnings. While I realize that these expenses are theoretically not part of operating performance and are also not easily predicable, my view is that the options are part of the compensation paid to employees that are part of operations. I need to think a little more about whether or not I'll add this amount back to pro forma earnings when I analyze Cisco's results in the future. It should be noted that in the current quarter this amount is relatively immaterial.

4. Cash-to-Debt of 1.5 or greater -- Cisco continues to have a debt-free balance sheet. As a group, its competitors continue to sport negative net cash on their balance sheets. Cisco's lack of debt-related interest expense also contributes to its high net margins.
   
   
5. Flow Ratio of 1.25 or less -- Cisco's Flow Ratio fell to 0.87, down nicely from 1.03 a year ago. This matches the best result I've calculated for the company.

Cisco continues to have one of the lowest levels of days sales outstanding (DSO) you can find for a company that sells products rather than services. (DSO = Accounts Receivable / (Sales / 90)) Cisco's strength in this area is a result of the shipment linearity of its products, ongoing process improvements, and its use of Web-enabled technology. Cisco does not factor any of its accounts receivable; i.e., sell them to another company that collects them and then pays Cisco something like $0.95 on the dollar. This is a method that some companies -- most notably, Lucent (NYSE: LU) -- use to improve the DSO figure.

Cisco also continues to focus on managing its inventory, the level of which should 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.

It's also important to note that Cisco's accounts receivables and inventory both grew at a slower rate than sales on a year-over-year basis.

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:

• According to John Chambers, one of the keys to the growth of Cisco's business is that "globally, business and government leaders are beginning to dramatically transform their traditional business models into Internet economy business models. Customers are increasingly seeking Cisco's expertise to help them through this transformation."
  
  
• During the quarter, Cisco's orders were greater than its shipments, meaning that its book-to-bill ratio is greater than 1.0. This is a good sign for the future.
  
  
• Cisco's optical business is now generating sales at an annual rate that should be close to $1 billion by next quarter. Sequentially, these sales were up by more than 60%.
  
  
• The primary concerns Cisco has identified for the future are competition (particularly start-ups), component supply, the size of the future investments required to enable its business to continue to grow, government regulation, and worldwide economic concerns.

If you wish to discuss this report further, please feel free to ask your questions on any of the message boards linked below. If you're interested in reading more about Cisco, you can also check out my Fool research report on Cisco (a quarterly update will be available in about two weeks).

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