Cisco Systems
My Favorite Rule Maker

By Phil Weiss (TMF Grape)

TOWACO, NJ (June 23, 1999) -- For the rest of this week, Matt, Rob and I will be writing about our favorite Rule Makers, and which company best merits additional investment dollars when we add $500 to the portfolio at the beginning of July. I'll kill any suspense right now. My view is that we should add some more shares of Cisco Systems (Nasdaq: CSCO). When I ran the company through our Ranker spreadsheet (linked at bottom) after May's earnings release, I gave it a Top Tier score of 53. At the same time, I also reviewed Cisco's results for its quarter ended May 1, 1999.

There are many ways to approach the decision as to which Rule Maker you should add money to. Some people like to add money to their worst performing stocks figuring that if their original analysis was right, then the stock is an even better bargain if it hasn't performed up to par. Others like to focus on the best performing stocks and keep adding money to those. As for me, my approach is somewhat of a hybrid of these two.

One of my favorite investment authors is Philip Fisher. Last September, I wrote a series of articles on his works (Part 1, 2, 3, 4). I agree with Fisher that there are times when one can purchase the stock of top-notch companies when they are out of favor. An example would be where market conditions are not favorable or the financial community does not properly perceive the true worth of such companies. Another might be when a company is bringing a new plant or product on-line. The reasoning here is that such events often lead to a company incurring some additional costs resulting in lower profits until economies of scale and efficiency are realized.

But oftentimes, the best companies are in favor with the financial community. In this case, I like to take a hard look at how a company has been performing (i.e., whether or not it is firing on all cylinders or simply sputtering along).

In adding shares to an existing holding, my overriding principle is to check the company's recent financial results against my original investment criteria. That means that, at a minimum, I look at the most recent quarterly balance sheet and income statement. Whenever I can, I also check the "Management's Discussion and Analysis" section of the most recent 10-Q or 10-K -- something I'll do a better job of when I'm finished paring down the number of stocks that I own.

So, considering our companies' recent financial performance, I'm left with the belief that there are better places to add new money right now than the underperforming stocks in our portfolio (Intel, T. Rowe Price, Pfizer, American Express and Schering-Plough). I will say, however, that a couple of our underperformers come close under this criteria. In particular, Intel looks well positioned due to its pending switch from 0.25 micron process technology to 0.18 micron technology and subsequently to 0.13 microns, as announced recently. Depending upon your view of things, our pharmaceutical stocks may meet this test as well.

But for me, Cisco is the place to add new money. One of the things that we like to talk about when we look at our financial criteria is the value of direction over location. Let's take a quick look at how Cisco has done over its last eight quarters. Its Flow Ratio has fallen by about 35%, from 1.63 to 1.05. That kind of improvement is something that you won't find all that often in Rule-Making stocks. A declining Flow Ratio tells us that the company is improving its management of current assets and current liabilities -- together known as working capital.

This improvement in the Flow Ratio has been driven by two factors: declining days of sales outstanding (DSO) and increasing cash. DSO, or "days in receivables," gives us a relative measure of the level of accounts receivable. On a rolling four-quarter basis, Cisco's DSO (calculated as receivables/sales/360) has fallen from 65 to 40 days. Less cash tied up in accounts receivable means more cash for productive uses such as reinvestment in the business and share repurchases. The second factor in the improving Flowie is increasing cash, which has grown from $1.8 billion to $3.1 billion over the past eight quarters. The only negative on the balance sheet is that days in inventory (calculated as inventory/cost of sales/360) has increased from 41 to 56 days.

I checked the Management Discussion and Analysis section of Cisco's most recent 10-Q (issued on June 15th) and found the following additional information:

"Accounts receivable decreased 1.8% from July 25, 1998 to May 1, 1999. Days sales outstanding in receivables improved to 40 days at May 1, 1999 from 49 days at July 25, 1998. Inventories increased 71.5% between July 25, 1998 and May 1, 1999, which reflects the Company's new product introductions and continued growth in the Company's two-tiered distribution system. Inventory management remains an area of focus as the Company balances the need to maintain strategic inventory levels to ensure competitive lead times versus the risk of inventory obsolescence because of rapidly changing technology and customer requirements."

As a Rule-Maker investor, I'm quite happy to see the downward trend in days sales outstanding, but I do realize that we need to keep an eye on inventory levels. I take some comfort in the fact that Cisco is focusing on this issue. Nevertheless, we'll keep our eye on inventory in the coming quarters.

Despite the fact that I believe Cisco is a good place to put our investment dollars, I also have to admit that it's one of the riskier stocks held in our portfolio. Part of this is related to the highly competitive nature of the telecommunications equipment market. According to the 10-Q "Cisco's competitors include Lucent, Nortel, Ericsson, 3Com, Cabletron, Fore, and IBM. Some of Cisco's competitors compete across many of Cisco's product lines, while others do not offer as wide a breadth of solutions. Several of Cisco's current and potential competitors have greater financial, marketing, and technical resources than Cisco."

