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Conference Call, Part 2
by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Nov. 11, 1998) -- Hey, it's the Boring guys here. We're still trying to figure out Cisco (Nasdaq: CSCO), which given things like this from one of their latest product brochures, should be a real snap for us:

"In the ingress direction, the FRASM converts SNA over SDLC protocol and BSC3270 over Bisync protocol to RFC1490 frame format. (RFC1490 defines an encapsulation method to transfer SNA, IP, and other protocols over a Frame Relay network.) The Frame Relay frames are then converted to ATM cells, using standards-compliant adaptation, for transmission through the network. Consistent with Cisco advanced networking features, FRASM cards support per-VC queuing on ingress."

I get the word "ingress," and I know some the acronyms stand for various network protocols, but if you line up a bunch of French words and you haven't ever taken French, you might recognize "bonjour" and "au revoir," but still not understand the sentence "On dit ordinairement avant "

While we figure out this stuff, we present the rest of the Cisco conference call for the first quarter, which we admit is quite impressive and instructive, as are most conference calls. If you can't come away from a conference call having learned something, there's either something wrong with the company or something wrong with you. In our case, it's most often something wrong with us. Special thanks to Greg Marcus for putting together some of the call summary below. The rest contains elements of the discussion that I chose to pick up on, because it helps us understand the company. Of particular interest, I thought the "first wave, second wave" discussion on winning contracts was interesting.

Have a good evening, and please do visit our Boring Portfolio boards.

Cisco Conference Call, Part 2

Impact of Economic Conditions

The percentage of total capital spending going into information technology, and especially into networking, is increasing in most countries. That said, total capital spending is greatly influenced by overall GDP growth. In countries with good economies, 30-50% growth in network industry revenues is projected. In countries with marginal economies, 0-30% growth is more likely. And, in troubled economies, negative growth in network spending is a possibility. By using its "high-touch" sales model and by educating business and government leaders on the importance of networking to economic competitiveness and even survival, Cisco can positively influence spending.

Service Provider Activity

Service provider activity has been good across all major geographies, with Q1 orders growing in excess of 50% year over year. A second, larger wave of service provider build-outs is expected to occur following the initial build-out phase. Orders tend to be large and lumpy, however, and therefore difficult to forecast.

Leading service providers are beginning to rapidly deploy new networks that can carry voice on data-optimized networks and, in contrast, see limited value in expanding traditional circuit-switched networks. Cisco's strategy remains to build new infrastructures supporting open standards and technologies.

Today, Cisco serves approximately $20 billion of a $40 billion global data networking market. According to Dataquest, the worldwide telecommunications market will represent a $340 billion market in the year 2002, of which Cisco believes its addressable portion is approximately $140 billion in that same year. Over the next four years, then, Cisco's potential market can increase as much as sevenfold.

Three factors will determine how quickly traditional voice networks will convert to data networks: the pace of genuine deregulation, the subsequent creation of new competition and, finally, the success of the initial New World network deployments. Deregulation has been occurring in many regions of the world, and competition is growing quickly.

Cisco is experiencing double-digit sequential order growth across all of its business units within the overall service-provider line of business. Cisco continues to gain momentum in broadband access with its xDSL offerings and estimates its market share to be in excess of 40%, with strong quarter-over-quarter growth. In the cable arena, Cisco continues to win infrastructure deals, as exemplified by Cisco's deal with Videotron and Bellcore in Canada. In the IP space, the Cisco 12000 continues to enjoy high-end leadership, with more than 1,000 units shipped to-date.

A total of 112 service providers in 23 countries have signed up as partners in the "Cisco Powered Network" program.

Year 2000 Challenges

There are two offsetting factors that play a role with regard to Y2K. The first is business leaders' recognition of the strategic value of network applications for competitive advantage and even survival. The second is the desire of CIOs to have a stable information infrastructure on January 1, 2000. How these two variables ultimately play out will vary from country to country and from business to business. It is too soon to predict the ultimate impact on the networking industry. For its part, Cisco will continue to educate business and government leaders and implement its high-tough sales model to limit any negative impact of Y2K to its business.

Guidance

Cisco's product pipeline continues to improve and is, by far, in the best shape ever in the company's history. Opportunities are limited only by Cisco's resources to address them all.

