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Technology Stocks : Cisco Systems, Inc. (CSCO) -- Ignore unavailable to you. Want to Upgrade?

To: Tim Luke who wrote (21921)	2/3/1999 10:08:00 PM
From: puborectalis	Respond to of 77397

THE BORING PORTFOLIO> Cisco's Cookin' by Dale Wettlaufer (DaleW@fool.com) ALEXANDRIA, VA (Feb. 3, 1999) -- Cisco Systems (Nasdaq: CSCO) reported quarterly results last night. Second quarter revenues were $2.83 billion compared with $2.02 billion last year and $2.59 billion last quarter. Pro-forma net income for the quarter was $606 million, which excludes a $319 million after-tax charge for in-process research and development. A word on that before we go forward, though. Cisco does numerous acquisitions each year to sustain its competitive advantage in its current markets and to gain entry and build its presence in new markets. There are some companies that Cisco buys for tens and hundreds of millions of dollars in stock that have negligible revenues and no earnings. Some of these turn out to be pretty bad investments. Some of them turn out to be huge, though. We're talking yearly returns on capital eventually in the thousands of percentage points. Taken as a portfolio, these companies generate very high incremental returns on capital for Cisco and represent the company's future opportunities. It's really not that much different from the way a large pharmaceutical company goes about its investments. The accounting treatment is similar, too, in that the R&D, as represented by the acquisition intangibles, is written off immediately. That lowers immediate earnings when your R&D budget is on an upward slope. On the level of per-share net cash flow from operations and free cash flow per share, however, it doesn't make a difference. The capital on the balance sheet does not adequately reflect the capital that has been invested, since the write-offs are immediate. To adjust for this, the better way of assessing return on investment would be to add back these acquisition-related charges and amortize them over a number of years, probably not exceeding five years. We don't care what that would do for book value on its own, though. In going through such an exercise, we would want to find out the company's cash-in versus cash-out dynamics. In other words, we want to know its true return on capital. On a cash flow level, we don't have any issues with the accounting of Cisco, and I personally feel there are no quality of earnings issues with Cisco. Some have a problem with the equity issuance that comes along with employees earning options. That does transfer some enterprise value from investors to employees, but without the ability to earn options, many good employees simply would not work at Cisco. The dilution versus the value created by these employees is not a problem to us. I'm whipping up the conference call transcript for Cisco. What's particularly worthy of notice are the company's discussions on the direction of the product line -- the proliferation of data traffic in our society and the supplanting of the circuit-switched voice networks with Internet-protocol based telephony are two gigantic factors that will decide much of the creation or destruction of value at Cisco in coming years. Lucent (NYSE: LU) wants in on this with its pending acquisition of Ascend Communications (Nasdaq: ASND), but Cisco's internetwork operating system (IOS) and dominant position in WAN routers give the company a highly important competitive advantage that will be hard to crack. Cisco is a software company that sells that software packaged in hardware. Its economics are those of a software company with an entrenched position in technical standards. Think of Cisco as being more like Microsoft (Nasdaq: MSFT) than Dell (Nasdaq: DELL). Just as Microsoft and Intel (NYSE: INTC) combined took hundreds of billions of dollars in enterprise value from IBM (NYSE: IBM), the thesis here is that that Cisco's technical lock-in and increasing marginal returns give it a chance at taking a similar amount of value as data of all sorts migrates to IP networks. If that's the case, and even without this "big hypothesis" thinking in the mix, at 75 times earnings annualized off this quarter, we don't think Cisco and the term "value" are mutually exclusive.