Rule Maker To Buy CSCO
June 22, 1998

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Rule Maker Portfolio Buy Report
Announcement: Purchasing $2,037 in Cisco Systems, Inc. stock.

Cisco Systems, Inc. (Nasdaq: CSCO)
170 West Tasman Drive
San Jose, CA 95134
(415) 526-4000

An Overview of the Company

I'd like to start off this buy report by saying thanks again to the thousands of Fools out there for guiding us to this, our 8th Rule Maker stock. There were hundreds of great research posts on Cisco and other great companies on the Rule Maker Companies folder, and the company was voted into our portfolio by a comfortable margin. I'll take this over mutual fund investing any day.

Okay. Time for the company overview.

Cisco Systems is the leading supplier of high-performance internetworking products for linking local and wide-area networks and computing systems. The company's products include routers, LAN and ATM switches, dial-up access servers, and network management software. The Cisco IOS software is used to tie these platforms together, deliver network services, and enable network applications.

Cisco's networking solutions allow people to access or transfer information without regard to differences in time, place, or type of computer system. As a matter of fact, some of its products are being used right now while you're reading this report.

The Basic Financials

Over the last five years, Cisco has continued to demonstrate spectacular sales and earnings growth while maintaining gross and net profit margins that are the best in the networking industry. During this time, Cisco has also had steadily increasing positive cash flow as well, as it has powered its way into a dominant position in providing networking products. Cisco is the leader in building out the Internet.

This all adds up to a very Foolishly run business that has consistently provided great returns to its shareholders. Let's start with a glance at some of the income statement numbers (and, of course, the complete 10-K is available for your perusal at

                      1997        1992    Annual Growth
Revenue               $6.4 bil.  $340 mil.        80.1%
Gross Profit Margin   65.2%       67.6%           -0.9%
Net Profit            $1.4 bil    $84 mil.        75.7%
Net Profit Margin     22.0%       24.8%           -2.4%
EPS                   $1.37       $0.11           65.6%
Dividend              $0.00       $0.00            0.0%

The thing that really jumps out at us when looking at these numbers is the explosive growth in revenue and earnings per share that Cisco has seen over the last 5 years. Even more amazing is the fact that this company has really only been around since 1988. In that year the company had revenues of just $5.5 million. This means that over a 9-year period, Cisco's sales have grown by a factor of 1000. During this period, Cisco has successfully protected gross and net margins -- though we do note they haven't been expanding.

Here's a look at some valuation levels with an eye on Cisco's position vis-a-vis our Rule Maker criteria.

The Basic Financials
(Fiscal year end is July)

Price.......................................................$84 5/8
Trailing earnings..........................................$1.64
Calendar 1998 Est. Earnings........................$1.75
Calendar 1999 Est. Earnings........................$2.16
P/E on Trailing Earnings................................50.7
P/E on 1998 Est...........................................47.5
P/E on 1999 Est...........................................38.5

Basic Rule Maker Criteria

Market Capitalization..........................$87.7 billion
Gross Profit Margin.....................................65.3%
Avg. Net Profit Margin.................................21.2%
Cash (and short-term securities)............$2.1 billion
Long-Term Debt...............................................$0
Cash as a multiple of Long-Term Debt ............N/A
Flow Ratio....................................................1.31
Unleveraged Flow Ratio ................................1.31

Additional Data

Consensus 5-Year Annual Growth Rate.......29.7%
Debt as % of equity.....................................0.0%
Debt as % of revenues.................................0.0%
Dividend Yield.............................................0.0%
Return on Equity.......................................20.0%
Return on Invested Capital..........................39.2%

Concentrated Look at the Business

Cisco is the gorilla of the networking industry, ranking first in market share in a half-dozen categories of key products. Its engineers are competent enough to assume system responsibility even in complex installations. This provides a strong inducement for prospective customers to deal with a single source -- Cisco -- rather than risk the service disputes that can arise from using a variety of vendors. Oftentimes, this factor will cause others to use Cisco's products even if other vendors claim to have superior product features. There's a brand advantage in there, Fools.

Cisco's overall strategy is to provide end-to-end networking solutions that its customers can use to either build their own unified information infrastructure or connect to someone else's network. The advantage of end-to-end networking solutions is that they provide a common technical architecture allowing network services to be consistently provided to all users of the network. In essence, there's one language running throughout the whole system.

But hey, let's take a step back and talk a little bit about what Cisco actually does.

Some of this may sound a bit technical, but it's important to remember that one of the beauties of Rule Maker investing is that it allows us to learn and understand more about the businesses of our companies. So, if we don't understand all of it today, we're pretty sure that we'll own this one long enough (hopefully, ten years and out) to understand the business pretty well in the future.

Cisco's end-to-end networking solutions include the following product categories:

Routing -- A foundation technology for computer communications. Routers move information from one network to another, applying intelligence in
the process to ensure that the information reaches its destination securely and in the fastest way possible.

