Rule Maker Portfolio
Going with Old Reliable
TOWACO, NJ (Sept. 28, 1999) -- It's hard to believe another month has passed us by. It's no longer summer. Fall has begun. It's almost time for the leaves in this neck of the woods to start changing into all sorts of bright colors. Our annual family apple picking expedition is also close at hand, provided that the orchards survived the ravages of Hurricane Floyd.
This past weekend was the highlight of the month, as my wife and I took our two-year-old son to Yankee Stadium for the first time. He was a little intimidated by all the crowd noise, but I got a big thank you kiss when the game was over. Now that's something that can only bring a big smile to this daddy's face.
The end of September also means that it's time for us to make our monthly nomination for which stock we should buy with our $500 monthly contribution. There's been much on my mind besides the stock market over the last month, so once again, I'm going with my old reliable pick Cisco Systems (Nasdaq: CSCO) for the third time in four months. (June $500 opinion and August $500 opinion.)
I've written quite a bit about Cisco in the past few months. It seems that the more I read about this company, the more I admire it. First, I'll sum up the reasons that I've given in the past for thinking Cisco is the place to put our additional funds:
1) The continuously improving quality of its Rule Making financial statements, highlighted by its Flow Ratio of 0.87 -- an all-time low.
2) The expanding future possibilities for its business are immense. In the recent conference call, 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 (spreadsheet linked at bottom).
4) Cisco's high-quality management team continues to demonstrate a clear focus on the long term.
5) Cisco's horizontal rather than vertical management structure.
6) The quality of Cisco's earnings as evidenced by its free cash flow.
What I'd like to do with the rest of my time tonight is take Cisco through some (but not all) of Philip Fisher's 15 points to look for in a great company, as written in Common Stocks and Uncommon Profits (If you want more background on this book, you can read either of these columns: Part I and Part II.)
POINT 1: Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
To me this one is easy. Cisco sells products that help form the backbone of the Internet. These products include hubs, switches, routers, switch routers, and firewall products. The size of the market for Cisco's products is still growing at a rapid pace. Our company is the number one player in 16 of its 20 markets. It's number two in the other four.
In addition, Cisco is preparing for the integration of voice and data by filling the gaps in its product line through strategic acquisitions. While its primary competitors in optical networking -- Lucent (NYSE: LU) and Nortel (NYSE: NT) -- may have some early advantages due to existing customer relationships, I think Cisco will be a leader in this market as well. I'm also quite impressed by the fact that Cisco's CEO, John Chambers, makes a point of meeting with dissatisfied customers to find out what Cisco is doing wrong, rather than what it's doing right. To me, this is both Foolish and good business.
POINT 2: Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
Cisco invests 12% to 13% of its sales revenue in research and development (R&D). Like the other technology leaders in our portfolio, such as Intel and Microsoft, Cisco regularly cannibalizes its existing products by introducing newer and more advanced models. Our company is always upgrading its products as part of its regular business. Like all leading technology companies, its aim is to stay ahead of the competition.
POINT 3: How effective are the company's research and development efforts in relation to its size?
Cisco invests heavily in R&D and has been doing so for some time. In addition, Cisco is an active acquirer of small companies that hold key technology, products, and engineering talent. Some people question whether it is better for a company to develop its own products or acquire those of others. Due to the highly competitive nature of the networking industry, I do not object to Cisco using acquisitions as a means of acquiring new talent that can be used to help further the growth of the company and its products. In addition, Cisco has a plan in place to develop products that meet the needs of those outside its existing core marketplace. That's one of the primary reasons behind its efforts in the optical networking area.
POINT 5: Does the company have worthwhile profit margins?
Cisco's net margin is well above the Rule Maker's target net margin of 7%. At 21%, Cisco's is also well ahead of its competitors' net margins. This high profit margin also helps to support Cisco's investment in its future via R&D.
POINT 6: What is the company doing to maintain or improve profit margins?
Cisco keeps a tight rein on its expenses. While it's not afraid to spend money now to improve its prospects for the future, the company has kept its expenses relative to sales in a tight range. The company has warned on a number of occasions that it anticipates declining profit margins in the future, but not of a magnitude that would threaten the success of its operations. Margins should remain well ahead of the competition.
Cisco also works hard to keep down its costs through ongoing cost reduction strategies. Price competition is also a factor in Cisco's ability to keep its margins at a high level. The company's real-time financial reporting system also helps to keep costs in check. The bottom line to this is that Cisco is managing its costs and profit margins quite well.
POINT 7: Does the company have outstanding labor and personnel relations?
Cisco's rate of employee turnover is incredibly low. From what I've seen, John Chambers does all he can to make Cisco a good place for its employees to work. In a recent 20/20 interview, I saw some of the company's policies that have been instituted to help keep morale high. Chambers walks around the office with bags of candy for his employees and each employee gets an opportunity to meet with Chambers on at least an occasional basis. To some these may sound like trivialities. To me they sound quite Foolish. Chambers also remembers how he felt when he had to lay off 5,000 employees while he worked at Wang. He's committed to avoiding that action again.
POINT 10: How good are the company's cost analysis and accounting controls?
From what I've learned, I'd say that Cisco's accounting policies are quite conservative. Revenue is not recognized until customers accept product delivery. Cisco's sales team does not have any extra incentive to back-load or front-load sales, as sales commissions are based upon this same recognition policy.
It's also quite comforting for me to see that Cisco has increased its sales at a faster rate than it has grown its receivables. As a matter of fact, days sales outstanding [Accounts Receivable/(Quarterly Sales/90)] have declined from 65 days to 36 days during the time that I have followed the company. (For more on Cisco's accounting controls, you can check out these columns: Cisco Call Part 1 and Part 2.)
POINT 15: Does the company have management of unquestionable integrity?
By all indications, John Chambers & Co. are extremely honest in freely sharing information with shareholders and the investing public. I've learned a great deal about the company by listening to its quarterly earnings conference calls and reading through all the information provided on its website.
I realize that I've left out a number of Fisher's points due to time and space limitations. But, to this Fool's eye, Cisco scores quite well on each of the items I've discussed. The bottom line is that once again, my money is on Cisco.
Phil Weiss, Fool
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