Boring Portfolio

Cisco's no Kid
...eighth and last in a series of Boring reviews

by Greg Markus (TMF Boring)

ANN ARBOR, Mich. (Sept. 18, 1998) -- For the most part, the Boring Portfolio prospects for good value in the field of small- and midcap companies. Given that orientation, the subject of tonight's review might seem to fit in about as well as Mark McGwire at a T-ball game. Weighing in at around $100 billion in market capitalization, Cisco Systems (Nasdaq: CSCO) is a behemoth by any measure. And trading at 53-times earnings for the fiscal year that ended in July, Cisco's stock is hardly cheap by conventional standards.

Perhaps the first question to be answered, then, is: How'd this gorilla get in here? And the second question is: At such a lofty price, how come we haven't sold it by now?

The quick answer to the first question is that we've never had a hard-and-fast rule against big companies. Besides, Cisco was only about a third of its current size when we acquired our original 100 shares (which have since grown to 225 through two splits) back in June of 1996. Cisco suits the Borefolio for another reason: it's, well, boring.

As a feature story on Cisco CEO John Chambers in the Sept. 7, 1998 issue of Fortune put it, "Plumbing is boring. Popular as Cisco is with investors, it is invisible to just about everyone else. Cisco sells nothing that the people who use the Internet ever see, nor any services that ordinary folk pay for. 'The joke around here,' says one Cisco staffer, 'is that we're the most important company no one's ever heard of.'"

Although the growth rate of the data networking industry has slowed somewhat from what it was in the early 1990s, when Cisco was roughly doubling its earnings every year, the hunger for bandwidth is far from being satisfied. Information from industry research firm Dataquest shows that the global LAN switch market increased by 78% in the second quarter of 1998, to top $2 billion. And by increasing its sales in that market by an astounding 168%, Cisco captured a 41% share, easily making it the market leader.

Even the "mature" router market grew by 23% in the second quarter, according to Dataquest, to $1.41 billion -- thanks to the introduction of a new generation of high-end devices. With a 71% share of that market, Cisco's stranglehold remains unchallenged.

As dominant as it is in the world of data communications, Cisco intends to become an equally significant presence in the much larger realm of telephony. The volume of data traffic over telephone networks is increasing at an exponential rate, while voice traffic is increasing linearly. Data volume is almost equal to that of voice currently, and industry pundits project that data could consume 80% of all bandwidth by the year 2003.

Cisco's new mission is to convince the telcos that rather than trying to shoehorn data (and, later, video) traffic onto legacy voice-oriented systems, the future lies in transporting voice over the kinds of packet-switched, digital networks that Cisco builds for data communications.

The stakes are huge: the global telecommunications infrastructure market is perhaps 10-times as large as the datacom pond. The risks are equally daunting. The Lucents (NYSE: LU) and Nortels (NYSE: NT) of the world have close, long-standing relationships with the telcos; the former are also even larger than Cisco. Phone companies are also accustomed to the kind of four-sigma reliability that circuit-switched communications can provide but that packetized transmission cannot... yet.

Despite the challenges, Cisco has one substantial advantage: the inevitable convergence of voice, video, and data communications almost certainly will take place on Cisco's turf and not that of the legacy telco providers. It's less that Cisco is trying to break into the land of the telcos than it is that the telco world is converging on Cisco. Sprint's (NYSE: FON) decision, announced this past June, to purchase key hardware from Cisco for Sprint's ambitious Integrated On-Demand (ION) communications network is perhaps the most significant, but by no means the only, example of this.

There's one other unique competitive advantage that Cisco possesses over its competitors in both the telecom and datacom industries: its people. I might personally question John Chambers's politics (why would anyone want to pal around with Al D'Amato?), but there's no second-guessing his formidable skills as a team builder and leader. Furthermore, the folks on the Chambers team -- from heir-apparent Don Listwin to the hundreds of engineers that Cisco has acquired (and, more importantly, retained) through a breathtaking series of buyouts of mostly small, leading-edge technology outfits -- are second to none.

Okay, okay. So I love the company. But what about the stock? After all, there's such a thing as too high a price to pay for part-ownership of even the most wonderful company -- particularly one in as fast-changing a field as advanced communications technology. Isn't Cisco, the stock, awfully expensive?

As the 12 million or so shares of CSCO that trade every day attest, there are differences of opinion in that regard. Based on analysts' consensus earnings estimates for Cisco of $1.45 for the current fiscal year (ending next July), at its current price of around $61 CSCO is trading at 42 times projected earnings -- a lofty multiple, but perhaps not an outrageous one in light of today's historically low interest rates and Cisco's practice of reliably turning in quarter after quarter of earnings gains in the 25 to 35 percent range.

A recent valuation exercise that I performed using what I considered to be a not unreasonable scenario of Cisco's discounted cash flows over the coming decade pegged fair value for the stock at around $69 (split-adjusted). The current report on Cisco by the folks at Standard & Poor's offers $76 (split-adjusted) as a fair price. By those standards, one could argue that CSCO is something of a bargain, now that's it's dropped back about 12% from its recently-established record high.

I'm not sure I'd want to push that argument terribly far in view of the current uncertainty in macroeconomic conditions in much of the world. On the other hand, I have no trouble locating stocks today that are trading at far higher multiples to their sustainable growth rates than CSCO is.

Back in June of 1996, I ended my "buy" report for Cisco with the following sentence: "It's an honor to have Cisco in the Boring Portfolio."

If anything, I feel that way today even more than I did then.

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09/18/98 Close

Stock  Change    Bid 
 ANDW  -  1/2   12.63 
 CGO   +  1/8   23.94 
 BGP   -  13/16 26.06 
 CSL   +  11/16 38.06 
 CSCO  -  7/16  61.06 
 FCH   +  11/16 22.94 
 PNR   -  7/16  29.56 
 TBY     ---    6.31 
                   Day   Month    Year  History 
         BORING   -0.51%   9.85% -14.63%   7.42% 
         S&P:     +0.12%   6.53%   5.12%  64.10% 
         NASDAQ:  +1.06%  10.98%   5.95%  59.83% 
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  225 Cisco Syst    23.96     61.06   154.90% 
   2/28/96  400 Borders Gr    11.26     26.06   131.54% 
   8/13/96  200 Carlisle C    26.32     38.06    44.59% 
    3/5/97  150 Atlas Air     23.06     23.94     3.81% 
   4/14/98  100 Pentair       43.74     29.56   -32.42% 
   5/20/98  400 TCBY Enter    10.05      6.31   -37.16% 
   11/6/97  200 FelCor Sui    37.59     22.94   -38.98% 
   1/21/98  200 Andrew Cor    26.09     12.63   -51.61% 
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  225 Cisco Syst  5389.99  13739.06  $8349.07 
   2/28/96  400 Borders Gr  4502.49  10425.00  $5922.51 
   8/13/96  200 Carlisle C  5264.99   7612.50  $2347.51 
    3/5/97  150 Atlas Air   3458.74   3590.63   $131.89 
   4/14/98  100 Pentair     4374.25   2956.25 -$1418.00 
   5/20/98  400 TCBY Enter  4018.00   2525.00 -$1493.00 
   1/21/98  200 Andrew Cor  5218.00   2525.00 -$2693.00 
   11/6/97  200 FelCor Sui  7518.00   4587.50 -$2930.50 
                              CASH   $5750.59 
                             TOTAL  $53711.53