Switching -- Another important network technology, which is used in both local-area networks (LANs) and wide-area networks (WANs).

Access -- Cisco's access solutions give groups and individuals that are located remotely the same level of connectivity and information access that they would have if they were located at the company's head office. This is something that's particularly important to those who telecommute and those who travel out of the office frequently.

SNA/LAN -- The Company's CiscoBlue strategy provides a roadmap for combining System Network Architecture (SNA) and LAN-based network architectures.

Internet Appliances and Software -- Cisco offers products that improve a network manager's ability to cope with a number of challenges posed by the growing popularity of the Internet, such as security, network traffic volume, and network address shortage.

Cisco IOS Software -- Cisco Internetwork Operating System (Cisco IOS) is the common platform used to connect otherwise disparate hardware to build a seamless, efficient infrastructure facilitating network growth and the deployment of new applications. This in turn enhances reliability and interoperability, while at the same time lowering the cost of ownership.

Network Management -- The purpose of the applications that Cisco provides is to centralize management and automate routine tasks. These applications can be integrated into customers' existing network management environments.

Cisco primarily sells to three different kinds of customers: Enterprises, Service Providers, and Small/Medium-size Businesses. Enterprise customers are generally large organizations with more complex networking needs. Service providers are those that provide data communication services to such entities as telecommunication carriers, Internet Service Providers, cable companies, and wireless communication providers. Small/Medium-sized business customers are those that have a need for data networks of their own, as well as a connection to the Internet and/or to business partners.

Cisco uses a number of different methods to market its products. These include its direct sales force, distributors, value-added resellers, system integrators -- and often the best sort of promotion: word of mouth. This multi-channel approach has several advantages as it allows customers to select the channel that addresses their specific needs and it provides the company with broad coverage of worldwide markets.

The company pursues strategic alliances on a variety of products. Currently, Cisco has alliances with two of our other holdings - Intel and Microsoft - as well as Hewlett-Packard, GTE and Alcatel, among others. Our company also does a healthy amount of its business internationally. International sales accounted for approximately 43.5% of Cisco sales in 1997, down from 48.2% in fiscal 1996. These sales are generally made in U.S. dollars. So, Cisco has networked its networking products into numerous markets.

Research and Development (R&D) expenditures are an important part of Cisco's business. In fiscal 1997 the Company spent close to $700 million on R&D. R&D is directed towards the three primary lines of business - Enterprise, Service Provider and Small/Medium Business. On the development side, Cisco is primarily focused on networking products tailored to customer needs. For that reason, our company concentrates a lot of attention on being able to provide end-to-end networking solutions. These end-to-end solutions help Cisco meet its goal of being the sole provider of goods and services to its customers for networking products.

From all accounts, Cisco's management team is young and energetic. President and CEO, John Chambers, who has been with the Company since 1991, is just 48.

Historical Stock Performance

Cisco was incorporated in California in December 1984. The company went public in 1990 and on a split-adjusted basis, its stock traded at a low of $0.40 per share that year. (Again, it never got that low -- this is a price adjusted for all those stock splits twixt then and now.) From that low price to the closing price of this past Friday, Cisco's stock has grown at an annualized rate in excess of 90%. Yep, 90% per year. $10,000 invested in Cisco stock in 1990 is worth over $1.7 million just eight years later.

It certainly would have been nice to buy this one at its IPO, but we're more than happy to join the ride now. We spend much more time as investors looking forward and studying the merits of the business than we do looking back and wishing we'd been there! We believe that Cisco's products, brand and business model has plenty of legs left.

On a per share basis revenues have grown at an annual rate of 94% over the last ten years. Earnings per share have risen by 116% per year. And cash flow is up by 122% per year. A good portion of this growth can be attributed to the fact that Cisco has acquired a number of companies. Each of these acquisitions has been aimed at furthering the company's commitment to providing an end-to-end networking solution.

Although the number of outstanding shares of Cisco's stock has grown over the last five years, the company does engage in regular stock buybacks. Between fiscal 1995 and fiscal 1997, Cisco repurchased over $500 million of its stock. The growth in shares outstanding can primarily be attributed to the issuance of stock options to company employees and for acquistions. These options are an important part of compensation at most high-technology companies.

Concerns Going Forward

Cisco competes in a market that is characterized by rapid growth, technological change, and converging technologies. These market factors lead to both opportunities for Cisco and competitive threats to their position. Our company also competes with a still growing number of vendors in each of its product categories.

Cisco's traditional competitors include 3Com, Bay Networks, Cabletron, Fore and IBM. As Cisco expands its focus towards new markets such as the transportation of voice, video and data traffic across the same network, it's expected that the company will increasingly compete with large telecommunications equipment suppliers such as Lucent, Ericsson and Nortel.

The principal competitive factors in Cisco's markets both now and in the future are price, performance, the ability to provide end-to-end solutions and support, conformance of standards, and the ability to provide added value features such as security, reliability and investment protection and market presence.

