<THE RULE MAKER PORTFOLIO>

Cisco's Earnings -- Part 2

By Al Levit (alanl@ix.netcom.com)

NEW ORLEANS, LA (Feb. 10, 1999) -- Yesterday, I began a routine review of Cisco Systems (Nasdaq: CSCO). I got through the Brand and Financial Location metrics from the Gardners' new book Rule Breakers, Rule Makers (a.k.a. the RuleBook). I found that Cisco's score was 18 after putting it through a series of tests. This is the same place that Cisco was when Tom Gardner reviewed the company based on the information in its annual report issued as of July 1998.

Now, it's time to see whether Cisco has continued to keep the pace in the Financial Direction metrics laid out in Chapter 13 of the RuleBook. There are six tests in this category, and up to three points can be earned from each test.

  1. Rising Gross Margins -- Gross margins for the 2nd quarter of 1998 were 65.4%, slightly higher than the 65.2% gross margin for the 2nd quarter of 1999. This gives Cisco 2 points.
  2. Rising Net Margins -- Net margins for the 2nd quarter of 1998 were 22.7%, more than 1 percentage point higher than the 21.4% net margin for the 2nd quarter of 1999. This gives Cisco 1 point.
  3. Share buybacks -- Fully diluted shares outstanding grew 5.3% between the 2nd quarter 1998 and 2nd quarter 1999. This gets Cisco 1 point.
  4. Cash outgrowing Debt -- No debt got Cisco 2 points in the excellence tests. It gets Cisco another 3 points down here.
  5. Decreasing Flow Ratio -- The Flow Ratio in the 2nd quarter of 1998 was 1.17. Now it's down to 1.12. That's a drop of between 0% and 5% and it's good for 1 point.
  6. Expanding possibilities -- This is a subjective test. Cisco is the unquestioned gorilla in an industry that doubles every 100 days. High margins and no debt. 3 points.

Score for Financial Direction metrics is 11. Cumulative score: 29.

At first I was a little surprised with this result for financial direction. After all, it was considerably lower than the result shown in the RuleBook for Cisco. However, as I looked further, I realized that there was probably less of a problem than there might appear to be. First of all, the change in gross margin was minute. Secondly, and more importantly, Cisco had a real problem with the flow ratio in 1997. This was corrected in 1998, which was worth 3 points. It was further improved in 1999, but the degree of improvement was slight. As a result, the comparison between 1998 and 1999 does not look very good.

Moreover, I think we need to be careful about how much weight we give to financial direction from one quarter to the next. Minor variations in the flow ratio and margins can cause big changes in the score of the financial direction, and this can give unusual weight to the entire model. For example, consider the score of Microsoft (Nasdaq: MSFT) on financial direction:

Rising Gross Margins -- Gross margins for the 2nd quarter of 1998 were 91.3%, slightly higher than the 91.2% gross margin for the 2nd quarter of 1999. This gives Microsoft 2 points.

  1. Rising Net Margins -- Net margins for the 2nd quarter of 1998 were 31.6%, more than 1 percentage point lower than the 40.2% net margin for the 2nd quarter of 1999. This gives Microsoft 3 points.
  2. Share buybacks -- Fully diluted shares outstanding grew 1.2%, 2 points.
  3. Cash outgrowing Debt -- No debt, 3 points.
  4. Decreasing Flow Ratio -- The Flow Ratio increased from 0.342 in the 2nd quarter of 1998 to 0.344 in the 2nd quarter of 1999. No points. (Meanwhile, good luck finding other companies with a flow ratio that low!)
  5. Expanding possibilities -- 3 points.

Total for Microsoft is now 13 points, four less than a quarter ago when Tom examined it in the RuleBook.

What does this mean? I'm not completely sure yet, but I'm pretty sure of what it doesn't mean. It doesn't mean that Cisco and Microsoft have suddenly become significantly poorer companies because of slight and by all accounts temporary deterioration in some financial ratios. Sometimes the tests in the Financial Direction category will show us problems or potential problems. For example, Cisco's declining net margins could be a concern if they continue.

