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With $46 billion in revenue Cisco (NASDAQ:CSCO) is the unquestioned giant in the communications and networking industry. For the last three years it started reporting revenues for its data center business under a separate segment. In FY2010 its revenues from data centers were $196 million which ballooned to $1.3 billion in FY2012. Emerging fields like big data are a part of the data center business and a lot of companies are adopting these technologies to increase scalability and profitability.

Below are the segment wise revenues for Cisco

Field

FY 2010

FY 2011

FY 2012

Total Revenue

40,040

43,218

46,061

Products

32,420

34,526

36,326

Switches

14,074

14,177

14,531

Collaboration

2,981

4,072

4,139

Service Provider Video

3,294

3,515

3,858

Wireless

1,134

1,400

1,699

Security

1,302

1,191

1,349

Data Center

196

696

1,298

Routers

7,868

8,186

8,425

Other

1,571

1,289

1,027

Service

7,620

8,692

9,735

In millions, all data taken from Cisco's 10 K

I was trying to investigate the impact on the stock price if revenues in the data center business grow at 50% for the next three years and all other individual segments grow at the two year average growth rate. An important valuation metric in such a model is the Price to Sales ratio which can be used to arrive at an estimated stock price given a sales figure. The condition being that the Price to Sales ratio should not have increased or decreased drastically over the past periods. However, in Cisco's case, this ratio has decreased constantly since 1998 when it was at an all time high of 34.8. As of now, the Price to Sales stands at an abysmal 1.86 and the chart below tells the story of the past 15 years.

Price to Sales = Stock Price as of fiscal year end / Revenue

This graphic tells us that since 1998 the market has awarded a smaller and smaller multiple to every dollar of revenue that Cisco generates. There is no doubt that Cisco has grown organically too, but the market clearly dislikes the inorganic approach that it has adopted. Thus, Cisco has grown bigger and bigger, but at the same time the shareholders aren't getting any richer.

Why does the market not award a higher price to sales ratio to a firm like Cisco that is growing its revenue and maintaining its profit margins?

The answer may lie in the fact that the company ends up using free cash flows to make acquisitions. Valuation theory says that the current price of a stock is the present value of all the future cash flows that the company can generate. Given a company's past history of acquisitions the market believes that it will keep utilizing its free cash flows for acquisitions in the future. Since price is a function of future free cash flows the market compensates by awarding a smaller multiple to the price to sales ratio which keeps contracting. This is true, as we see, at least in the case of Cisco.

In the table below we see that Cisco's revenues have grown almost 109% from its 2004 levels but the free cash flow has grown by only 60%. This is an important data point that validates our hypothesis that the market values free cash flows.

2004

2012

Growth Rate

Free Cash Flow

6508

10365

59.3

Revenue

22045

46061

108.9

Having established this, it may make sense to estimate Cisco's future free cash flows and try and arrive at an estimated stock price.

In one of my earlier posts I applied the Discounted Cash flow analysis to Microsoft and explained the detailed mechanism here.

The three important metrics for the method are:

Required Rate of Return: For the required rate of return we use the Weighted Average Cost of Capital (OTC:WACC). The current WACC for CSCO stands at 8.7%, an all time low because of the current low interest rate environment. In order to build in a margin of safety we use a required rate of return of 14% which is an approximate average of the WACC over the past several years.

Growth Rate for the next three years: This is the rate at which the cash flow will grow for the next three years. For a reasonable estimate I calculate the average FCF growth rate for the past ten years which is 7.5%. So, here we are going to build two scenarios:

  1. Assuming the growth rate for the next three years is 7.5%.
  2. For investors who want more margin of safety, we assume that the cash flow for the next three years is 2.5%.

Perpetual Growth rate: This is the rate at which the cash flow grows into perpetuity after the three years. Again, I shall build three scenarios:

  1. Assuming the growth rate is 3% (for optimistic investors)
  2. Assuming the growth rate is 1.5% (for medium risk investors)
  3. Assuming the growth rate is 0.1% (for cautious investors)

Using these rates we get six different scenarios and six different prices for the stock. Investors can make a call depending on their risk profile.

Estimated price when the three year growth rate is 7.5% and,

  1. The perpetual growth is 3% is : 17.2 - Scenario 1
  2. The perpetual growth is 1.5% is : 15.25 - Scenario 2
  3. The perpetual growth is 0.1% is : 13.76 - Scenario 3

Estimated price when the three year growth rate is 2.5% and,

  1. The perpetual growth is 3% is : 14.8 - Scenario 4
  2. The perpetual growth is 1.5% is : 13.05 - Scenario 5
  3. The perpetual growth is 0.1% is : 11.76 - Scenario 6

We get six different scenarios for the stock price based on the different rates that we use.

Scenario 1 and 2 can be categorized as the most optimistic scenarios where as scenarios 5 and 6 incorporate a very cautious outlook. Our most optimistic price for Cisco is around $17 where as Cisco is currently trading at around $20. On the basis of this analysis it is clear that Cisco looks over priced on a free cash flow basis. And given the history of the price to sales ratio it is likely that it contracts further which means that the market awards a much smaller multiple to every dollar of revenue that Cisco earns. If such is the case, does it make sense for the average investor to stay invested?

Source: Cisco: Everything Is Priced In