Growth in a few of the key enterprise industry groups is slowing, which is causing the enterprise market to grow at rates approximately 10 percentage points below Cisco's overall annual growth rate. For example, global financial institutions are experiencing challenges. However, regional banking, regional investment, insurance, and retail industries continue to expand.

Cisco continues to target revenue growth at or above that of the overall industry average, which it says that analysts estimate to be 30-50% annually in countries with reasonably good economies. The company continues to expect gross margins to decline over time. Operating expense is expected to remain in the range of 36%, plus or minus a half-point. Goodwill expense is projected to increase to $12 million in Q2 and $17 million in Q3. The tax rate is expected to remain at 33% for fiscal 1999. In Q2, Cisco will close three acquisitions, resulting in extraordinary write-offs of purchased in-process R&D totaling approximately $0.12 to $0.21 per share

The share count is expected to increase by approximately 8-10 million shares per quarter on an ongoing basis. In Q2, the share count will increase by an additional 5 million shares in connection with acquisitions expected to close in the quarter.

Next Conference Call

The Q2 1999 earnings report and conference call will occur on Tuesday, February 2, 1999, after the close of the market.

Q & A

In relation to a question asked about the level of sales of equipment to service providers, the company said that it had mentioned several quarters ago that it was seeing activity level accelerate and that is continuing today. It's also a fair assumption to say that the order rate and sales have accelerated as well. In all geographies, in the major areas the company talks about, service provider growth of 50% year-over-year is being seen. The percent of business to service to service providers is in excess of 30% now in many areas, though it's very difficult to quantify because often these are handled by multiple channels, so Cisco doesn't have the ability to break out industry verticals into as much detail as you would like to see because the channels don't always report back the mix and where they're selling the business into.

The company doesn't plan to convert routers into layer 3 switches. There should be a continued strong market in the router industry, a continued strong market in the layer 3 switch industry. Those technologies will combine with both having the same functions in common. Router growth since last quarter was over 10%, so the company is seeing good router growth, particularly on the high-end in the $7,000 to $12,000 range.

Year-over-year, enterprise sales grew at about 30% while the entire market grew at about 40%. This 10 percentage point growth gap is what the company is planning for over the next couple quarters.

A very large percentage of bookings are shipped in the same quarter, and therefore accurate visibility beyond one quarter is difficult. About 90% of the new business, as opposed to service/maintenance/leases revenues, bills in the same quarter as booked. Lead times will stay relatively low. The company goes into this quarter with a little lower hiring rate but it feels very good with the balance of the countries worldwide and with its service provider momentum and two-tier momentum in small and medium businesses.

All product areas saw double-digit growth. The highlight this quarter was in broadband infrastructure. The 12,000 product saw very strong growth. Broadband access, cable, and xDSL really got some traction this quarter with customers shipping and deploying and installing in volume.

A number of requests for proposals for substantial multi-service infrastructure projects are expected to be awarded in the fiscal second quarter. Big RFPs outstanding right now are from SwitchCom in Europe, Telstra, British Telecom has their MSP bid out, MCI WorldCom has a convergence opportunity, and US West has an RFP out. Each of the leads, Telstra, MSP, and MCI WorldCom, are network-level commitments and those are as substantial. Management noted that if you win your first wave and you do well with the installation and the customer is satisfied with it, then you might see a very large second wave behind it if they're building it out such as they might be with xDSL or cable.

Cisco Capital Corp. was formed approximately two years ago to provide equipment financing for customers. To date, Cisco Capital has done about $300 million in various types of leases. Approximately 80% of those leases would qualify as purchase leases, with the remainder falling into the category of operating leases. In the former case, revenue is recognized when the product is shipped; in the latter case, revenue is recognized over the term of the lease, typically over a three-year period. Cisco has done no working capital financing to date.

Most of the competitive pricing pressure during the quarter was in the LAN switching category. The company is seeing aggressive pricing across the board from almost all its traditional competitors. It continues to see very aggressive pricing from some of the people who have traditionally been consistently pricing there. That's a major area of usually active aggressive pricing, which Cisco continues to see. When new competitors are tempted to get into a market, they tend to lead, particularly when they're well financed, with very aggressive pricing. Order growth was in the 6-8% range quarter-over-quarter for most LAN switching products.

