<THE RULE MAKER PORTFOLIO>

A Conversation with Cisco Part II

By Phil Weiss (TMF Grape)

TOWACO, NJ (April 29, 1999) -- Last night, I shared with you the first part of a conversation that I had with Cisco Systems' (Nasdaq: CSCO) investor relations department. That report focused on issues directly related to Cisco's management of the most important components of its Flow ratio, including accounts receivable, inventory and accounts payable. Tonight, I'll share the rest of our discussion.

Due Diligence on Acquisitions

Cisco regularly acquires smaller companies. I asked the company about the importance of reviewing balance sheet items during the due diligence process.

Answer:

Review of the balance sheet is an important part of the due diligence process. There have been times that Cisco has walked away from transactions as a result of information uncovered during this process.

The approach that Cisco takes to due diligence depends on the nature of the company that it is looking to acquire. If the company is beyond the development stage, then earnings quality is important. Cisco also looks at whether or not the company's accounting practices are conservative. The review of the balance sheet often involves an examination of what's on the balance sheet versus what's not there. For example, Cisco checks for any potential sales or state tax obligations that the company has not yet acknowledged.

Deferred Revenues and Accrued Warranties

In Cisco's annual report, I noted that the company has recorded deferred revenues and accrued warranties. I asked, "What gives rise to these amounts and why aren't they reported in the company's quarterly financials?"

Answer:

Revenues are deferred if the earnings process is not yet complete. Examples of deferred revenue include maintenance contracts that are billed and collected in advance of the service period, billings for installation contracts that are incomplete, and billings prior to formal acceptance of the product by the customer.

Accrued warranties are the amount of warranty expense that Cisco expects to be incurred for the warranty period of each product sold. This liability is immediately "accrued" at the time the product is sold, but the actual cash outlay doesn't take place until a customer files a warranty claim. These amounts are labeled in the quarterly financials as "Other Accrued Liabilities," just as they are in the annual report. However, the quarterly financials do not give the same level of detail comprising each balance sheet account pursuant to SEC filing guidance.

Cisco's policy of less detail in the 10-Q filings is in line with SEC guidance for reporting condensed financial information. The company does not believe that a lot of people are interested in this information. Deferred revenues are also relatively insignificant compared to the total revenues realized by the company.

Personally, I would like to see the detail of Cisco's accrued liabilities each and every quarter, as I find the information to be of interest. Numerous other companies in the technology industry, including Intel, America Online, Microsoft, and Yahoo!, present this information each quarter.

For more on Cisco's current liabilities, including explanations and examples, I wrote about the topic last month.

Debt

Cisco has not a lick of interest-bearing debt on its balance sheet, which is something that we Rule Maker investors really love about the company's financials. I asked for insight on why the company chooses to manage the balance sheet this way, especially in light of the fact that one of their competitors -- Lucent Technologies (NYSE: LU) -- has a significant amount of debt on its balance sheet.

Answer:

Cisco doesn't need to take on debt at this time because cash from operations is more than sufficient to fund investment in the company's future. Plus, the company likes the flexibility that comes from having no debt on its balance sheet and no interest expense on its income statement.

In-process Research & Development Accounting

Much has been in the news lately about Cisco's disappointment with FASB's (Financial Accounting Standards Board) attempts to change the rules on accounting for in-process research and development (IPR&D). I asked for Cisco's thoughts on this subject.

Answer:

Direct quote: "We believe that the SEC should crack down on companies that abuse the rules, not punish all companies. Cisco has complied with all accounting policies in regards to IPR&D. We will, of course, comply with any changes that occur to the IPR&D accounting rules. Having said that, we believe that the newly proposed IPR&D accounting policies will stunt technology innovation and economic growth. It will be painful for Cisco and other large companies, but the large companies will be okay. This will really hurt the smaller companies and start-ups and stifle competition. In addition, these changes will probably make companies think twice about acquiring intelligent risk (risky development). Given that it is intelligent risk, it is too risky to be considered an asset. It should be expensed up front. The proposed changes attack conservative accounting practices in this regard."

If you're unfamiliar with IPR&D, I provided a brief explanation of the term in the report that can be found at this link. As I pointed out in that report, abuse of the rules on IPR&D is one of the ways that companies can falsify the economic reality of their reported earnings. However, I do not believe that this applies in Cisco's case.

Pooling of Interests Acquisitions

Cisco's acquisitions in the past have been accounted for as pooling of interests. I asked the company why they prefer this method of accounting to purchase accounting. I also asked why the company prefers to use stock, rather than cash, for its acquisitions. (Note: This question was posed before the recent announcement that FASB will eliminate pooling of interest treatment for acquisitions after January 1, 2001. For more on this announcement you can check this recent Fool on the Hill column.)

Answer:

In the past Cisco has done both pooling and purchase transactions. Pooling is preferred because it doesn't carry amortization with it. Stock is preferred because Cisco's stock is excellent currency and the employees of the acquired company immediately get Cisco stock, which aligns their interests with that of shareholders.

