The Boring Portfolio, Feb. 3, 1999

<THE BORING PORTFOLIO>
Cisco's Cookin'

by Dale Wettlaufer ([email protected])

ALEXANDRIA, VA (Feb. 3, 1999) -- Cisco Systems (Nasdaq: CSCO) reported quarterly results last night. Second quarter revenues were $2.83 billion compared with $2.02 billion last year and $2.59 billion last quarter. Pro-forma net income for the quarter was $606 million, which excludes a $319 million after-tax charge for in-process research and development. A word on that before we go forward, though.

Cisco does numerous acquisitions each year to sustain its competitive advantage in its current markets and to gain entry and build its presence in new markets. There are some companies that Cisco buys for tens and hundreds of millions of dollars in stock that have negligible revenues and no earnings. Some of these turn out to be pretty bad investments. Some of them turn out to be huge, though. We're talking yearly returns on capital eventually in the thousands of percentage points. Taken as a portfolio, these companies generate very high incremental returns on capital for Cisco and represent the company's future opportunities.

It's really not that much different from the way a large pharmaceutical company goes about its investments. The accounting treatment is similar, too, in that the R&D, as represented by the acquisition intangibles, is written off immediately. That lowers immediate earnings when your R&D budget is on an upward slope. On the level of per-share net cash flow from operations and free cash flow per share, however, it doesn't make a difference. The capital on the balance sheet does not adequately reflect the capital that has been invested, since the write-offs are immediate. To adjust for this, the better way of assessing return on investment would be to add back these acquisition-related charges and amortize them over a number of years, probably not exceeding five years.

We don't care what that would do for book value on its own, though. In going through such an exercise, we would want to find out the company's cash-in versus cash-out dynamics. In other words, we want to know its true return on capital. On a cash flow level, we don't have any issues with the accounting of Cisco, and I personally feel there are no quality of earnings issues with Cisco. Some have a problem with the equity issuance that comes along with employees earning options. That does transfer some enterprise value from investors to employees, but without the ability to earn options, many good employees simply would not work at Cisco. The dilution versus the value created by these employees is not a problem to us.

I'm whipping up the conference call transcript for Cisco. What's particularly worthy of notice are the company's discussions on the direction of the product line -- the proliferation of data traffic in our society and the supplanting of the circuit-switched voice networks with Internet-protocol based telephony are two gigantic factors that will decide much of the creation or destruction of value at Cisco in coming years. Lucent (NYSE: LU) wants in on this with its pending acquisition of Ascend Communications (Nasdaq: ASND), but Cisco's internetwork operating system (IOS) and dominant position in WAN routers give the company a highly important competitive advantage that will be hard to crack. Cisco is a software company that sells that software packaged in hardware. Its economics are those of a software company with an entrenched position in technical standards. Think of Cisco as being more like Microsoft (Nasdaq: MSFT) than Dell (Nasdaq: DELL).

Just as Microsoft and Intel (NYSE: INTC) combined took hundreds of billions of dollars in enterprise value from IBM (NYSE: IBM), the thesis here is that Cisco's technical lock-in and increasing marginal returns give it a chance at taking a similar amount of value as data of all sorts migrates to IP networks. If that's the case, and even without this "big hypothesis" thinking in the mix, at 75 times earnings annualized off this quarter, we don't think Cisco and the term "value" are mutually exclusive.

Speaking of that sort of thing, a good friend of the Borefolio asked why I thought Costco (Nasdaq: COST) is undervalued. I haven't 100% arrived at that conclusion just yet, but the thinking behind that is that you have to make an attempt at getting your cash flow model to reflect reality. When I model Costco, I have to model large cash flow growth rates at least for five years. I'm talking about the 20% range, though the company's yearly growth goal is 15%. I don't do that because I have a natural bias towards being aggressive with valuation models, I do it because that's what I think its cash flows will look like. I don't want to over- or underestimate a company's cash flows. I just want to be somewhere near reality.

When I consider how many people rave about Costco, both in its new markets and in its mature markets where it is part of the consumer shopping landscape, I have to consider that I'm not mapping my own idiosyncrasies onto the rest of the population. People genuinely rave about the company. That's because it delivers 1) quality; 2) at the best price; and 3) with great service. It's simple -- deliver that to customers in the retail arena, keep on top of what customers want, and do it with good financial controls and you've got a great company.

Carlisle Companies (NYSE: CSL) reports tomorrow morning, by the way.

Finally, consider the following in relation to our investments and yours. It's highly important to some of Berkshire Hathaway's (NYSE: BRK.A) businesses, especially the insurance underwriting operations, in my opinion.

If we could shrink the Earth's population to a village of precisely 100 people... with all existing human ratios remaining the same, it would look like this:

• There would be 57 Asians, 21 Europeans, 14 from the Western Hemisphere (North & South America), and 8 Africans.
• 50% of the entire world's wealth would be in the hands of only 6 people and all 6 would be from the United States.
• 80 would live in substandard housing.
• 70 would be unable to read.
• 50 would suffer from malnutrition.
• 1 would be near death.
• 1 would be near birth.
• Only one would have a college education.
• No one would own a computer.

Have a good Wednesday night.

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Stock  Change    Bid
BRKb  +60      2528.00
CSL   -1 7/8   45.56
CSCO  -1 17/64 111.13
PNR   -  5/8   38.38

                   Day    Month   Year  History
        BORING   -0.35%   4.15%   2.43%  37.54%
        S&P:     +0.80%  -0.59%   3.80% 111.99%
        NASDAQ:  +1.22%  -0.50%  13.71% 139.53%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    111.13   363.88%
  8/13/96  200 Carlisle C    26.32     45.56    73.08%
 12/31/98    8 Berkshire   2244.00   2528.00    12.66%
  4/14/98  100 Pentair       43.74     38.38   -12.27%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  25003.13 $19613.14
  8/13/96  200 Carlisle C  5264.99   9112.50  $3847.51
 12/31/98    8 Berkshire  17952.00  20224.00  $2272.00

  4/14/98  100 Pentair     4374.25   3837.50  -$536.75


                             CASH  $10594.54
                            TOTAL  $68771.67