Cisco's Greatness

by Tom Gardner

ALEXANDRIA, VA (Sept. 30, 1998) -- A few weeks ago, I offered a fairly comprehensive review of the recent quarterly statements of two unrelated public companies bound in unrelated directions. The first, Nine West Group, was struggling through an inventory headache of maximum penalty (cf. Nine West Stumbles). The retailer's balance sheet was collapsing like a sandcastle ridden under by high tides. And its stock was on a sharp and steady decline from $52 to $9 1/2 today.

Second up, I walked through Pfizer's performance through the six months of fiscal 1998, and found our drugmaker driving high-margin sales across the planet (cf. Which Way Pfizer?). The analysis did turn up some warning signs, though, as Pfizer's cash reserves weren't keeping up with debt, and the company's Flow Ratio was on the rise (cf. Step 7). All in all, Pfizer's performance was moderately good. Matched up with the news of a growing worldwide acceptance of Viagra, it at least convinced me that Pfizer would make for a rewarding addition to any stock portfolio committed for the long term.

It is now time -- in the wake of the recent release of its 10-k report for fiscal 1998 -- to review a third public business (a Cash-King at that), taking it through our standards and mapping out the direction of its performance. Without further ado, I present the third best performing position in the Cash-King Portfolio, the one that Fools across our forum chose via our online poll, the stock that's up 12% for us since its late-August addition (ratta-tatta-ratta-tatta-tap!) -- Cisco Systems.

Cisco Systems, the leading manufacturer of networking products for local- and wide-area networks and computing systems, has been on an absolute roll during its 8 1/2 years in the public markets. It's hard to believe, but back in 1989, the company had less than $10 million in annual sales. Today, Cisco Systems is valued at more than $95 billion and is the runaway leader in building out and supporting the Internet. During its time in the public markets, the stock is up 400-fold, turning a $10,000 investment in early 1990 into more than $4 million today.

Enough of the past, what of the present and future.

Let's take a trip down Financial-Statement Lane, and study Cisco Systems' performance in fiscal 1998, with an eye toward our Cash-King criteria. We'll start with the income statement, moving down the list item by item.

The Income Statement

1. Sales Growth

Cisco certainly isn't experiencing a slowdown in demand for its networking products and services. Sales growth in 1998 rose more than 33%, from $6.4 billion to $8.5 billion. This growth rate places Cisco Systems in the 99th percentile of companies with a base of more than $5 billion in sales.

2. Gross Margins

In fiscal 1998, Cisco Systems inched its gross margins higher by 0.3 percentage points, to 65.5%. The company is gaining ground in pricing power while marginally narrowing its manufacturing costs. This mark meets our baseline standards and pleasingly reflects upward momentum.

3. Net Margins

Cisco Systems net margins for fiscal 1998 were 16.0%, down slightly from net margins in 1997 of 16.3%. The slight decline reflects higher marketing costs and a rise in research & development costs relative to sales. While not ideal, the decline is not significant enough to raise any red flags for Cash-King investors. And net margins of 16% easily o'erleap our 7% standard bar.

4. Shares Outstanding

In fiscal 1998, Cisco Systems issued 3.7% more shares than last year, far within our acceptable range. The new issuances do mark a slowdown in the growth rate of fully-diluted shares. Name this attractive as well.



At the half, simply put, Cisco Systems has put up some great numbers. Gross and net margins far exceed our expectations and are either holding steady or on the rise. In the meantime, sales are blistering higher -- confirming what many of us know to be true, that the Internet is in hot demand. Add to this that the company is not financing its future growth with the ever-dangerous secondary offering or heavy acquisitions, and you have an income statement on solid ground.

Looking toward the second half of this report, remember that both Nine West and, to a lesser extent, Pfizer had thrived on the income statement only to then post disappointing balance-sheet statistics. Nine West was suffering an inventory glut. Pfizer was lightly padding its performance with rising accounts receivable. The former was an absolute disaster. The latter, a mild disappointment. Given the context, Cisco Systems' short-term successes in evidence on the income statement may be crossed out by a fundamental weakening of their business, revealed on the balance sheet.

The Balance Sheet

1. Cash-to-Debt Ratio

Cisco Systems closed out fiscal 1998 with $1.7 billion in cash and no long-term debt. The cash position represents an increase of more than $400 million over the previous year. And the relationship of cash-to-debt at Cisco obviously sits it in the upper echelons of Cash-Kingness. Whereas we search for companies with 1.5 times more cash than long-term debt, Cisco has no debt and a growing pile of savings. Out-standing!

2. The Flow Ratio

Cisco's Flow Ratio has improved dramatically over the past year, falling from 1.63 in 1997 to 1.17 in 1998. The stunning decline is the result of Cisco's slimming down inventory and fighting back the temptation to a carry a load of uncollected sales. The nearly thirty percent decline in the Flow Ratio is a powerful positive for Cisco. And the company has also now ducked under our baseline expectation of no Flow Ratios over 1.25.

