Today the Federal Open Market Committee (FOMC) raised its target interest rate by another quarter percentage point to 2%. It's the Fed's fourth interest rate hike this year, doubling the federal funds rate from what was a four-decade low of 1% earlier this year. For perspective, however, keep in mind that the Fed's overnight interest rate target was between 6% and 7% in 2000.

The rate increase was anticipated on Wall Street, and in all likelihood investors should expect rates to keep inching up as they have been. The FOMC said it thinks that "even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity." You can read the whole statement here.

The market reacted with a big yawn, the major indexes finishing off just about even.

In today's Motley Fool Take:

Cisco's Inventory Bloat


Tim Beyers

Last week, newly publicDreamWorksAnimation(NYSE: DWA) released Shrek 2. I love the film for two reasons. First, it captivates my daughter. (You haven't lived till you've seen my 2-year-old running through the house yelling: "Mommy! Daddy! See! Shrek!") And second, the comedy of Antonio Banderas' Puss 'N Boots character. Is there a better moment than when the swashbuckling kitty faces down Shrek only to be completely incapacitated by a hair ball?

Yeah, I know the attack of the giant gingerbread man was pretty cool, too. And, yes, Rupert Everett as Prince Charming was also hysterical. Maybe I'm drawn to Puss' on-screen coughing fit because it reminds me so much of what's going on in parts of the tech industry. Witness Cisco Systems'(Nasdaq: CSCO) first-quarter 2005 earnings report issued yesterday.

Though year-over-year the networking giant boosted sales by 17.1% to $5.97 billion and net income by 28.5% to $1.4 billion, inventory and margins remain problematic. Let's tackle inventory first. For the current quarter, inventory rose by 38.3% from the same period last year, but it was essentially flat from July. Though, interestingly, it's the first quarter in a while that inventory hasn't spiked sequentially. Why interesting? Because for five straight quarters now inventory has been rising faster than sales year-over-year.

At first the increases were mild, such as in last year's first quarter. Back then, sales rose 5.3% from the year prior, with inventory up only slightly more at 5.7%. That's hardly worrisome. Yet it would get worse at Cisco and across the industry. Through yesterday's earnings report, inventory growth has outpaced sales by an average of 16.1%. This quarter's gap of 21.2% is the second-highest it's been over that period, trailing only the 24.8% gap from last year's second quarter.

Make more, sell less? Maybe in the past, but this quarter it seems more like this: make about the same, but sell it for a whole lot cheaper. Indeed, gross margin dropped from 68.4% in July to 67.2% as of yesterday's report. It's probably a safe bet that the competition CEO John Chambers lamented in yesterday's conference call is taking its toll.

Well, maybe two competitors in particular: China-based Huawei Technologies, and local kid Juniper Networks(Nasdaq: JNPR). By operating in China and making clear its intention to compete on cost, Huawei is likely putting pressure on Cisco to cut prices on its big equipment for telcos and large companies. Juniper, on the other hand, is attacking Cisco's dominance in its core router market, and is on pace to grow sales by nearly 30% over 2003, according to Morningstar.

Investors haven't exactly warmed to Cisco's results, cutting the stock by nearly 6% as of this writing. I can't say I blame them, yet investors ought to take heart in the fact that Cisco prints money like the Federal Reserve. Structural free cash flow for the quarter appears to have been nearly $1.3 billion. (That backs out an estimated $300 million for stock options expense, roughly equal to last year's quarterly average.) At that pace, Cisco will grow cash flow by 13% over fiscal 2004, to $5.2 billion.

That's a healthy clip for any firm, but like a bag of catnip for a tech tiger like Cisco. It's a good thing, too, because the networking giant may have a few more hair balls left to choke up.

For related Foolishness:

Fool contributor Tim Beyers has networked his house, but he owns no Cisco products. He doesn't own any of the stocks mentioned in this story, either. To get a peek at what Tim is invested in, check his Fool profile, which you can find here.

Discussion Board of the Day: Living Below Your Means

Are you like Arrested Development's Lucille Bluth, feeling that curly fries are "poor" food, or do you embrace the ways of being miserly? Are discount department store chains a great way to save money or is not spending the money in the first place the ideal budgeting plan? All this and more -- in the Living Below Your Means discussion board. Only on

Netflix Sees Green


Rick Aristotle Munarriz (TMF Edible)

To celebrate this past weekend's debut of Shrek 2 on DVD, Netflix(Nasdaq: NFLX) is giving folks a break from seeing red. No, it's not that shareholders are getting a reprieve from the pounding the stock took after the company announced that it was waging a price war in the DVD rental market. It's the customers who are seeing green mailers instead of the traditional red disc covers.