Cisco feels that the United States' technological lead over the rest of the world is partly due to the value creation that has come from pooling of interest acquisitions. Cisco backs up this belief based on a study of the top 30 companies (by revenue) in the U.S. and Europe, comparing the results in 1979 versus 1997. In the U.S., only 30% of the companies were in both top 30 lists. In Europe, where the IAS (international accounting standards) do not allow pooling, 63% of the companies appeared on both lists. Cisco attributes much of the United States' change in corporate leadership to pooling of interests. In short, Cisco believes that pooling has generated a positive impact on the technology economy, which accounts for a significant portion of the economic growth that has occurred in the U.S.

Restricted Investments

Cisco's balance sheet includes a fairly significant amount of restricted investments. Note 7 of the company's 1998 balance sheet explains the reason that this amount has been restricted. I asked why the company does this.

Answer:

Cisco uses off-balance sheet leasing for real estate transactions. This structure requires a certain amount of restricted cash. The way the restricted investments work and the value that Cisco gets from them is pretty kewl. Cisco has a lot of operating leases, which don't show up on the balance sheet (an operating lease is akin to paying rent -- your apartment is not part of your net worth). These leases require Cisco to keep certain investments as collateral. The collateral is used to protect the lessor in the event of default. The benefit to Cisco is lower lease payments. The restricted investments are only available to the lessor in the unlikely event that Cisco defaults on the lease. Cisco can invest this money in accordance with its regular investment policies and is entitled to the earnings that result from these investments.

Those were the only questions that I had for Cisco this time. Based upon how our conversation started, I'm pretty sure that the company will read my reports. So, I'd also like to publicly thank them for their time.

As I stated last night, if you're new to investing and some of this accounting lingo is Greek to you, feel free to drop a question in our Beginners folder. A bunch of Fools, including myself, hang out there and are happy to Answer questions.

I'll be back tomorrow to take a company through the Rule Maker paces to see how it stacks up under our criteria.

Phil Weiss, Fool

04/29/99 Close

Stock Change    Bid
AXP   +2 5/16   135.38
CHV   +  11/16  103.56
CSCO  -2 9/16   109.19
EK    +1 9/16    77.25
GM    +1 11/16   90.00
GPS   -1 7/8     65.25
INTC  -  3/8     60.81
KO    -  1/8     67.81
MSFT  -  1/16    82.06
PFE   -2 1/16   115.94
SGP   -  7/8     48.63
TROW    ---      38.88
XON   +3         84.50
YHOO  +1 1/2    175.00


                  Day     Month  Year    History
        R-MAKER  -0.29%   0.97%  12.47%  42.31%
        S&P:     -0.60%   4.39%   9.56%  35.52%
        NASDAQ:  -0.86%   2.71%  15.31%  52.97%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     82.06   109.69%
    5/1/98   55 Gap Inc.      34.37     65.25    89.85%
   6/23/98   34 Cisco Syst    58.41    109.19    86.93%
   2/13/98   44 Intel         42.34     60.81    43.64%
    2/3/98   22 Pfizer        82.30    115.94    40.87%
   2/17/99   16 Yahoo Inc.   126.31    175.00    38.55%
   5/26/98   18 AmExpress    104.07    135.38    30.08%
    2/6/98   56 T. Rowe Pr    33.67     38.88    15.45%
   8/21/98   44 Schering-P    47.99     48.63     1.32%
   2/27/98   27 Coca-Cola     69.11     67.81    -1.87%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     84.50    31.34%
   3/12/98   17 General Mo    72.41     90.00    24.30%
   3/12/98   15 Chevron       83.34    103.56    24.26%
   3/12/98   20 Eastman Ko    63.15     77.25    22.33%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   3939.00  $2060.55
   6/23/98   34 Cisco Syst  1985.95   3712.38  $1726.43
    5/1/98   55 Gap Inc.    1890.33   3588.75  $1698.42
   2/13/98   44 Intel       1862.83   2675.75   $812.92
   2/17/99   16 Yahoo Inc.  2020.95   2800.00   $779.05
    2/3/98   22 Pfizer      1810.58   2550.63   $740.05
   5/26/98   18 AmExpress   1873.20   2436.75   $563.55
    2/6/98   56 T. Rowe Pr  1885.70   2177.00   $291.30
   8/21/98   44 Schering-P   2111.7   2139.50    $27.80
   2/27/98   27 Coca-Cola   1865.89   1830.94   -$34.95

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1690.00   $403.30
   3/12/98   15 Chevron     1250.14   1553.44   $303.30
   3/12/98   17 General Mo  1230.89   1530.00   $299.11
   3/12/98   20 Eastman Ko  1262.95   1545.00   $282.05

                              CASH     $70.09
                             TOTAL  $34239.22

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.

Read More Rule Maker Reports