Last night, Cisco Systems (Nasdaq: CSCO) released its second quarter results. Fellow portfolio manager, Rich McCaffery shared his thoughts on the quarter last night in a Fool News piece, Cisco Skids. I'll review these results in a future column, but my initial reaction to the results for the quarter is disappointment.
I'm not overly concerned that Cisco failed to beat earnings expectations for the first time in almost four years. What I am troubled by is a continued decline in its Rule Maker metrics, particularly when it comes to working capital management. Cisco's Foolish Flow Ratio surpassed our standard of 1.25, its days sales outstanding increased by 7 days to 47 days and its cash conversion cycle increased by 24 days over last quarter's results.
The deterioration of Cisco's working capital metrics is something that's been going on for several quarters, and if you follow its business closely, this is something that could have been foreseen before it even started to show itself in the financial statements. In order to meet its growth targets, Cisco must sell more products to telecommunication companies. Working with these companies is different than working with the traditional large-enterprise customers that have been Cisco's biggest customers historically.
The reason that I say this is that in order to be truly successful investors we have to do more than just follow the companies in which we've invested. We have to study what I like to call 3 C's and an S (catchy, eh?). It shouldn't surprise long-time readers of my columns to know that this approach is one closely associated with the works of Philip Fisher, author of Common Stocks and Uncommon Profits.
Fisher believed that in addition to studying our Companies, we should also study their Customers, their Competitors, and their Suppliers. Over the last year, many of our holdings haven't performed up to snuff. In a number of recent columns I've been sharing some thoughts on what's behind the devaluation of some of our companies. Tonight I'd like to take a quick look at some of our companies and look at them in the context of the 3 C's and an S.
First, I'll briefly summarize why these issues are important.
A company's success (or lack thereof) in terms of developing new products and/or maintaining the quality of its current line of products is one factor that contributes to its success. Its ability to develop a strategy and execute upon that strategy is also a significant contributor to its success or failure.
Sometimes a company can succeed or fail as a result of the methods it utilizes to combat the efforts of its competitors. In addition, it's possible that a company that's been leading the field can take its eye off the ball and provide an opportunity for a competitor to step in and take some of its market share.
The type of end users that a company sells to and the external environment in which they are operating can affect a company's success or failure. It can also change the way that the market values the company.
If your company's principal supplier releases disappointing results, then it's possible that your company is contributing to the supplier's underperformance. On the other hand, positive results for the supplier can be indicative of a strong quarter for your company.
Let's take a look at the impact these factors have had on some of our portfolio's holdings, as well as some of the companies with which they do business:
Cisco and JDS Uniphase
The current weakness in the economy combined with the inability of many companies in the telecom industry to obtain the financing necessary to fund the expansion of their businesses has had a severe impact on the performance of companies like Cisco and JDS Uniphase (Nasdaq: JDSU). In addition, the inability of Cisco's customers to fund product purchases has led Cisco to start providing vendor financing to its customers. The amount of inventory Cisco carries has also increased substantially over the last year. Initially this had a positive impact on suppliers like PMC Sierra (Nasdaq: PMCS) and Broadcom (Nasdaq: BRCM). When Cisco announced that it would be reducing the level of its inventory last quarter, the share prices of these suppliers and other similar companies fell.
Intel's (Nasdaq: INTC) problems over the last year can primarily be attributed to two different issues. First, Advanced Micro Devices (NYSE: AMD) is now a much tougher competitor than it was a year ago. Second, the demand for microprocessors from the company's customers has slowed down. In addition, during the first half of last year Intel was unable to meet customer demand for microprocessors. This gave AMD a window of opportunity to sell its product to customers to which it normally wasn't able to sell its wares. AMD has been relatively successful in its efforts to serve these customers.
Yahoo! (Nasdaq: YHOO) has been affected by the inability of many of its customers to pay for the advertising services Yahoo! markets. As a result, its business model and valuation has changed. (I explored this topic in more depth recently in this piece: Yahoo!'s True Value.)
For Cisco, JDSU, Intel, and Yahoo!, each of these companies has seen its business decline as a result of customer-related issues. To a certain extent, when we decided to buy these companies we strayed a bit from two of our Rule Maker criteria -- dominant brand and repeat purchase business. Each of these companies does pass these tests, but the difference is that they sell their products and services to a relatively small number of corporate customers, rather than to millions of consumers. Intel, Cisco, and JDSU each sell products over and over again to their customers, but you don't need to buy a new PC or a new router or a new laser every day; instead, you need to find new users of these products.
One of the reasons that we don't support owning a large number of companies is that doing a good job of selecting and following an investment requires a fare amount of time and intellectual curiosity. To get the best investment results, you'll want to keep an eye on the companies you own, the companies that they do business with, and the companies with which they compete. Looking at prospective investments from this type of 360 degree point of view will reveal the companies that have the long-term compounding potential that we seek in Rule Makers.
That's exactly why we'll be exploring all these topics in a good bit more depth in our upcoming Rule Maker 2001 online investment seminar. For $49, we'll deliver you eight interactive email lessons, in which you'll learn about the all-important but sometimes hard-to-pin-down aspects of a great long-term Rule Maker investment. We guarantee you'll love the seminar. If you don't love it, we'll give you your money back. That's The Motley Fool promise with all of our products and services. You can get more information or sign up now at this link: The Art of Rule Maker.
Unfortunately, I have to end tonight's column on a sad note. In November I wrote that our 14-year-old Shih Tzu Amelia had taken ill. I was quite overwhelmed by the volume of email I received from Fools all over the world wishing her a speedy recovery. While I was unable to respond personally to each of you, I sincerely appreciated everyone's wishes.
At first the doctors found nothing, so we thought Amelia was OK. Unfortunately, in early December we learned that she had cancer. Despite our best efforts to save our good friend, I held Amelia in my arms as she was put to sleep this past Friday. The cancer that she was stricken with proved to be even more aggressive than we could have ever imagined. Having had her since she was a pup, I know that I feel a void in my life without her there. I've been doing a lot of reminiscing about her and writing down stories to make sure that they'll never be forgotten. I decided to share a few of them in this message board post. Good-bye my friend, I'll miss you dearly.
Phil Weiss, TMF Grape on the Discussion Boards
Phil Weiss and his family reside in snow-covered northwestern New Jersey. At the time of publication he owned shares of JDSU, Cisco, Intel, Yahoo!, and Broadcom. You can see his other stockholdings on his profile page. The Motley Fool is investors writing for investors.