Let's Buy More Cisco

by Phil Weiss (TMF Grape)

TOWACO, NJ (August 26, 1999) -- If you take a look at the list of columns that I've written over the last few months, it's not hard to guess which company I'd like to see us invest in this month -- Cisco Systems (Nasdaq: CSCO). The most unusual element of this choice is that -- as we learned last night -- this is the third month in a row that Rob and I have selected the same stock for investment.

Tonight marks the sixth report that I've written on Cisco since April. Included in that bunch are coverage of each of the last two earnings reports (Fiscal Q3 and Fiscal Q4). In addition, I made a call to the company back in April to discuss some of the items that appear on its income statement and balance sheet. The results of that call were published in two reports (Part 1 and Part 2). Finally, I also suggested that we buy additional shares of Cisco in my June $500 opinion.

I guess it's not all that surprising that at a recent family gathering in Roanoke, Virginia, my great uncle (who reads my columns on WebTV) referred to me as the Cisco Kid.

The best way to sum up what I've written in those articles is to say that I like Cisco for the following reasons:

1) The continually improving quality of its Rule Making financial statements, highlighted by the fact that its Flow Ratio is now down to an all-time low of 0.87.

2) The expanding future possibilities for its business are immense. In the recent conference call, our company's CEO John Chambers said that he expects Cisco's market will grow at a rate of 30 to 50 percent over the next several years in those countries with growing economies.

3) Cisco has a substantial advantage over its competitors from a Rule Maker perspective as found in the Monopoly comparison section of its Rule Maker Ranker.

4) Cisco's high quality management team continues to demonstrate a clear focus on the long-term.

There are some additional factors that I'd like to discuss tonight, as well. The first is something that was discussed during the recent earnings conference call -- Cisco's horizontal rather than vertical business structure. Cisco has formed partnerships with Hewlett Packard, Qwest Communications, Mitsubishi, Telecordia, Electronic Data Systems, Sprint, PeopleSoft, KPMG, Sony, U.S. West, and Microsoft, as well as a number of others.

These partnerships have enabled Cisco to form relationships with Internet appliance companies, service providers, consulting firms, systems integrators, server companies, and application providers. All of these are areas in which Cisco does not have an existing knowledge base. Rather than spending significant sums of money to expand its business vertically into these areas, Cisco has chosen to get better leverage from its resources and take advantage of the knowledge of its partners.

There are two significant advantages to this strategy. The first is related to Cisco's recent decision to invest $1 billion in KPMG's consulting business instead of purchasing International Network Services as Lucent did. Chambers said that he'd rather make a $1 billion investment providing access to 4,000 consultants from KPMG than spend $3.7 billion for about 2,000 INS consultants while incurring other ongoing costs as well. The second advantage of partnering with KPMG is that it enables Cisco to focus on its own core competencies in data networking.

Cisco competitors such as Lucent (NYSE: LU) and Nortel Networks (NYSE: NT) are what Chambers likes to refer to as "old world companies." These companies expand their businesses vertically rather than horizontally. This is generally more costly as new knowledge must be created. These costs drive down profit margins and can also lead to increased debt levels.

As Chambers mentioned during the conference call, historically the most successful companies in the computer industry have been the ones that build their businesses by expanding their existing base of knowledge sideways rather than up and down. Our other two technology holdings, Intel (Nasdaq: INTC) and Microsoft (Nasdaq: MSFT), are two examples of companies that have succeeded using this horizontal expansion strategy. In addition, another of our holdings, Pfizer (NYSE: PFE), has done something similar as it has recently disposed of its medical device businesses and formed marketing alliances in order to focus more on what it does best -- market, sell, and discover pharmaceutical products.

Earlier this week, Matt discussed the impressive amounts of free cash flow that Microsoft has been generating. Cisco has also been a top performer in this area. The growth rate of its free cash flow over the first three quarters of this fiscal year has been particularly impressive. We haven't yet seen Cisco's year-end cash flow statement, but we do know from the conference call that the sum of cash and total investments increased by approximately $1.6 billion from last quarter and now totals $9.8 billion. In addition, our company is generating approximately $400 million of operating cash flow every month!

