Cisco, Not Sysco Offers A Margin Of Safety And Considerable Upside

| About: Cisco Systems, (CSCO)

The ferocity of the stock market's rally over the last 18 months or so in the face of an extremely weak global economic environment, has been a fine example of how price and intrinsic value eventually converge, but the volatile swings will not always ebb and flow with the underlying economics of an investment or the economy in general. Most market pundits feel the need to always seem relevant and attempt to make use of economic data that ultimately will have very little impact on the success of an individual investment, but by focusing on what is understandable and being patient, the investor can benefit from a time-arbitrage through buying an out-of-favor security and allowing the passage of time to correct the disconnect between price and intrinsic value. Cisco (NASDAQ:CSCO) is a perfect example of a business that has performed exceptionally well, but due to the negative convergence from an outrageous stock valuation in the late 1990's, to a much closer approximation of intrinsic value in recent years, many market participants consider the company to be a "value-trap." While buying a stock at 20 times earnings that once traded at 100 times earnings, and seeing it drop to 10 times earnings, might seem like a value trap, it is more often a case of mistaken analysis, and using that past performance to cloud your view of the stock's future can be highly detrimental. Cisco trades at an extremely pessimistic valuation, despite a pristine balance sheet, and a very solid business with reasonable durable competitive advantages and growth prospects. As earnings continue to grow and the capital structure becomes more befitting to a mature technology concern, Cisco's stock should lead to above-average stock returns for the long-term investor.

I remember when I was in college in the early 2000's and was on vacation in Hawaii, I was reading the Intelligent Investor with added commentary from Jason Zweig where he compared Cisco and Sysco Corporation (NYSE:SYY) in the same way that Benjamin Graham used to do in his classes at Columbia. The idea was that the hot technology concern traded at outrageous multiples, while the steady food distribution company likely offered much better value due to a more sensible valuation. When I look at the market today, I can't help but notice slow growing consumer staples, telecom and utility companies trading at 17-20 times trailing earnings, while potential double-digit earnings growers such as Cisco trade at high single-digit multiples. Heck, Sysco trades at 20 times trailing twelve month earnings displaying the radical change of perceptions that has occurred in favor of the steady blue-chip type companies. Interestingly, when the market crashed in the early 2000's, the "boring" bricks and mortar type companies generally fared adequately to well, while the tech stocks came crashing down; and I believe that we might see a reversal of fortunes over the next few years, but the fall won't be as severe because valuations are just buzzed instead of drunk. Barring a steep degradation of Cisco's business, or poor capital allocation, I'd expect mathematics to shine through and Cisco's stock price to appreciate closer to my estimate of intrinsic value, which is in the high $20's to low $30's over the next 3-5 years.

Over the last 30 years, various large-cap technology companies such as Cisco, Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC) have had to reinvent themselves many times. Change and adaptation either through internal R&D, acquisition, or even replication are key components to these companies' DNA. In addition, these businesses have had the financial wherewithal to make the adjustments necessary to compete and ultimately win. The evolution to wireless, the data center and the cloud have challenged these companies, but ultimately I believe all three are making the changes necessary to maintain prominence into the future. Cisco is becoming much more of an integrated IT company than a purely networking operation, with expanding offerings in software and services, to go with its core products of routers and switches. CEO John Chambers acknowledges that the company misfired on its efforts to deviate from its core enterprise and corporate clients, into the consumer set top box and router business, and has since divested non-core assets, and expanded the company's offerings through acquisitions to widen the company's competitive moat.

Make no mistake, the enterprise and government markets have been terrible for IT in general and Cisco has suffered as well. Company after company has reported dismal financial results due to belt-tightening in western developed countries, and a general lack of confidence in the corporate world. It is in these times of turmoil that strong companies such as Cisco enhance their market share and relationships with key customers, and it is clear that the company is navigating these rough waters with tremendous acumen based on Cisco's financial performance versus its competitors. When the global economy recovers from its daze and grows at a reasonable rate, I'd expect to see Cisco's revenue and earnings growth accelerate markedly, as will market participants' perceptions of the stock.