On the other hand, I believe that some of the direction tests will result in "false negatives" for some of our strongest companies. I think that this is what is happening with the gross margin and flow ratio for both Microsoft and Cisco. Therefore, I suggest that you run these financial direction tests on all your companies when their earnings are released but that you are careful about how you interpret their results. A series of quarters will provide a much better picture of direction than merely a one-time look.

Finally, the last category of tests is for Monopoly Status. Tom compared Cisco to 3Com (Nasdaq: COMS) in the RuleBook, and Cisco got a perfect score of 20. Space prevents me from running the comparison based on the 2nd quarter earnings here, but I will note that some reports from the Cisco conference call were that Cisco's CEO suggested that the company might actually be taking more market share from 3Com going forward. For right now, I'll take that as enough confirmation to let Cisco maintain its perfect 20 score in this category.

That brings Cisco's total score to 49, which is not bad, but not very good for a company like Cisco. It will be interesting to see what happens as time goes on. We may find that future quarters from Cisco and Microsoft will make the financial direction score from this quarter a true blip, and we may find that a little tweaking of the financial direction metrics is in order. For example, I showed a draft of this column to Phil and Rob a couple of days ago. Phil suggested that we might look at both sales growth and accounts receivable from quarter to quarter as well. Rob basically just cautioned against reading too much into any single quarter's performance when compared with another's. Phil and Rob may have more to say on this down the line. On the other hand, we may actually have found a true early warning for both Cisco and Microsoft, though I'll bet against it.

At any rate, I'll be back tomorrow with some remarks for those of us who follow Tom's advice in the RuleBook and have both Rule Makers and Rule Breakers in their portfolios. Until then, Fool on.

Al

02/10/99 Close

Stock  Change    Bid
AXP   +  13/16 96.75
CHV   -1 1/8   78.63
CSCO  +2 5/8   98.56
KO    +1 11/16 63.63
GPS   +  5/16  61.63
EK    -  1/16  65.88
XON   +  3/8   72.56
GM    +  1/16  84.75
INTC  +3 1/2   128.81
MSFT  +  9/16  160.63
PFE   +1 3/4   126.88
SGP   +  9/16  53.44
TROW  -  3/4   31.38
                   Day   Month    Year  History
        R-MAKER  +0.86%  -4.93%   3.08%  30.44%
        S&P:     +0.61%  -4.38%  -0.14%  23.61%
        NASDAQ:  -0.06%  -7.84%   5.33%  39.72%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    160.63   105.22%
    5/1/98   55 Gap Inc.      34.37     61.63    79.30%
   6/23/98   34 Cisco Syst    58.41     98.56    68.74%
    2/3/98   22 Pfizer        82.30    126.88    54.16%
   2/13/98   22 Intel         84.67    128.81    52.13%
   8/21/98   44 Schering-P    47.99     53.44    11.34%
    2/6/98   56 T. Rowe Pr    33.67     31.38    -6.83%
   5/26/98   18 AmExpress    104.07     96.75    -7.03%
   2/27/98   27 Coca-Cola     69.11     63.63    -7.93%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     84.75    17.05%
   3/12/98   20 Exxon         64.34     72.56    12.79%
   3/12/98   20 Eastman Ko    63.15     65.88     4.32%
   3/12/98   15 Chevron       83.34     78.63    -5.66%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3855.00  $1976.55
    5/1/98   55 Gap Inc.    1890.33   3389.38  $1499.05
   6/23/98   34 Cisco Syst  1985.95   3351.13  $1365.18
    2/3/98   22 Pfizer      1810.58   2791.25   $980.67
   2/13/98   22 Intel       1862.83   2833.88   $971.05
   8/21/98   44 Schering-P   2111.7   2351.25   $239.55
    2/6/98   56 T. Rowe Pr  1885.70   1757.00  -$128.70
   5/26/98   18 AmExpress   1873.20   1741.50  -$131.70
   2/27/98   27 Coca-Cola   1865.89   1717.88  -$148.02

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1440.75   $209.86
   3/12/98   20 Exxon       1286.70   1451.25   $164.55
   3/12/98   20 Eastman Ko  1262.95   1317.50    $54.55
   3/12/98   15 Chevron     1250.14   1179.38   -$70.77

                              CASH   $2205.98
                             TOTAL  $31383.11

Added $ 2,000 on August 4, 1998 to the portfolio; this will show in the numbers at a later date.

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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