With Shrek and his sidekick Donkey on the face of the mailer, one may wonder how much DreamWorks Animation(NYSE: DWA) is paying Netflix for the rampant promo. While the rental specialist has promoted character overlays in the past -- Garfield and My Big Fat Greek Wedding come to mind -- this time the entire mailer is in on the marketing gimmick.

The point is that the public is perhaps underestimating the company's potential to create new revenue streams to help partly offset the $4 monthly price cut on its most popular subscriber plan that allows consumers the right to keep as many as three DVDs out for as long as they like.

While the market may have gone cold on Netflix, the fact that 2.3 million homes welcome its signature DVD mailers several times a month is not insignificant. These are not just any 2.3 million subscribers, either. They're 2.3 million subscribers who have the disposable income to indulge in the convenient rental service. Think sponsors wouldn't want a piece of that?

Yes, the company will be barely profitable next year, but the aggressive pricing has the company confident that it may double its subscriber base by the end of next year. Why would Amazon(Nasdaq: AMZN) be entertaining thoughts of entering the market or Blockbuster(NYSE: BBI) be determined enough to enter into the price war that may ultimately devalue its offline bread and butter?

There is more money to be made here than by just loaning out discs. While CEO Reed Hastings' prolific role in education may keep the company out of erotica and it may take another heavy player offering video game rentals for Netflix to throw its hat into that ring, the company's magnetic ways can still reap profits. Google(Nasdaq: GOOG) has become a publicly traded money machine on the strength of paid search results, and Netflix clearly has the web traffic to make some serious money there by hooking up with a third-party search portal. If you think advertising on the mailer is profitable, why can't software and music companies pay for the right to piggyback lightweight samples?

I offered more potentially lucrative revenue streams in my Tomorrow Version 2.0 article back in August, but the green that consumers are seeing this week may be only the beginning. If you scratch the surface on a disc you may damage it, but when you scratch the surface on this business model it's only the beginning.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and investor -- since 2002. He is part of the Rule Breakers newsletter analytical team that will be looking to unearth the next Netflix early in its growth cycle.

Quote of Note

"A girl phoned me the other day and said, 'Come on over, there's nobody home.' I went over. Nobody was home." -- Rodney Dangerfield

Natus Delivers


Rich Smith

Natus Medical (Nasdaq: BABY) , a maker of infant health screening equipment (and a Hidden Gems Watch List stock) set the bar high for itself last quarter when it projected $8.7 to $9.0 million in third-quarter revenue and earnings from continuing operations of $0.03 to $0.04. In a series of highly hypothetical back-of-the-envelope calculations, I figured that in order to hit its target, the company needed to execute three successive steps: (1) hit $9 million in revenues minimum, (2) reestablish a 60% gross margin, and (3) keep operating expenses around $4.9 million.

So how did the little guy do? Pretty well, actually. First, Natus hit the top of its revenue target, increasing its sales by 18% to reach an even $9 million on the back of a 70% increase in international sales. The company couldn't quite push its gross margins over the 60% mark, making it only as high as 57.1%. But Natus made up for that by doing even better than I had anticipated in slashing its operating costs -- it got them down to just $4.7 million. As a result, Natus still delivered on its promise of at least $0.03 in earnings from continuing operations.

Year-to-date, the results remain more mixed. Revenues rose 21% in comparison with the year-ago period. Meanwhile, the company's GAAP loss widened from last year's $0.19 to this year's $0.23.

As for next quarter, Natus projects a continued trend onward and upward. It bumped its revenue estimates up to $10 to $10.3 million, while holding its profits prediction steady at $0.07 to $0.09 per share (creating the possibility of an end-of-year "earnings surprise"). And for the year to come, Natus expects revenues of from $41 million to $43 million to translate into diluted per-share profits of $0.26 to $0.28.

Valuation-wise, that would give Natus a forward P/E of 26 (I'd work an EV/FCF for you, but Natus remains free cash flow-negative). Even with its stock trading at just $7 a stub, that seems a bit pricey. If your appetite for risk can stomach an even smaller-fry competitor of Natus, though, you may find a better bargain in tiny Bio-Logic Systems(Nasdaq: BLSC). That one's already profitable, and it has very nice free cash flow to boot -- giving it a price-to-free cash flow ratio of about 10 and an EV/FCF of under 6.

Fool contributor Rich Smith owns no interest in either of the companies mentioned in this article.

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