Much has been written in the past 12 months about Cisco Systems, Inc. (CSCO) and how it is "deeply undervalued" and is a great investment going forward. While CSCO is still dominant in its industry, I will argue that Cisco perhaps isn't the screaming buy a lot of investors seem to think it is. This article will include a deep dive into Cisco's valuation and attempt to determine if Cisco shares deserve your capital. You can judge for yourself if Cisco warrants a long position in your portfolio.
I will argue that Cisco's growth by acquisition strategy is expensive and could be construed as a sign of desperation by a Board that knows they are stagnating. Cisco has historically purchased several companies per year (at least) and is showing no signs of stopping with the recent acquisitions of NDS and Meraki as examples. Cisco tends to keep the acquisitions relatively small so they are certainly not bankrupting themselves to buy other companies, but if Cisco could grow on its own, they wouldn't need to pay huge prices for tiny companies every couple of months. In addition, acquisitions are difficult to implement on any scale and Cisco seems to be implementing acquisitions non-stop. Of course, data transmission needs are expected to explode worldwide in the next few years but this doesn't necessarily mean huge growth for Cisco. All the data that will need to be transmitted will be done without necessarily needing much more hardware than what is currently available. Certainly some upgrades will be performed and that means Cisco has a revenue stream for the foreseeable future but I do not believe this will result in terrific earnings growth since companies and consumers will be able to move more data with the same, or less, equipment.
In addition to simply being expensive, constantly paying premiums for acquisition targets results in destruction of value for the acquirer's shareholders. If Cisco buys a company, they must pay a premium over the book value of the acquisition's assets. This premium gets recorded as goodwill on the balance sheet; an intangible "asset" that basically tells you how much money a company has wasted overpaying for companies in the past. In essence, Cisco is trading cash (which it can use to pay for things) for goodwill (which is useless). This constant destruction of value isn't productive for shareholders. While value isn't technically destroyed until the goodwill is written down, my point of exchanging a useful asset for a useless one stands.
All numbers are as of the most recent quarter or newer. A weekly chart is above for price reference on where CSCO has been for the past 3 years.
Cisco currently has a book value of $52.686B, or $9.92/share based on 5.31B shares outstanding. This value represents slightly more than half the company's market cap as of this writing. I believe this value is in line with a very mature, slow growing dividend payer like Cisco. While it may seem cheap for a tech company, Cisco's high growth days are well behind it and thus, does not warrant more than 2X book value.
The company is obviously quite well capitalized, including $57.907B in current assets and only $16.272B in long-term debt. Cisco's balance sheet is of no concern to me as they have only 16.26% debt financing and the rest equity. In addition, they generate very strong free cash flow and their debt is financed very cheaply (3.65% weighted average, by my calculation). The balance sheet is a source of strength for Cisco and allows them to go on their acquisition sprees.
The stock currently has greater than 70% institutional ownership which, I would argue, limits the amount of upside since we all know that institutions are the big buyers of large-cap companies. While there is room for increase, I think this might serve cap share appreciation in the future.
Cisco has famously been buying back stock since (seemingly) the beginning of time but they also reissue a lot of those shares as compensation to employees. Cisco currently has a years-old buyback program that has about $5.9B left on it. Nobody expects Cisco not to complete this buyback so this is a positive for EPS and the share price. However, Cisco typically reissues about $1.5B (from their 10-Q) of stock each year as compensation. As you can easily see, buying back stock doesn't help shareholders if you give it back out. While they are shrinking share count, Cisco is shrinking it much more slowly than the huge buyback program would suggest they might.
Cisco's dividend is robust at $0.56 per share annually, offering a 2.9% yield at the time of this writing. In addition, Cisco's strong balance sheet and generous free cash flow generation suggest the dividend could be increased, possibly significantly, in the future. This is an overwhelming positive for the stock and should not be ignored.
Discounted Cash Flow Analysis and Valuation
Before we dig into the numbers of the DCF analysis, let's quickly review what CSCO analysts are expecting for the stock. According to Yahoo Finance, CSCO has 46 analysts following it currently. Their ratings include: 19 Strong Buys, 10 Buys, 14 Holds, 3 Underperforms. Obviously, there is a bullish bias among Wall Street analysts for Cisco. However, the 14 holds means there is potentially some room for upgrades and the pops that often accompany them. Unfortunately for Cisco bulls, this concept works in reverse too.
