Cisco Is Using Its Balance Sheet Constructively

May.22.13 | About: Cisco Systems, (CSCO)

Cisco Systems (NASDAQ:CSCO) has been a favorite stock of mine for some time. I recently pointed out in this article that its balance sheet is some $8 billion stronger than generally assumed because of the large amount of "financing receivables" which should be counted as part of balance sheet cash. CSCO has been aggressively increasing dividends and has a reasonably aggressive share repurchase program. CSCO has also taken advantage of the very favorable credit market to issue bonds at ultra low interest rates.

In this article, I am going to discuss another use CSCO has been making of its strong balance sheet. CSCO has lately been quite active in the acquisition market. Its biggest recent acquisition has been NDS, which was acquired in July 2012 for $5005 million. It also acquired Lightwire in the third quarter of fiscal 2012 for $239 million and Meraki in the second quarter of fiscal 2013 for $974 million. Its SEC filings also refer to miscellaneous acquisitions between July 26, 2012 and January 26, 2013, costing $233 million as well as a pending acquisition of Intucell for $475 million. I have been able to identify roughly $7 billion worth of recent and pending acquisitions by CSCO.

In comparing the recent third quarter financial results of CSCO with similar results from a year earlier, I tried to isolate the impact of the NDS acquisition (made early enough to affect this year's third quarter results but too late to affect last year's). CSCO has a line of business called sales to Video Service Providers - the year over year increase in that business was a jump from $999 million to $1299 million or a $300 million increase. Annualized, this would come to $1.2 billion. CSCO's SEC filings give NDS credit for this increase. It is, of course, difficult and perhaps impossible to generate counterfactual financials demonstrating what CSCO's results would have been without NDS. But it appears very likely that NDS contributed to CSCO's recent positive results in a significant way.

For the sake of the point I am trying to make in this article, I am going to make some simplifying assumptions. I am going to assume that NDS was responsible for all of the increase in CSCO's sales in the Video Service Provider segment, that NDS did not contribute to any other CSCO sales, that the NDS business earns the same net after tax income as a percentage of gross revenue earned by CSCO as a whole (20%) and that this quarter's results can be annualized. These assumptions are clearly oversimplifications but please hang in there with me.

The question before the house is - making the above assumptions - what impact did spending money to buy NDS have on CSCO's financials. I am assuming a $1.2 billion increase in annual sales and a $240 million (or 20% of sales) increase in net income for a cost of $5 billion. I have made some assumptions about other uses of CSCO's cash and prepared the table below illustrating how the numbers play out. The first assumption is that CSCO would have the same debt it has now if it hadn't done the NDS deal but would have $5 billion less cash, the second assumption is that CSCO would have the same cash it has now but $5 billion less debt without acquisition and the third

Net Income Share Count Net Income Per Share
With NDS $9912 billion 5.387 billion $1.84
No NDS More Cash $9722 billion 5.387 billion $1.80
No NDS Less Debt $9772 billion 5.387 billion $1.81
No NDS Share Repurchase $9672 billion 5.137 billion $1.88
Click to enlarge

assumption is that CSCO would have the same balance sheet it has now but would have used $5 billion to buy back stock at an average price of $20 per share. Share count is based on fully diluted shares.

I have assumed that CSCO earns 1% after tax on its balance sheet cash and that its after tax debt cost is 2%. All of the cases without NDS subtract $240 million in net income but the more cash adds $50 million back in and the less debt case adds $100 million back in.

Admittedly, this analysis is grossly oversimplified. For example, CSCO's acquisitions included some $150 million of cash and cash equivalents, which CSCO acquired when it made the acquisitions. CSCO almost certainly would have had to pay an average price higher than $20 for its shares over the relevant time period.

Still the basic point is sound. CSCO earns roughly 1% on its cash after taxes and pays roughly 2% after taxes on its debt. If it can use cash or borrow money to buy NDS at an earnings yield of nearly 5%, the acquisition is net income positive. CSCO itself still sells for a P/E of 11 or 12, which is an earnings yield of 8 or 9%. Buying back its own stock is even more accretive to net income per share.

None of these calculations make any assumptions about synergy or growth on the part of the acquired operations. Obviously, acquisitions are made largely because business executives anticipate positive developments of this type. The important point is that even without these positive developments, acquisitions make sense as long as the acquirer is paying less than 50 times earnings.

A few years ago, I invested in a company called EasyLink and it was a kind of poster child demonstrating the dynamics of these numbers because it acquired companies of about its own size, borrowed at low rates and then used the cash flow to pay down the debt. I wrote about it here in November 2010 when it was trading at $3.95 a share and again in May 2012 when it had just been acquired for $7.25 a share.

CSCO is on a roll partly because it is starting to put its cash and balance sheet strength to work. Corporate balance sheets are extremely strong right now and lenders and investors seem to snap up bonds like piranha in an isolated creek. I think we are likely to see more and more cash for stock acquisitions and it may be a considerable factor in improving the earnings of the acquiring companies as well as providing a nice payday for the owners of the acquired companies. And, of course, it will take shares off the market from time to time. This is just another way in which low interest rates work themselves into the stock market and another argument that there is probably a kernel of truth in the "Fed Model" which I wrote up here.

Needless to say, I am still long CSCO even after the recent run up in the stock price.

Disclosure: I am long CSCO. 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.