The nature of Cisco's business is such that it is subject to fluctuation in both its stock price and its quarterly results. This next paragraph will read like a disclaimer, but it's important for context. Cisco may well be the most volatile stock in the C-K Portfolio for years to come. So here goes nothing...

These are a few of the factors that can cause marked fluctuations in Cisco's valuation: the introduction and market acceptance of new technologies; the timing of orders and manufacturing lead times; the management of inventory; variations in sales channels; product costs or the mix of products sold; increased competition in the networking industry; the overall trend towards industry consolidation; the integration of people, operations and products from acquired businesses and technologies; and changes in general economic conditions and specific economic conditions in the computer and networking industries.

Cisco's operating results are also highly dependent upon its ability to reduce the costs to produce today's and tomorrow's products. The success of new products is dependent upon several factors, including proper new product definition, product cost, timely completion of new products, differentiation of new products from those of the company's competitors, and market acceptance of these products.

Additionally, Cisco's gross and net profit margins, although significantly in excess of the standards that we have set for Rule Maker, have fallen slightly over the last five years. We don't like to see this. There is a significant margin for error here, but we're hoping Cisco can right this over the next decade... moving its margins up inchmeal, one year at a time.

Prospects Going Forward

As noted above, Cisco is the gorilla of the networking industry, in a global market whose growth is spurred by the increasingly critical role that electronic information plays in almost every facet of life today. While computer networking has traditionally been a highly complex science employed primarily by large organizations, the growth in the use of the global Internet has proved beneficial to organizations of all sizes, as well as individuals worldwide. This explosive growth has been a key factor in the growth of Cisco.

According to Zacks, the 30 analysts who currently follow Cisco's stock have forecast a mean 5-year annual earnings growth rate of 29.71%. The range of estimates is between 14% and 44% per year -- quite a large range. The company has demonstrated an ability to grow at these levels or higher in the past, and there is no reason to believe that it should not continue to deliver this level of growth going forward.

Cisco trades at a premium to its 5-year growth rate. This premium is based upon both the company's long-standing history of consistent, solid growth as well as the high margins earned on its sales. The market rewards companies that deliver consistently by discounting that growth years forward. On a YPEG (5-year growth rate times projected year-ahead earnings) basis, the growth is being discounted forward about 1.5 years. In other words, if Cisco meets growth projections, we're buying Cisco's earnings growth 18 months and out.

This may cause the stock price to go sideways for awhile, but we're buying our piece of the business now with an eye on what it might mean to us in a decade, or two, or when we retire (that is, IF we retire!). We feel that some patience with this stock in the short term will reward us with years of market beating growth over the long term.

Is Cisco a Rule Maker Stock?

Let's go through the criteria quickly.

Consumer mindshare - In terms of consumers like you and I, Cisco falls short. However, like Pfizer with doctors, Cisco does have great name recognition with its customer base -- businesses of all sizes. Its end-to-end networking solutions also help to make it a repeat-purchase business for its customers. Plus, as Tom Gardner said in a recent post on the Rule Maker Companies board, convenience is something we like to see our companies provide to its customers. Cisco's business objectives seem to center around making networking solutions for customers as convenient as possible. So, although it falls short in the strict sense of the word, Cisco does have mindshare qualities that we're looking for here.

Global consumer brand. 43% of Cisco's sales are to international customers. So, Cisco's brand is clearly global. It is not a consumer brand -- but we'll endure that to be a part of its sterling financials.

Historical stock performance. At 90% per year growth, Cisco has certainly been a top-notch creator of value for its shareholders. No complaints here.

Super-size the company. With a market cap of over $80 billion Cisco certainly passes our $5 billion hurdle with flying colors.

Gross margins above 50% and net margins above 7%. Yep. 65% and 21%, respectively.

Cash 1.5 times long-term debt: Yep. No debt.

Leveraged flow ratio below 1.25, and unleveraged flow ratio below 1.5. Cisco's unleveraged flow ratio passes this test. Its leveraged flow ratio just misses -- as it needs to whittle receivables and inventory down a bit. However, Cisco has been consistently reducing its Foolish Flow Ratio over the last several quarters -- as it improves product and cash flows. We like the direction and expect to see good ol' flowie under our standard shortly.

A direction that exceeds location. The Flow has been improving. Sales and earnings are plowing ahead. The Internet is only becoming more important and more ubiquitous with every passing year. In fact, the Commerce Dept. reported a few months back that Internet traffic was doubling every 100 days. Wow.

Cisco's mean 5-year growth rate is currently around 30% per year. We think that might be low. From this and other vantagepoints, this company has compelling prospects for the future. We're certainly excited about adding the market leader in a rapidly growing industry to our portfolio. Our one concern is the direction of gross and net margins. Hopefully, Cisco can stabilize these and then inch them forward over the next decade.

We're looking forward to adding Cisco's stock to the Rule Maker Portfolio at some point over the next five days. If you have questions about this report, please drop by the Rule Maker Companies folder.

Fool on,

Phil Weiss