Boring Portfolio

Cisco Conference Call
Nice Numbas!
by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Nov. 9, 1998) -- Cisco Systems (Nasdaq: CSCO) is one of those companies that perplexes us a bit. On one hand, the company's results are stupendous, with a return on invested capital performance of 87% (annualized) and an ROE of 35.4% (annualized, both ROIC and ROE on beginning of period amounts) for the fourth fiscal quarter. Both of these are excellent, especially considering that the company uses very little leverage. Obviously, it's a juggernaut. But we're not in the camp that thinks a company that has had all sorts of success is due all sorts of success in the future. Sure, odds are that such companies will continue to have success, but we don't bring any insight to the investment on why they will continue to do so.

It's not like we can't figure out that routers are a vital part of the growth in the internet or that 300 million internet users are projected for the year 2003 and that Cisco estimates sales over the internet to reach into the trillion dollar+ range by the year 2003. We don't disagree with that. But we don't know why Cisco's routers are better and what they can do to continue to occupy a position of dominance in the internetworking equipment business. Right now, the company is worth about $104.7 billion less excess cash and investments of about $5 billion.

If we were a gigantic corporation trolling the world with $100 billion in cash and didn't have to pay a control premium to take over any company we wanted, Cisco wouldn't be on the top of our list. For just about the same amount of money, we would be much more interested in something like a Berkshire Hathaway, a number of smaller companies, or significant minority positions in some larger companies that we know something about. This isn't to say that we think Cisco Systems is not a good value or that somehow its gigantic market capitalization is outside of the realm of reason. To the contrary, they've definitely created this value through executing on the best strategies in the networking business.

They haven't been afraid to go out and do the number of acquisitions it takes to gain the intellectual property they need to dominate their industry. Rather than a few big acquisitions and mergers in their lifetime, this company has made very likely hundreds of smaller acquisitions to build what you see today. Some of those deals are flops. Some of them generate returns on investment that would knock your socks off. Taken as a whole, the strategy has led to world-beating returns in an explosive-growth industry. However, that doesn't mean we understand it. Yeah, we can talk to people that use the equipment and look at all the market surveys, but swimming and reading about swimming are two different things entirely.

You know what's funny, though? This company carries about the same valuation as Home Depot (NYSE: HD). This valuation parity is measured by the Bore Ratio, which is ROIC divided by the ratio of enterprise value to invested capital, which, extending things one more turn, is what your return on invested capital would be if you acquired these two companies today. Which would you pay more for? A retailer selling products you know will probably not go obsolete or a rapid-growth internet capital equipment manufacturer that you know could lose five steps technologically in a very short order?

That's the kind of stuff that would let us sleep like a baby - we'd wake up every two hours and cry. This is going to be the toughest decision in the port, because we know what a good company it is and we don't believe this company is overvalued. But it's something that we can't wrap our brains around very tightly, and that's ALWAYS a dangerous situation in investing. Nevertheless, we're not doing a thing with this investment for now. It's not going anywhere. In the meantime, we've listened to the conference call for the fourth quarter and we will summarize it in tonight's and Wednesday's Bore reports. Here's part one:

Cisco Q4 Conference Call, Part 1

All share amounts in press release reflect a 3/2 stock split paid in September.

35th consecutive quarter of revenue and earnings growth since John Chambers joined the company as CEO.

Dramatic increase and awareness of the Internet's strategic value from business and government leaders worldwide. More and more, the internet is being accepted as an economic driver that will level the playing field for businesses, countries, and individuals in the Internet economy.

Cisco continues to expand its New World technology offerings, with solutions and broadband access and network management through the acquisitions of Clarity Systems, which will close in the second quarter of fiscal 1999, and AIC, respectively.

Cisco continues to gain market share against both our traditional competitors and the old world telecommunications manufacturers. Sequential [revenue] growth from Q4 to Q1 was 8%. The company's goal was to grow as fast or faster than the overall market. In time, it may grow above or below that. Book-to-bill was above one. Gross margins were at 65.5%. Approximately 55% of its bookings came from the U.S.. Management was pleased with the linearity in Q1, which was in-line with a number of previous quarters that were considered relatively smooth.