Management said there are more opportunities in R&D than could be addressed and its deliberately moving away from $100 million-types of opportunities purely because of the resources required to address them. Once you invest in R&D, it should be 12-30 months before you begin to get the feedback with the products. In sales, investments are going to take 6-18 months before you get your paybacks. Almost without exception, you get a very good payback wherever you've got the resources in place. The company has about 36% of revenues in operating expenses and that's about where we would want to stay ideally, give or take a half-point or so. Cisco could get surprised on revenue numbers that might change that. If management gets more comfortable with next year's economic outlook and the Year 2000 implications, then it might come back and say that it wants to be aggressive in its investing.

In the high-end router space, Cisco is very clearly number one, though there are no [readily] available market share numbers on this. There are improvements being made to the Cisco 12,000 being made constantly. The most recent one was the OC-48 capability as well as channelized OC-12 capability no one else in the market has. In this particular phase of high-end routers, all of the operational networks in the world run Cisco 12,000s. I think some of the competitors [that release hot specs and are talk about as the next big thing] are in the labs. 1999 is going to be another competing phase on another level of competition and another level of performance.

Management will recognize revenues from the MGX series of ATM products in Cisco's fiscal second quarter and the initial response from customers is encouraging, but the proof will be in the pudding with these RFPs.

Management always believes Cisco's best end-point product competition would come from startups so it measure effectiveness in how products compare versus the end-point product from a specific start-up and then on into the customers who understand the value of end-to-end vendor relationships -- the calls, shipping, time-to-market type of approach. Cisco probably has about ten router start-up companies that it's tracking and a lot more than that in the WAN area. At the present time, management believes its in pretty good shape with Cisco's product pipeline.

All of the studies that have been done show that the market can support 100% year-over-year growth across all geographies.

The company's strategy on price is that it can't give an 80% discount to one company and 20% to another. They'll figure that out over time and two things happen. Number one, your street price deteriorates and number two, you've got a pretty upset customer group that you didn't give the discount to. Cisco's stayed pretty tight with our discounting latitude and to chart list price in the area that it needs to be competitive given our normal discounts. You're not going to see Cisco being super-aggressive in pricing. The company will walk from opportunities that don't make good financial sense.

Startup and newer service providers are utilizing IP for both user connectivity and network-to-network connectivity. Among incumbent providers (RBOCs, PTTs, interexchange carriers), IP is used for the former while ATM plus IP is used for the latter.

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

FoolWatch -- It's what's going on at the Fool today.


11/11/98 Close

Stock  Change    Bid 
 ANDW  -  1/2   17.56 
 CGO   -1 1/8   34.25 
 BGP   +  7/16  27.25 
 CSL   +  3/8   43.75 
 CSCO  -  15/16 66.06 
 FCH   -  11/16 21.88 
 PNR   +  1/8   40.00 
 TBY   -  1/16  7.00 
 
 
                    Day   Month    Year  History 
         BORING   -0.63%   4.41%  -4.49%  20.18% 
         S&P:     -0.64%   2.03%  15.51%  80.33% 
         NASDAQ:  -0.19%   5.12%  18.58%  78.89% 
  
     Rec'd   #  Security     In At       Now    Change 
   6/26/96  225 Cisco Syst    23.96     66.06   175.77% 
   2/28/96  400 Borders Gr    11.26     27.25   142.09% 
   8/13/96  200 Carlisle C    26.32     43.75    66.19% 
    3/5/97  150 Atlas Air     23.06     34.25    48.54% 
   4/14/98  100 Pentair       43.74     40.00    -8.56% 
   5/20/98  400 TCBY Enter    10.05      7.00   -30.31% 
   1/21/98  200 Andrew Cor    26.09     17.56   -32.68% 
   11/6/97  200 FelCor Sui    37.59     21.88   -41.81% 
  
     Rec'd   #  Security     In At     Value    Change 
   6/26/96  225 Cisco Syst  5389.99  14864.06  $9474.07 
   2/28/96  400 Borders Gr  4502.49  10900.00  $6397.51 
   8/13/96  200 Carlisle C  5264.99   8750.00  $3485.01 
    3/5/97  150 Atlas Air   3458.74   5137.50  $1678.76 
   4/14/98  100 Pentair     4374.25   4000.00  -$374.25 
   5/20/98  400 TCBY Enter  4018.00   2800.00 -$1218.00 
   1/21/98  200 Andrew Cor  5218.00   3512.50 -$1705.50 
   11/6/97  200 FelCor Sui  7518.00   4375.00 -$3143.00 
  
                              CASH   $5750.59 
                             TOTAL  $60089.65 
 

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