On May 15th, Cisco reported very strong Q3 results, with net sales up 5% YoY to $12.2 billion, and net income up 14.5% YoY to $2.5 billion. Earnings per share increased 15% from the same time last year to $.46, while non-GAAP net income and earnings per share were $2.7 billion and $.51, respectively, in the quarter. Net sales for the first nine months of fiscal 2013 were $36.2 billion, compared with $34.4 billion from the first nine months of fiscal 2012. Net income for the first nine months of the fiscal year on a GAAP basis was $7.7 billion or $1.44 per share, up from $6.1 billion or $1.38 per share from the same time last year. Non-GAAP net income for the first nine months of fiscal 2013 was $8.0 billion or $1.50 per share, compared with $7.5 billion or $1.38 per share for the first nine months of fiscal 2012. Cash flow from operations was $3.1 billion for the 3rd quarter of fiscal 2013, up from $3.0 billion at the same time last year.

In the 3rd quarter, Cisco saw product revenue growth of 5%, with a total product book-to-bill of approximately 1%, and services revenue grew by 7%. The company believes that it can attain services revenue growth of 9-11% CAGR over the next 3-5 years, which would obviously be highly beneficial to achieving above-average earnings growth. Non-GAAP operating margins were 28.2%, while non-GAAP gross margin was 63%. Challenges in Europe and the Public Sector were the primary culprits as to why switching revenues decreased 2% in the quarter, but in the data center the company's Nexus switching product line grew by approximately 12% YoY. Overall data center growth was 77% and the company continued to pick up market share. The UCS plus Nexus business is now on a combined run rate of approximately $5.5 billion annually, growing over 35% YoY. Wireless revenue grew by 27% YoY and the company's business is picking up steam in this crucial area fueled by acquisitions. In video, total SD video grew 30% driven largely by NDS. Cisco's security business saw a decline of 4% with weakness in content security driving the decline. Encouragingly, order growth for enterprise licensing agreements, identity service engine, and cloud web security continue to outpace overall business.

Geographically, the Americas region grew by 7%, with a strong balance between enterprise, commercial, service provider and even public sector picked up a bit by growing by 5% in the quarter. Asia-Pacific, including China and Japan saw orders up only 1%, largely due to tough comps from a strong quarter last year. China has been a challenge for Cisco but the company believes that it is making progress, which will show a few quarters out from now. The Europe, Middle East, Africa and Russia geographical division was flat, after a decline of 6% in Q2. Southern Europe has been declining in the mid-teens and is the clear source of the problems there. In emerging countries, Cisco saw growth of 13%, with India up 29%, Russia up 16%, Brazil up 14%, China up 8% and Mexico up 4%. The remaining emerging markets around the world were up by 13% and constitute about 50% of total emerging market revenue.

As always, Cisco remained highly acquisitive in the quarter, completing the acquisition of Intrucell, Ltd., a provider of advanced self-optimizing network (SON) software solutions that enable mobile carriers to plan, configure, manage, optimize, and heal cellular networks automatically, according to changing network demands. The company also announced and completed the acquisition of Cognitive Security, a privately-held company that integrates a range of sophisticated software technologies to identify and analyze key IT security threats through advanced behavioral analysis of real-time data. The company also announced its intent to acquire SolveDirect, a privately held company that guides innovative, cloud-delivered services management integration software and services. Cisco also announced its intent to acquire privately held Ubiquisys, a leading provider of intelligent 3G and long-term evolution small-cell technologies that provide seamless connectivity across mobile heterogeneous networks for service providers. The company also completed its divestiture of Linksys in the quarter. Acquisitions have always been a big part of Cisco's business strategy, which overall has been highly successful, but it is very difficult assessing the return on investment of each acquisition, so the best metrics to watch are return on invested capital to get an overall assessment of the profitability of the business in relation to the capital employed.