Also from Yahoo, 38 of these brokers have provided price targets on CSCO as follows: High target of 25.00, Low target of 14.00, Mean of 21.62 and Median of 22.00. Again, virtually no one expects this stock will be lower 12 months from now. While the targets are optimistic, they are not outlandish and are probably based mostly on the dividend yield (my speculation). Nevertheless, bullish opinions abound.
Now, let's move on to the DCF analysis of CSCO. There is a broad set of inputs for DCF analysis (some requiring assumptions) and we will review those quickly before diving in.
- Tax rate = 20.65% (from the MRQ 10-Q)
- 10 year Treasury = 1.60% (quoted, used as the risk free rate)
- Debt % = 16.26 (from the MRQ 10-Q)
- Equity % = 83.74 (from the MRQ 10-Q)
- Equity risk premium = 10% (assumed)
- Debt cost = 3.65% (from the MRQ 10-Q)
- Earnings growth assumption = 3% (my own personal estimate, long term)
- WACC = 8.84% (calculated from various inputs)
- 2012 earnings = 8.041B (from the 10-K)
- 2013 earnings estimate = 1.96 (Yahoo!)
- 2014 earnings estimate = 2.09 (Yahoo!)
- Assume 10% dividend growth rate per year from here, starting in 2013
Please note the DCF analysis presented below is using the "Abnormal Earnings" method which, simply put, demands that a company earns in excess of its Weighted Average Cost of Capital. The amount of earnings required to cover the company's WACC is "Normal" earnings and anything in excess is "Abnormal." The goal, obviously, is to discount the "Abnormal" earnings to figure out what the company is worth in today's dollars.
Also note, anyone who performs this analysis will probably come up with a different value than I have based on their personal viewpoints on the company and much of the analysis is based on the company's WACC, which I believe I have calculated with a very realistic set of estimates. There will always be room for discussion any time estimates and forecasts are involved. If you disagree with my methods, please let me know in the comment section. I would be happy to discuss.
Reported earnings per share
x(1+Forecasted earnings growth)
=Forecasted earnings per share
Equity book value at begin of year
x Equity cost of capital
Future abnormal earnings
x discount factor
=Abnormal earnings disc to present
Abnormal earnings in year +6
Assumed long-term growth rate
Present value of terminal year
Estimated share price
Sum of discounted AE over horizon
+PV of terminal year AE
=PV of all AE
+Current equity book value
=Estimated current share price
I'm not going to read the table to you but as you can see, from my numbers, Cisco is worth about $19.27 in today's dollars. The two components of this price are 1) current book value of $9.92 and 2) the present value of Cisco's abnormal earnings of $9.35. These numbers assume a constant share count because it is impossible to forecast what Cisco will do with buybacks and re-issuances of stock in the future. As a result, for simplicity's sake, I have excluded that criterion from my calculation. If Cisco gets serious about actually retiring stock instead of just buying it to pay employees, these calculations could prove to be conservative.
I believe Cisco deserves a multiple of about 9 times earnings based on its growth rate. As a side note, I base my earnings multiples on Benjamin Graham's theory that a company should get an earnings multiple of 8 + (earnings growth rate / 2). As it is currently trading above that, I don't believe Cisco is cheap here. In fact, as shown above, I think Cisco is fairly valued given its growth prospects for the next 5 years or so. Also, at $2.35 of earnings in 2018 and an earnings multiple of 9, a price of $21.15 is implied six years from now. That doesn't sound like proper capital appreciation to me so I will be staying away from CSCO unless their growth prospects improve or it gets a lot cheaper.
As of this writing, Cisco is trading at $19.14, implying a $0.13 safety margin to my fair value price. As a result, I cannot see any reason to buy Cisco right now other than the dividend yield. If you are looking for capital appreciation, look elsewhere. However, if you want to collect 3% of payments that are safer than most bonds, Cisco is probably a good vehicle for you to do so. Cisco, I believe, does not have much room to grow in its industry and thus, should not be part of an investor's portfolio that is looking for growth. The dividend is solid and will probably grow each year and is, therefore, a solid option for an income investor who just wants the regular income. As noted, Cisco will most likely continue to increase its dividend payout due to a solid balance sheet and generous free cash flow.