Clearly, Cisco is up against some real heavyweight competition, but as our company's CEO, John Chambers, has said many times, it is not these large companies that pose the biggest threat to Cisco, but rather the smaller competitors, many of which are not even publicly traded. So far, however, no competitor even comes close to Cisco's stellar financials. In terms of gross and net margins, net cash, and the Flow Ratio, Cisco is the undisputed leader of the industry. In addition, its proprietary IOS software (Internetworking Operating System) helps to lock customers into Cisco products, thereby maintaining high profit margins and strengthening customer ties. For more on the competitive advantage of IOS, I encourage you to read this excellent PC Week article.

Despite these advantages, there are no guarantees that Cisco will continue to be the networking leader. In case you need any reminders, you may want to take a look at the numerous risk factors listed in Cisco's most recent 10-Q:

  • Exposure to customer credit risk and weakened markets;
  • Numerous risks involved in the acquisition of other companies;
  • Difficulty in predicting operating results for a particular quarter due to such factors as a slowdown in future growth rates;
  • Fluctuations in future operating results due to the fact that results from one quarter are not necessarily indicative of what will happen in the future;
  • Year 2000 issues;
  • Potential patent infringement;
  • Potential regulation of the Internet;
  • Entrance into new or developing markets;
  • Dependence on suppliers to deliver parts on time;
  • Dependence on the development of new products to meet the needs of a changing marketplace;
  • Risks associated with strategic alliances;
  • Cisco's industry is subject to consolidation;
  • Variation of sales in the service provider market;
  • Risks associated with manufacture of product parts and components;
  • Changes in telecommunication regulation and tariffs;
  • Risks of doing business in international markets; and
  • Substantial dependence upon growth of the Internet and Internet-based systems.

    That's all for tonight. As we contemplate this month's $500 question, we look forward to your ideas and opinions on our Companies Board (linked below).

    Phil Weiss, Fool

    06/23/99 Close

    Stock Change    Bid
    AXP   -2 1/8    122.63
    CHV   +2 1/2     92.63
    CSCO  +2 3/8     61.88
    EK    -  5/16    71.25
    GM    -1 3/4     61.88
    GPS   +  1/16    46.50
    INTC  +  7/8     56.56
    KO    -  7/8     61.75
    MSFT  -  1/2     86.00
    PFE   +  7/16    98.88
    SGP     ---      47.25
    TROW  +  3/16    36.13
    XON   +1 1/16    78.13
    YHOO  +3        155.50
                      Day     Month  Year    History
            R-MAKER  +0.64%   2.90%   7.74%  36.32%
            S&P:     -0.21%   2.40%   9.03%  34.87%
            NASDAQ:  +0.69%   5.17%  18.49%  57.19%
    Rule Maker Stocks
        Rec'd    #  Security     In At       Now    Change
        2/3/98   48 Microsoft     39.13     86.00   119.76%
       6/23/98   68 Cisco Syst    29.21     61.88   111.86%
        5/1/98 82.5 Gap Inc.      22.91     46.50   102.94%
       2/13/98   44 Intel         42.34     56.56    33.60%
       2/17/99   16 Yahoo Inc.   126.31    155.50    23.11%
        2/3/98   22 Pfizer        82.30     98.88    20.14%
       5/26/98   18 AmExpress    104.07    122.63    17.83%
        2/6/98   56 T. Rowe Pr    33.67     36.13     7.28%
       8/21/98   44 Schering-P    47.99     47.25    -1.55%
       2/27/98   27 Coca-Cola     69.11     61.75   -10.65%
    Foolish Four Stocks
        Rec'd    #  Security     In At     Value    Change
       3/12/98   20 Exxon         64.34     78.13    21.43%
       3/12/98   20 Eastman Ko    63.15     71.25    12.83%
       3/12/98   15 Chevron       83.34     92.63    11.14%
       3/12/98   17 General Mo    72.41     61.88   -14.54%
    Rule Maker Stocks
        Rec'd    #  Security     In At     Value    Change
        2/3/98   48 Microsoft   1878.45   4128.00  $2249.55
       6/23/98   68 Cisco Syst  1985.95   4207.50  $2221.55
        5/1/98 82.5 Gap Inc.    1890.33   3836.25  $1945.92
       2/13/98   44 Intel       1862.83   2488.75   $625.92
       2/17/99   16 Yahoo Inc.  2020.95   2488.00   $467.05
        2/3/98   22 Pfizer      1810.58   2175.25   $364.67
       5/26/98   18 AmExpress   1873.20   2207.25   $334.05
        2/6/98   56 T. Rowe Pr  1885.70   2023.00   $137.30
       8/21/98   44 Schering-P   2111.7   2079.00   -$32.70
       2/27/98   27 Coca-Cola   1865.89   1667.25  -$198.64
    Foolish Four Stocks
        Rec'd    #  Security     In At     Value    Change
       3/12/98   20 Exxon       1286.70   1562.50   $275.80
       3/12/98   20 Eastman Ko  1262.95   1425.00   $162.05
       3/12/98   15 Chevron     1250.14   1389.38   $139.24
       3/12/98   17 General Mo  1230.89   1051.88  -$179.02
                                  CASH     $70.09
                                 TOTAL  $32799.09

    Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.

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