The company expects Q4 revenue growth to be in the range of 4-7% on a YoY basis, factoring in the divestiture of Linksys, which contributed approximately 1% of total revenue in Q4, FY 2012. The company expects non-GAAP gross margin to be between 61-62%, and non-GAAP operating margin to be in the range of 27.5-28.5% in the 4th quarter. Non-GAAP earnings per share is expected to be in the range of $.50-$.52 per share and the company anticipates GAAP earnings to be $.07-$.10 per share lower than non-GAAP earnings per share.

Cisco ended the quarter with 5.387 billion shares outstanding, down slightly from 5.418 billion one year ago, so at a recent price of $21.21, the market capitalization is roughly $114.26 billion. Cash and cash equivalents and investments were $47.4 billion at the end of the 3rd quarter, up from $46.4 billion at the end of the 2nd quarter of fiscal 2013. Long-term debt was $12.956 billion at the end of the 3rd quarter, so the enterprise value of the company is approximately $79.816 billion. Net cash per share at the end of the quarter was about $6.36 and I believe Cisco should earn about $2.00 this year, so backing out the net cash the stock trades at about 7.43 times earnings, which is staggeringly cheap for a business of this quality. Yes, if the company were to repatriate its foreign cash there would be a tax liability, but I don't need to do a discounted cash flow analysis to tell me this company is too cheap. Now if earnings per share grow by 2-3%, some might call it a value trap, but I'd say my analysis was incorrect. I believe that the company is well on its way to achieving 8-10% earnings per share growth over the next 3-5 years, and there is the potential for a low-teens number.

Assuming fiscal year 2013 earnings per share of $2.00 and using a projected 8% and 10% growth rate, Cisco's earnings per share would be roughly $2.94 and $3.25, respectively, in 2018. A simple 10 multiple on those earnings and excluding the large likely net cash position would get you to the low $30's. Because Cisco generates in excess of $10 billion in free cash flow based on current earnings, the company can add to its potential 6-9% organic growth rate, with 3-5% growth through stock buybacks. While Cisco has come a long way towards improving its capital allocation with the declaration about a year back that the company would pay out approximately 50% of free cash flow through dividends and buybacks, there is more the company can do. There is no reason that the company needs $47.4 billion in cash and investments on the balance sheet, and I'd like to see the company use about $25 billion to buy back stock, in addition to the current program. Assuming an average price of $25 per share, this would reduce the share count by 1 billion or nearly 20%, by itself, drastically enhancing per share earnings. This would ultimately lead to a higher multiple because cash in the bank of a company with a mixed capital allocation record, derives very little stock market value. When your stock has an effective free cash flow yield in excess of 12.5% and your cost of capital has never been lower, this is the type of strategy that optimizes the capital structure without limiting the company's ability to be flexible strategically. This also requires management to be pickier about what companies they buy and what price they pay, because there isn't a limitless piggy bank that can be tapped into to fill every whim for enterprise building.

The company used approximately $1.6 billion on dividends and stock buybacks in the quarter, including a $905MM or $.17 per common share dividend, and buying back approximately 41MM shares at an average price of $20.85 per common share for an aggregate purchase price of $860MM. As of April 27, 2013, Cisco had repurchased and retired $3.8 billion shares of common stock for an average price of $20.35 per share for an aggregate purchase price of approximately $77.7 billion since the inception of the stock repurchase program. The company still has about $4.3 billion in authorized stock purchases remaining. Cisco's share count has been trending lower but because the company issues quite a bit of stock, buybacks haven't been as accretive to earnings per share as they could be. I believe John Chambers and Cisco management have done an exceptional job enhancing Cisco's business, but if the company further improves its capital allocation I believe the stock has 50% upside from current levels. While you are waiting, the company has a dividend yield of about 3.2%, which is very comparable with many of the stocks being bought primarily for yield in this low interest rate environment. Perhaps years from now books will be written illuminating the obvious opportunity to pick up some of the finest large-cap technology companies at single-digit earnings multiples, and we will wonder what market participants were thinking paying well above-market multiples for slow growth companies based on the perception of safety, and the absurd notion that price doesn't matter because of the relative price to Treasuries. I'll take my chances on the cheapest sections of the market with above-average growth prospects and see where things shake out.

Disclosure: I am long CSCO, MSFT, INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.