<THE RULE MAKER PORTFOLIO>

A Conversation with Cisco, Part I

By Phil Weiss (TMF Grape)

TOWACO, NJ (April 28, 1999) -- Buying and holding Rule Makers for the long haul gives us plenty of time to gain an in-depth understanding of how each of our companies runs its business. One of the best ways to dig deep and learn more is to call the company and ask some probing questions. That's just what I did when I recently spoke with Cisco Systems' (Nasdaq: CSCO) investor relations department. Over the next two nights, I'll be sharing the details of our conversation, most of which revolves around the primary components of the Flow ratio, particularly focusing on accounts receivable, inventory, and accounts payable.

Income Statement -- Focus of the Wise?

First, we talked about my sense that most of the Wise focus much more heavily on the income statement than the balance sheet.

Answer:

While analysts ask questions about both financial statements, they tend to ask for more guidance related to the income statement. Fact is, there's not much to worry about on Cisco's balance sheet. If you take a look at it, you'll see that cash and investments normally make up 60-70% of total assets. Compared to the total asset base, accounts receivable and inventory are relatively small. Also, the balance sheet is totally free of interest-bearing debt of either the short- or long-term variety. To the extent that the Wise do ask about the company's balance sheet, their questions primarily relate to days of sales outstanding (DSO) and inventory turnover.

Cisco made it clear that it doesn't manage its financials statements; rather, it manages its operations, and the financial statements follow. The company operates its business in a way that helps it to meet Wall Street's expectations. This is not to say, however, that Cisco "manages earnings." Sometimes, companies are accused of managing earnings in order to meet or slightly exceed analysts' consensus earnings estimate. One way companies can do this is by reclassifying certain items on the income statement and/or balance sheet, such as increasing or decreasing reserves. In contrast to this sort of financial statement finagling, Cisco manages its business for operational results. This distinction is very important to the company.

I was also told that Cisco does not want management of its balance sheet to affect its revenues or have a negative impact on its ability to meet its customer needs. For example, there are times when inventory will turn over a little more slowly than usual due to the release of a new product or suite of products.

Accounts Receivable Collection

Next, we discussed the quarter-to-quarter trend in days of sales outstanding (DSO), which is the average number of days between a sale and the collection of cash. DSO has decreased in each of the last seven quarters from 62.2 for the quarter ended 4/97 to 44.7 for the quarter ended 1/99. I inquired about the reasons behind the improved collection time.

Answer:

Cisco has kept its accounts receivable in check by being very proactive when it comes to the resolution of issues related to receivable collection. If payment on a receivable seems to be a bit slow, the company will step in to solve a potential problem before it becomes a major problem. I was also pleased to learn that Cisco has people on the ground in Europe (where collection times historically are lower) to help with the collection process.

Cisco's conservative accounting with regards to revenue recognition also helps to control accounts receivable. The company only recognizes revenue when the customer takes delivery, and to ensure that salespeople do not have an incentive to stuff the sales channel (thereby increasing accounts receivable), they are compensated in the same way as sales are recognized.

Overseas Accounts Receivable Collection

I was also interested in discussing whether Cisco finds that sales to foreign companies have substantially different terms than those to domestic clients. In the past, this has been a common lament of companies suffering from slower collection periods, particularly those that are just moving into international markets.

Answer:

In the aggregate, foreign customers take longer to pay than U.S. customers. Cisco's challenge is to get the payment patterns of its foreign customers in-line with those in the U.S. As one means of addressing this situation, Cisco has people working locally overseas as a means of helping with the collections process.

Days in Inventory

Next, we discussed days in inventory, which represents how long inventory is held before being sold. This figure declined from the quarter ended 4/97 through the quarter ended 1/98, but it has increased every quarter since then. I asked about the cause for the increase, and whether it is expected to continue, level off, or start moving lower again.

Answer:

Inventory has increased for several reasons: flexibility requirements to meet customer ordering patterns, product-mix shifts, continued growth in two-tier distribution (where revenue is not recognized until point of sale), and especially new product ramps.

Again, Cisco's revenue recognition policy is very conservative. Sales are not recognized until the point that the actual sale has taken place (i.e., the customer has the product). This helps to avoid the type of accounts receivable build-ups that have plagued some of Cisco's competitors -- notably 3Com (Nasdaq: COMS) and Lucent Technologies (NYSE: LU).

At this point in the conversation, I asked how long it takes for Cisco to deliver ordered products to customers. As expected, there is not a uniform Answer to this question. Some products are built-to-order; others are shipped the same day. The customer's needs and requirements can have a significant influence here as well. Overall, the average lead-time required to fill an order is 2-3 weeks.

Days in Accounts Payable

We then discussed the days of payables outstanding, which is how long Cisco has use of purchased supplies before paying out cash. Along these lines, I also inquired about the company's standard terms under which it pays for purchased goods. In addition, I asked about the company's relationship with suppliers.