3. General Assessment of Expansion Opportunities

It's hard to look at Cisco's business today, with a Foolishly-trained eye, and not be very excited about their prospects for growth in the U.S. and around the world. The demand for the things that speed up the globe's communication network is dramatically on the rise, and unlikely to subside for many, many years to come.

Most importantly, Cisco Systems has modeled itself as a company with long-term interests and a legitimate claim to the throne of an extremely valuable industry. Even as Intel talks about moving toward embedding networking products into its overall business plan, even as Lucent sticks a toe or two in Cisco's swimming pool, it's going to be extremely difficult for anyone to supplant, or even slow down, this leader's progress. Thankfully, if there are serious obstacles along the way for Cisco, they'll show up in our simple analysis of the company's balance sheet.

Concluding Thoughts

I'll put it simply: I believe that Cisco Systems is one of the two or three most attractive businesses in our portfolio and, by extension, one of the two or three most attractive businesses in America. I would be a long-term buyer of Cisco Systems, and would continue to hold so long as its business fundamentals remain strong. I say this because I believe that as long as a business is expanding its base of pure earnings (marked by low receivables and managed inventory), the market -- focused on the p/e ratio and market direction -- will naturally undervalue its stock.

Given this, I consider the 12% fall from its highs, in line with the market's stumble, to present an excellent opportunity for long-term investors in Cisco. These folks are the premier player in an industry exploding with demand. And the operation is managed by executives that are focused on the long-term -- a fact that is evident in the expanding cash reserves and the tightening down on inventories and receivables. I think it deserves a second, third and fourth Foolish look here, and recommend that you drop by the Cisco Systems folder with any questions or opinions on this report.

Have I overestimated its prospects and its worth? The Cisco Systems Message Folder.

Fool on,

Tom Gardner

Cash-King Strategy Folder
Cash-King Companies Folder

09/30/98 Close

Stock  Change    Bid 
 AXP   -3 1/4   77.63 
 CHV   -3 15/16 84.06 
 CSCO  -2 13/16 61.81 
 KO    -1 1/16  57.63 
 GPS     ---    52.75 
 EK    -  5/8   77.31 
 XON   -  5/8   70.63 
 GM    -3 1/8   54.88 
 INTC  -2 3/4   85.75 
 MSFT  -2 13/16 110.06 
 PFE   -1 1/16  105.75 
 SGP   -3 1/2   103.56 
 TROW  -  5/8   29.38 
                 Day     Month    Year    History 
         C-K      -2.48%   7.18%   5.63%   5.63% 
         S&P:     -3.05%   6.21%   1.09%   1.09% 
         NASDAQ:  -2.32%  12.98%   1.65%   1.65% 
 Cash-King Stocks 
     Rec'd    #  Security     In At       Now    Change 
     2/3/98   24 Microsoft     78.27    110.06    40.62% 
     2/3/98   22 Pfizer        82.30    105.75    28.49% 
    8/21/98   22 Schering-P    95.99    103.56     7.89% 
    6/23/98 34.5 Cisco Syst    57.56     61.81     7.38% 
     5/1/98   37 Gap Inc.      51.09     52.75     3.25% 
    2/13/98   22 Intel         84.67     85.75     1.27% 
     2/6/98   56 T. Rowe Pr    33.67     29.38   -12.76% 
    2/27/98   27 Coca-Cola     69.11     57.63   -16.61% 
    5/26/98   18 AmExpress    104.07     77.63   -25.41% 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko    63.15     77.31    22.43% 
    3/12/98   20 Exxon         64.34     70.63     9.78% 
    3/12/98   15 Chevron       83.34     84.06     0.86% 
    3/12/98   17 General Mo    72.41     54.88   -24.21% 
 Cash-King Stocks 
     Rec'd    #  Security     In At     Value    Change 
     2/3/98   24 Microsoft   1878.45   2641.50   $763.05 
     2/3/98   22 Pfizer      1810.58   2326.50   $515.92 
    8/21/98   22 Schering-P   2111.7   2278.38   $166.68 
    6/23/98 34.5 Cisco Syst  1985.95   2132.53   $146.58 
     5/1/98   37 Gap Inc.    1890.33   1951.75    $61.42 
    2/13/98   22 Intel       1862.83   1886.50    $23.67 
     2/6/98   56 T. Rowe Pr  1885.70   1645.00  -$240.70 
    2/27/98   27 Coca-Cola   1865.89   1555.88  -$310.02 
    5/26/98   18 AmExpress   1873.20   1397.25  -$475.95 
 Foolish Four Stocks 
     Rec'd    #  Security     In At     Value    Change 
    3/12/98   20 Eastman Ko  1262.95   1546.25   $283.30 
    3/12/98   20 Exxon       1286.70   1412.50   $125.80 
    3/12/98   15 Chevron     1250.14   1260.94    $10.80 
    3/12/98   17 General Mo  1230.89    932.88  -$298.02 
                               CASH     $48.07 
                              TOTAL  $23015.91 
 *Please note: On 8/4/98 $2,000 cash was added to the
portfolio for future investment. This will be reflected
in the numbers as soon as possible.

*The year for the S&P and Nasdaq will be as of 02/03/98