During the conference call, the term internet was used to describe all types of networking, including intranet, extranet, and the capital "i" Internet. Cisco continues to see a dramatic shift in the general awareness of the Internet among business and government leaders worldwide. Increasingly, companies and countries and individuals are recognizing that the Internet is driving economic change globally. The Internet will have a similar impact as the Industrial Revolution. It will define competitive advantage for creating new jobs and market opportunities globally. The Internet will also level the playing field between big and small companies and between countries on a worldwide basis. In short, it won't be the big companies or countries beating up on the small ones or vice-versa. The game is now about the fastest versus the slow.

Almost everyone agrees that circuit-based voice networks will convert to packet-based data networks for future communications needs. It was emphasized that this is not a convergence but a conversion. The distinction being that data, voice, and video will not merge. Instead, voice and video will converge in a data infrastructure in a single network. While this conversion plays to Cisco's strengths, we represent less than 10% of the total market for these integrated networks. The market over time will no longer be defined as a data market, voice market, or video market, but rather a single data-voice-video market.

Total revenues included $208 million from training, royalties, service, and support. Gross margin was 65.5%, down from 65.7% last quarter but was comparable to the average gross margin reported over the prior eight quarters. This latest sequential decline was attributed to unfavorable product mix variances and aggressive pricing from various competitors, both of which were partly offset by the company's ongoing cost reductions. Management's guidance continues to be that Cisco's gross margin will decline over time due to unfavorable product mix shifts, a more diverse customer and channel mix, ongoing combative pricing pressures in all of its key markets, as well as less component cost savings, especially in memory.

Total operating expenses for the quarter increased to 35.7% of sales, as compared to last quarter's 34.6% of sales. R&D increased as a percentage of sales to 12.6% from 12.3% in the prior quarter. Sales and marketing expenses increased sequentially to 19.9% of sales from 19% in the fourth quarter. Engineering headcount was up 10% sequentially as the company continued to focus on new opportunities. Sales and marketing headcount was also up 10% sequentially, as we continued to increase our Direct Touch model in various regions. G&A was 3.2%, same as the prior quarter. Excluding goodwill [amortization] of $10.5 million that was included in that, G&A would have been at 2.8%, flat with the prior quarter sequentially and one year ago. Going forward, Cisco expects goodwill [amortization] to increase from the $10.5 million in Q1 to approximately $12 million in Q2 and $17 million in Q3. Tax provision declined in Q1 to 33% from the 35% that was incurred in fiscal 1998. That decrease is due to the implementation of several tax strategies and the re-enactment of the R&D tax credit. The 33% rate is expected to continue throughout fiscal 1999.

Pro-forma net income was 21.6% of sales as compared to 21.9% last quarter and 22.2% a year ago. Pro-forma EPS on a fully diluted basis was $0.34. Both pro-forma net income and pro-forma EPS exclude the $41 million or approximately $0.03 per share of extraordinary write-offs of purchased in-process R&D for American Internet Corp. The company will close acquisitions next quarter that will result in the write-off of in-process R&D of approximately $0.12 to $0.21 per share. Given the ongoing competitive pressure, our focus continues to be on balancing market share with EPS growth, which will require a careful mix of revenues, product mix, gross margins, and expenses, as well as investments in new opportunities.

Cash, short-term, long-term, and restricted investments increased by approximately $821 million to $6.5 billion. Accounts receivable increased from Q4 by $35 million to approximately $1.3 billion. Given good shipment linearity during the quarter, sales outstanding (DSO) declined from 50 days to 47 days. Inventory increased by $13 million sequentially, to $375 million due to requirements for flexibility to meet customer ordering patterns, product mix shifts, new product ramps, and continued growth in two-tiered distribution, where the company does not recognize revenues until point-of-sale. Cisco's quarterly inventory turns were 9.7 versus 9.8 last quarter. The total inventory of $375 million breaks down as follows: Raw materials: $41 million, work-in-process: $165 million, finished goods: $146 million, and billed systems $34 million.

The company continued to execute well this quarter with respect to overall inventory management and it intends to focus on maintaining our performance in this area. Inventories to all our levels should be expected to increase as the company provides flexibility in order to satisfy overall customer expectations, especially with respect to lead-times and availability in addition to its continued growth in two-tiered distribution.

For Q1, total headcount ended at 15,986, a net increase of 1,363 from Q4. Our plan is to add an incremental 1,100 to 1,300 personnel during our fiscal second quarter, including approximately 500 individuals from acquisitions that are expected to close during the quarter. Similar to prior quarters, the primary focus here will be on sales and engineering.