Let's go to Cisco's Q3 Statement of Cash Flows and calculate its free cash flow.

The first section that we find is "Cash Flow from Operating Activities." This section starts with net income of $1,452 million and then adds back non-cash items such as depreciation and amortization expense and deferred income tax. Next, the changes in the balance sheet accounts for current assets (e.g., accounts receivable) and current liabilities (e.g., accounts payable) are considered. This leaves net cash provided by operating activities of $2,956 million.

Now, to calculate free cash flow, we need to subtract out capital expenditures, which include such physical investments as new computers, software systems, and office equipment. As with the Microsoft example presented on Tuesday, capital expenditures are summed up in the single line item "Acquisition of property and equipment" which totals $377 million. Arguably, the $19 million "Acquisition of Selsius Systems" could also be included as a capital expenditure, but since it is a one-time investment, let's exclude it from this example in order to get a better idea of ongoing free cash flow. Here's the calculation:

                                             9 mo.   9 mo.
                                             FY 99   FY 98
  ($ millions)
Net cash provided by operating activities $2,956 $1,984 - Acquisition of PP&E (377) (282) = Free Cash Flow $2,579 $1,702 Net Income (for comparison) 1,452 859
Not only is Cisco's free cash flow substantially more than its earnings, but it's grown by more than 50% over this period as well. Like Intel and Microsoft, Cisco is able to use this money to make investments in a number of different companies around the world. In fact, just today, Cisco made two new acquisitions, though the company used its stock as currency rather than cash, as reported in this morning's Fool Breakfast News. Cisco's growing ability to generate free cash flow enhances its ability to acquire fast-growing Internet infrastructure companies.

Before closing, I want to go over some of the more confusing line items in the investing activity portion of Cisco's statement of cash flows.

In calculating free cash flow, I excluded all the purchases and proceeds of investments. In essence, these items simply represent the movement of Cisco's cash from one parking spot to another. Such movements of cash are outside of the company's core business activity. I was less sure of what to do about the "Increase in lease receivables" and "Other" line items, so I decided to place a call to Cisco's investor relations department to see what I could learn about these accounts. Here's what I found out:

Cisco has a capital/financing business. The lease receivables are part of that business and represent "capital core transactions." The amount found on the cash flow statement represents sales-type lease receivables that include direct financing as well as residual values. They're not included in accounts receivable due to the fact that they are long-term in nature. The long-term classification is because the property is leased under capital rather than operating leases. (If you're unfamiliar with these terms, I discussed them in this column.)

Cisco provides financing support to customers as well as tech support that may be needed as the customer takes on equipment. This is not a very big segment of Cisco's business right now, but it is one that's growing. It's viewed by Cisco as another sales tool.

The typical lease is three years, so the lease receivables are long-term in nature. There is a small piece of each lease that's current, but it's not material enough to be moved to the current assets section of the balance sheet. Lease receivables are included in the "Other assets" line item on the balance sheet. The "Other assets" are not broken out separately in the quarterly financials, but you will find a breakout of this item in the footnotes to the year-end statements. Because the lease receivables aren't part of working capital (they're not current assets), you find them in the investing activities section of the cash flow statement.

I also asked about the "Other" line on the cash flow statement. It primarily represents growth in goodwill and other intangibles created in acquisitions. I didn't include either of these amounts in my calculation of free cash flow. Others might include the lease receivables there, but since it's not a core business and its not an operating activity, I felt it should be excluded.

All in all, I think the bottom line on Cisco is that it's one of the highest quality companies in our portfolio, and with our focus on business quality over valuation, Cisco deserves the nod for next week's $500 investment.

If you have any questions about tonight's report or want to continue this discussion, please ask them on either our Companies Board or the Cisco Message Board.

Phil Weiss, Fool