You might not recognize Cisco Systems (Nasdaq: CSCO) by its most recent quarterly report.
Cisco with a $2.7 billion net loss for the quarter? Cisco with gross margins under 10%?
By now, investors know the struggles Cisco has had as capital spending slowed across the economy, telecommunications companies struggled to pay bills, and inventory levels soared. Cisco's market value dropped from over $400 billion less than a year ago to about $140 billion today.
The point for Rule Maker investors is that you have to be careful when you take a company's temperature. For example, which company do Cisco investors own, the one of a year ago with 64% gross margins, or the one of late, with gross margins in the 6.9% range?
Of course, the current quarter's gross margins aren't representative of Cisco's earnings power. The $2.4 billion inventory writedown means its products weren't selling fast enough, which sent its cost of goods sold soaring. This crushed gross margins for the quarter. Cisco had just $328 million in profits before it paid a nickel of operating expenses.
Eventually, the inventory that hasn't been written off will work its way through the system, customers will start buying again, and we'll see margins expand. What we want as investors, however, and what we need to do in the Rule Maker Portfolio, is to get a more accurate profile of Cisco's financial characteristics.
One way to do this is by measuring the company's performance over a much longer time period than one quarter, or one year. Rule Maker co-manager Todd Lebor mentioned this in his Yahoo! (Nasdaq: YHOO) article last week. Looking at financial results over one business cycle will give you a better picture of the company's operating abilities than a one-quarter snapshot.
In other words, valuing Cisco as though it could sustain 64% gross margins, as we in essence did last year, is almost as far off base as valuing it as though gross margins won't ever again top 10%. Neither measure is representative.
In The Intelligent Investor, Ben Graham told investors never to take one year's financial results seriously. Rather, we need five or ten years of results to really get a feel for a company's profitability. This is hard to do with a company that's grown as fast as Cisco. It had the wind at its back for a decade, and investors started thinking the wind would never change.
But the markets, just like nature, regularly send us messages that things aren't always what they seem. Consider Lake Eyre in Australia, one of the world's largest salt flats. Normally, it isn't a lake. In fact, prior to 1950 no one thought it was a lake at all. When it rains hard, however, the salt flat, which sits well below sea level, fills with water.Well, in the Rule Maker we need to invest with an understanding that it's going to rain every so often, and rain hard. We can do this by considering Ben Graham's advice about margin of safety. We need to factor the likelihood of a hard rain into the price we're willing to pay for a stock.
When we look at Cisco's free cash flow, therefore, and try to estimate its earnings power, it's not sufficiently conservative, in my opinion, to take a look at numbers from the last year or two, when the sales winds roared, and assume this is a company that produces more than $2.5 billion in annual free cash flow, as it did in 1999 and 2000.
What's the solution? I don't have a scientific answer, but when I consider Cisco's Cash King Margin, for example, I see that it has varied wildly over the last five years:
Year Cash King Margin 2000 13.5% 1999 23.7% 1998 23.7% 1997 13.1% 1996 14.8%This is only a five-year sample, but a 13% or 14% Cash King Margin makes a lot more sense than a 23% margin. Maybe it makes sense to take the average, or the low number, or the average minus the standard deviation. You need to make that choice yourself based on what you know about the company, and how conservative you want your estimate. It all boils down to getting numbers that are more representative of a company's sustainable performance than a one-year figure.
Have a great day.
[If you're interested in crunching numbers and learning how to better evaluate companies, have a look at the preview for the Fool's upcoming online seminar: Choosing Stocks With The Motley Fool.]
Rich McCaffery has never visited the world's largest salt flat (on the Bolivian plateau of Altiplano), but he does consume salt pretty much every day. To see his stock holdings, view his online profile. The Motley Fool is investors writing for investors.