Geographic balance for Q1 bookings:

Europe, Middle East, Africa (EMEA): 29% versus 29% in Q4
Americas, including 55% from the U.S.: 61% versus 64% in Q4
Asia: 10% versus 7% in Q4

Most of the company's major European countries had a solid quarter, with an average of 10% sequential booking growth and 50% year-over-year booking growth. For example, Germany had an outstanding quarter with more than 20% sequential order growth. Cisco anticipates continued good growth for this country. Although it experienced good growth in the UK, it is cautious about the potential economic impact of rising interest rates on capital spending and therefore on the network industry as a whole. Business in southern Europe continues to gain momentum, where year-over-year order growth reached 70%. Despite the economic challenges in Russia, the company grew its central European bookings 14% sequentially and 60% year-over-year. It was also a good quarter in Northern Europe, which includes the Netherlands and Scandinavia, with approximately 10% sequential growth and approximately 50% year-over-year growth. Throughout all of the EMEA, the company is gaining service provider market presence and momentum. Management also believes that many of these countries are climbing the technology and option curve and despite economic difficulties, will continue to have good growth potential for Cisco.

The Americas market, which includes the U.S., Canada, and Latin America, continues to have overall balanced bookings and year-over-year growth across all key areas. The United States, in particular, had another successful quarter. The company reports that throughout the Americas its service provider strategy and market presence has continued to expand. Growth in a few of the key enterprise industry groups is slowing, which is causing the overall enterprise market to grow slower. Current estimates are approximately 10% year-over-year slower than Cisco's total company growth rates. For example, the global financial institutions are experiencing challenges that cause growth in their industry to be slower. However, the regional banking, investments, insurance, and regional industries continue to expand. In the small to medium-size markets, Cisco continues to expand its market presence. Also, its two-tier booking growth was above 30% sequentially and up 100% year-over-year.

For Asia, Cisco's economic outlook remains cautious and it anticipate that this geography will continue to have economic challenges. The company first signaled caution about the Asian market, especially Japan, six quarters ago during its conference call. Four quarters ago, it moved one of its top up-and-coming leaders to this area and asked him to focus on the rest of Asia, not including Japan. The company's position was that anytime you have a market in transition, in a good or bad transition, like Asia was at that point in time, it's a good opportunity to gain market share. During a time when most companies have reduced headcount and resources in the rest of Asia, Cisco increased its headcount almost threefold with a focus on getting closer to its customers and delivering its higher level of customer satisfaction.

10/01/98: The New Boring Port Transitions Facts

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11/09/98 Close

Stock  Change    Bid 
 ANDW  -  5/16  17.94 
 CGO   -2 1/8   36.44 
 BGP   -  11/16 28.19 
 CSL   +  1/2   43.00 
 CSCO  -  7/16  67.00 
 FCH   -  5/16  23.63 
 PNR   +  3/8   39.38 
 TBY     ---    7.00 
 
 
                    Day   Month    Year  History 
         BORING   -1.10%   6.37%  -2.70%  22.43% 
         S&P:     -0.95%   2.87%  16.46%  81.82% 
         NASDAQ:  +0.24%   5.06%  18.51%  78.78% 
  
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  225 Cisco Syst    23.96     67.00   179.69% 
   2/28/96  400 Borders Gr    11.26     28.19   150.42% 
   8/13/96  200 Carlisle C    26.32     43.00    63.34% 
    3/5/97  150 Atlas Air     23.06     36.44    58.02% 
   4/14/98  100 Pentair       43.74     39.38    -9.98% 
   5/20/98  400 TCBY Enter    10.05      7.00   -30.31% 
   1/21/98  200 Andrew Cor    26.09     17.94   -31.25% 
   11/6/97  200 FelCor Sui    37.59     23.63   -37.15% 
  
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  225 Cisco Syst  5389.99  15075.00  $9685.01 
   2/28/96  400 Borders Gr  4502.49  11275.00  $6772.51 
   8/13/96  200 Carlisle C  5264.99   8600.00  $3335.01 
    3/5/97  150 Atlas Air   3458.74   5465.63  $2006.89 
   4/14/98  100 Pentair     4374.25   3937.50  -$436.75 
   5/20/98  400 TCBY Enter  4018.00   2800.00 -$1218.00 
   1/21/98  200 Andrew Cor  5218.00   3587.50 -$1630.50 
   11/6/97  200 FelCor Sui  7518.00   4725.00 -$2793.00 
  
                              CASH   $5750.59 
                             TOTAL  $61216.22 
 

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