Share repurchase plans can be one of the most effective ways for management to reward patient long-term shareholders. By actively reducing the number of shares outstanding, each existing share is entitled to a larger percentage of the company's future earnings. One of easiest ways to visualize this concept is through the terms of a simple math equation. Earnings per share are simply derived from earnings divided by total shares outstanding, with earnings being the numerator and shares outstanding representing the denominator. Even if earnings were to remain stagnant, the simple act of shrinking the denominator will generate larger earnings per share figure.
Cisco Systems (CSCO) declared on its most recent earnings report it would earmark an additional $15 billion to its share repurchase plan. I divided CSCO's market cap by the amount of the buyback program and quickly determined the plan was worth more than 10% of all shares outstanding. If CSCO would properly execute the plan, it would in my view offer a compelling risk reward ratio especially when coupled with its 3% dividend. The article below will examine the progress CSCO has made with its August 2012 pledge to return 50% of free cash flow via a combination of dividends and share repurchases.
Dividends Paid in millions
Repurchase of common stock, dollar value in millions
Source: CSCO recent press release
For the 3 months ending
Oct 26, 2013
Oct 27, 2012
Net income in millions
Net income per share- Basic
Net income per share- Diluted
Shares used in calculation- Basic
Shares used in Calculation- Diluted
CSCO has indeed returned a significant amount of capital to existing shareholders via its capital allocation plan. As we can see from the table above, CSCO has managed to return $8 billion via dividends and share repurchases. Everything initially seems to be in order; perhaps this would be an opportune time to initiate a position in CSCO. As I continued to analyze the consolidated statement of operations for CSCO, my enthusiasm dimmed significantly.
CSCO spent over $4.5 billion purchasing shares which should have made a significant impact on shares outstanding. Instead the share count went up which didn't please me in the least. I suspect the culprit is an enormous amount of employee options and would need to dig further to find the answers.
Name of employee
Number of securities underlying unexercised options
Option exercise price
Option expiration date
Gary B. Moore
The answers appeared in the 2012 annual proxy statement, specifically on page 52. As we can see from the table above, CSCO potentially had over 2.4 million new shares that would be issued if the option holder would execute his option contract. As we can see from the chart below, going into August of this year, CSCO was comfortably above the strike price hence 2.4 million new shares were created. CSCO's repurchase program was able to offset some of the dilution; however, in my opinion existing shareholders should be less than thrilled with this sort of behavior.
To its credit, CSCO has adopted a policy similar to IBM as far as options are concerned. CSCO will no longer issue options to executives, instead they will be awarded restricted shares with a predetermined vesting period. I was encouraged by this policy along with CSCO's aggressive dividend hikes; however, my enthusiasm seems to have been misplaced. CSCO has similar option awards outstanding through 2016. I suspect the increase in the repurchase plan will be used to offset dilution instead of retiring shares outstanding.
CSCO in my opinion is desperately trying to copy the IBM playbook. CSCO has become a slow growing mature company instead of the growth machine of the very early part of the last decade. Revenue and earnings growth will be far harder to come by especially in a very weak IT market. CSCO's inability to shrink its shares outstanding in these lean times when the stock is unloved will significantly impact future gains. If management was successful in actually reducing shares outstanding by at least 10% when the inevitable upswing in the IT market begins, earnings growth would be superior to what it would have been sans a buyback program. As a trade perhaps, CSCO holds some value here yet for me I find it an unappealing long term investment. I prefer IBM and its far superior capital allocation program.
In summary, I find CSCO to be an unappealing long-term investment at this time. Management in my view isn't looking out for the best interest of shareholders with its compensation practice.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.