Answer:

There is no real trend in this area. The company has standard terms of net 30 days (i.e., payment is due 30 days from receipt of the product). There are instances where Cisco works with its vendors, and it may use different scenarios to accommodate the needs of both parties. I also discovered that, at times, Cisco pays faster than its standard terms as a means of getting better pricing.

Some of Cisco's suppliers provide goods on an as-needed basis. Then, within five days of use, Cisco pays cash to the suppliers. By paying quickly, Cisco receives a better price than it would under standard terms. This nifty deal benefits both parties. Cash-rich Cisco receives better pricing, while cash-starved supplier gets much-needed cash. I was fascinated by this arrangement -- the first of its kind that I've seen -- as it really strengthens the argument that companies with lots of cash on their balance sheet have significant advantages over the competition.

I also asked whether Cisco seeks to pay its suppliers as quickly as possible or holds off payment as long as it can without upsetting its suppliers. Based upon what I was told above, I was not surprised to learn that Cisco always pays to term and never attempts to hold off payments.

Higher Prices vs Faster Payment

If given the choice between charging more for a product or receiving faster payment terms, what is the company's preference?

Answer:

Cisco tries to work with the customer to see what terms are best for the customer, so that it is a win-win situation. As a general rule, Cisco uses the same standard terms (30 days) for all of its customers. Cisco doesn't offer any real incentives to receive cash more quickly.

Special Payment Terms

We also discussed whether or not any clients are given special payment terms. If so, why?

Answer:

Generally, Cisco sells sophisticated end-to-end solutions to its customers. During the process, there are certain acceptance criteria. Cisco does not, however, recognize revenues until the customer has accepted the product. Special payment terms are not regularly offered.

That's all for tonight's report. I'll be back to finish things up tomorrow.

If you have questions about any of the terminology (days of sales outstanding, inventory, payables, etc.) in tonight's report, feel free to drop a question in the Rule Maker Beginners folder -- reserved for "dumb" questions.

Have a Foolish evening.

Phil Weiss, Fool

04/28/99 Close

Stock Change    Bid
AXP   -5 11/16  133.06
CHV   +3 15/16  102.88
CSCO  -3 5/16   111.75
EK    -1 15/16   75.69
GM    -  3/16    88.31
GPS   -1 3/4     67.13
INTC  -1 1/16    61.19
KO    -1 1/2     67.94
MSFT  -1 7/8     82.13
PFE   -3 1/8    118.00
SGP   -2 3/8     49.50
TROW  -  1/16    38.88
XON   +3 1/4     81.50
YHOO  -11       173.50


                  Day     Month  Year    History
        R-MAKER  -2.16%   1.27%  12.80%  42.73%
        S&P:     -0.87%   5.02%  10.22%  36.33%
        NASDAQ:  -2.00%   3.60%  16.31%  54.29%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     82.13   109.85%
    5/1/98   55 Gap Inc.      34.37     67.13    95.30%
   6/23/98   34 Cisco Syst    58.41    111.75    91.32%
   2/13/98   44 Intel         42.34     61.19    44.52%
    2/3/98   22 Pfizer        82.30    118.00    43.38%
   2/17/99   16 Yahoo Inc.   126.31    173.50    37.36%
   5/26/98   18 AmExpress    104.07    133.06    27.86%
    2/6/98   56 T. Rowe Pr    33.67     38.88    15.45%
   8/21/98   44 Schering-P    47.99     49.50     3.14%
   2/27/98   27 Coca-Cola     69.11     67.94    -1.69%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     81.50    26.68%
   3/12/98   15 Chevron       83.34    102.88    23.44%
   3/12/98   17 General Mo    72.41     88.31    21.97%
   3/12/98   20 Eastman Ko    63.15     75.69    19.86%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   3942.00  $2063.55
   6/23/98   34 Cisco Syst  1985.95   3799.50  $1813.55
    5/1/98   55 Gap Inc.    1890.33   3691.88  $1801.55
   2/13/98   44 Intel       1862.83   2692.25   $829.42
    2/3/98   22 Pfizer      1810.58   2596.00   $785.42
   2/17/99   16 Yahoo Inc.  2020.95   2776.00   $755.05
   5/26/98   18 AmExpress   1873.20   2395.13   $521.93
    2/6/98   56 T. Rowe Pr  1885.70   2177.00   $291.30
   8/21/98   44 Schering-P   2111.7   2178.00    $66.30
   2/27/98   27 Coca-Cola   1865.89   1834.31   -$31.58

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1630.00   $343.30
   3/12/98   15 Chevron     1250.14   1543.13   $292.99
   3/12/98   17 General Mo  1230.89   1501.31   $270.42
   3/12/98   20 Eastman Ko  1262.95   1513.75   $250.80

                              CASH     $70.09
                             TOTAL  $34340.34

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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