CISCO Systems (CSCO:US): Value in the most unlikely of all places!

This post was written before this week’s positive earnings surprise sending the stock up 7% in after hour trading, confirming in some way the low expectations built into the stock price. Read the link for details:

http://www.bloomberg.com/news/2014-05-14/cisco-third-quarter-sales-top-estimates-on-mobile-demand.html

I wrote a few posts ago, that I was surprised to find interestingly valued companies in what I consider to be overvalued markets. This is especially true of Cisco Systems which I consider at least fairly valued. Needless to mention: in an environment where tech-stocks, some of which produce little long run benefit to society (what is Twitter good for?), are valued at absurd multiples, it is an achievement to find a fairly priced blue-chip stock. Although I am far from being a tech-geek, even I knew Cisco Systems: it is one of the leading tech companies of the world and market leader in computer network equipment (servers, routers a.s.o.) and has been around since the beginning of the internet age. The company refers to its business model as providing the “backbone” of the internet, and that metaphor is probably not too far-fetched.

Cisco: strong fundamentals at low multiples

The company has a market cap of USD 122 bn. with a liquid asset position (cash + investments) of around USD 47 bn. Total debt of the company sums up to USD 42 bn. of which USD 17 bn. are interest bearing, i.e. the company is debt free and conservatively financed. Full year revenues (2013) came in at USD 48.6 bn. and a net income of around USD 10 bn. which results in a trailing PE of around 12.5. The company started paying a dividend in 2011 and has raised it twice in the following years and currently yields a respectable 3.2 percent. The dividend is comfortably covered three times. Furthermore, the company has a policy to return 50% of its Free Cash Flow, which it estimates at USD 11.7 bn., to its shareholders via dividends and buybacks. Usually I am no fan of buybacks, but since I think the company attractively valued I am comfortable with this decision. If you include the likely buybacks, cash returned to shareholders stands at roughly 5.7% – not bad at all!

Considering that revenue growth has averaged 9.5% p.a. for the past ten years, the stock looks cheap at these multiples unless one is either willing to predict either a significant reduction in growth or a substantial reduction in profit margins – or both. Since the stock trades 30% below its Dec. 2007 high it looks as if this is what market is pricing in. It is true, growth has slowed somewhat and it stood at 8% for the past four years.  The company certainly is maturing but the pessimism looks somewhat overdone to me. The net profit margin has fluctuated between healthy 20% – 25% over the past ten years hinting at the presence of a “moat”, which seems plausible. After all, ask yourself: how likely are you to switch your server provider just because a somewhat cheaper competitor comes along? Think of all the security risks you are taking! I am no tech expert, but it feels quite well entrenched to me. Furthermore,  I also like the fact that it is also not as sexy as “social media” and hence less likely to be undercut by an irrationally acting, venture capital financed would-be entrant.

Risks: goodwill and NSA spying

Of course no investment comes without risks. In Cisco’s case I feel most uncomfortable with the numerous acquisitions it undertakes every year. Goodwill  stands at USD 32 bn. and is up from USD 12.5 bn. in 2010. Heck, it looks like a serial acquirer! It is little consolation that no major goodwill impairments had to be booked so far. I will conservatively assume that a large part of these acquisitions are really substitutes for R&D spending, which has implications for the Free Cash Flow estimate. I will (arbitrarily) assume that the goodwill has to be amortized over 10 years and that 2/3 of it constitute “maintenance capex”. If you agree with me the company specified Free Cash Flow (FCF) of USD 11.7 bn. would have to be adjusted for USD 2 bn. leading to a “adjusted” FCF of USD 9.7 bn. and a – still attractive – FCF Yield of around 8%. Obviously, this is just a rough, unscientific and arbitrary adjustment which certainly could be done better. However, it nonetheless confirms the attractive valuation.

The second biggest risk factor is purely qualitative, however certainly no less important. The fact that American internet companies have been complicit in NSA spying has angered many outside the US, especially in emerging markets such as China and Brazil. Some companies such as IBM have already felt the pinch. Whereas I do not know whether Cisco has been involved, this probably doesn’t matter as clients might grow weary of American internet companies generally. This could prove a hindrance to growth in these markets.

Summary

At these levels I consider Cisco attractively priced and have established a small position, small because I am not a tech expert and do not feel confident enough evaluating the business model. The market seems to price in a reduction in either growth or profit margins that seem excessive to me and I am willing to bet against that. This is not a recomendation to buy or sell any stock. Do your own research!

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