Cisco's Head Is In The Clouds

Mar.26.14 | About: Cisco Systems, (CSCO)


Cisco is making a push into the cloud.

Move will not help declining revenues in the short term.

Investors should look at the name as a capital return story for now.

This low growth picture equals a low valuation for Cisco.

When it comes to large cap technology, one name that is struggling in terms of revenue growth is Cisco Systems (NASDAQ:CSCO). The networking giant is in the midst of a bad fiscal year, with analysts expecting revenues to decline by about 4.5%. That's a decline of about $2.2 billion dollars. Recently, Cisco announced it would be making a large investment in cloud computing. While this may be an incremental positive, the latest news doesn't change the story yet. Today, I'll detail why the investment thesis for Cisco as a capital return play remains the lead.

Late to the party:

Cisco announced on Monday that it will invest $1 billion over the next two years on a cloud computing service similar to Amazon (NASDAQ:AMZN) Web Services. Cisco will focus on large corporations and government agencies. The company has already snagged partners such as Australian telecom operator Telstra and Canada's Allstream.

The cloud computing space has certainly been one of the biggest growth stories in today's market. Gartner was estimating about 2% of IT spending on the cloud in 2013. That was just about $30 billion of a $1.4 trillion IT market. There's been a number of cloud based IPOs in the market recently. In the past year, cloud based names have seen strong rallies, even with the recent fall. (NYSE:CRM) is up about 30% in the past year, and Workday (NYSE:WDAY) is up around 50%. These two names alone have a combined market cap of more than $50 billion, despite only being expected to pull in about $6 billion or so in revenues for their fiscal years ending January 2015. In comparison, Cisco has a market cap of about $115 billion, and is expected to have revenues of around $47 billion or so for a similar timeframe.

There has been a sizable debate recently over whether cloud computing is in a bubble, thanks to many of these IPOs coming to market. One of the arguments is that this space does not have a high level of profitability at this point, especially on a GAAP basis. In fact, over the past three fiscal years, had almost $9.4 billion in revenues, as per its 10-K filing. At the same time, GAAP net loss has been over $510 million.

Cisco is entering a market that is seen as hot right now, although recent stock declines have cooled the party down for the short term. For the short term, entering the cloud is unlikely to have a large impact on Cisco's business. Cisco is expected to have more than $46.4 billion in revenues for the July-ending fiscal year, so it probably will be a few years before the needle is really moved. Monday's announcement won't do much to ease the 4.5% expected revenue drop this year. Analysts are looking for a 3.7% revenue rebound in the following year, and analysts may be pricing in some new business lines. I don't think estimates will change too much based on this announcement.

Taking out a lot of debt:

In late February, Cisco announced an $8 billion debt offering. This was not a surprise, as the company needed to raise a bit of cash. Cisco had about $47 billion in cash and investments on the balance sheet, as per the 10-Q filing. But as the company details on page 41 of that filing, roughly $43.8 billion of that was held by foreign subsidiaries. Only $3.3 billion of Cisco's "cash pile" was located inside the US. Cisco can only use the US based funds for the dividend and the buyback. To use foreign funds, Cisco would have to repatriate, and pay additional taxes, or Cisco could borrow against these foreign resources. Cisco did just that.

Cisco issued a number of fixed and floating rate notes due in 2015, 2017, 2019, 2021, and 2024. I won't go into all of the details, which can be read in the prospectus. This will help bolster Cisco's US cash position, which is a bit lacking as I detailed above. Cisco announced that the funds would be used for three main purposes:

  • To repay $3.75 billion (aggregate principal amount) of outstanding unsecured senior notes that mature in 2014.
  • Share repurchases.
  • Dividends.

After the new debt was taken out, and assuming the repayment of the old debt, it would leave around $7.5 billion in cash for Cisco in the US. That excludes any cash generated during the quarter, as well as the dividend payment and the buyback. I did find it a little interesting that most of the debt has a maturity of 5 years or less, and that Cisco did not go over 10 years. Lately, a lot of companies that have decent dividend yields that are using debt for dividends and buybacks have used 30 year debt in some fashion.

A capital return story:

I mentioned in my latest Cisco earnings write-up that the status quo had changed a bit. Cisco's results were okay and guidance was fair. The big news was that Cisco announced a dividend raise and the company had spent roughly $4 billion on stock repurchases in the quarter. That was a big move, and was comparable to Apple's (NASDAQ:AAPL) purchase of $14 billion in stock after its earnings report.

Cisco started its dividend program in 2011, at which point it was paying just 6 cents per quarter. That was raised to 8 cents for half a year and then to 14 cents for the second half of that respective dividend year. Last year, Cisco upped the dividend to 17 cents a quarter. After four payments at that rate, Cisco upped the dividend to its current 19 cent a quarter payout. That's $0.76 a year, and great dividend growth in recent years. In the chart below, you can see how Cisco's annual yield compares against Apple, Intel (NASDAQ:INTC), and Microsoft (NASDAQ:MSFT) as of Tuesday's close.

Cisco has the second highest dividend yield, and is just about 13 basis points behind Intel for the lead. That lead was down to about 6 basis points in recent days, and Cisco could easily jump into the top spot soon. Cisco currently yields about 62 basis points more than Microsoft, with Microsoft expected to raise its dividend later this year. Cisco's yield leads Apple's by about 116 basis points, and many are expecting a raise from Apple next month.

The buyback is also important, as it helped the diluted share count to decline for fiscal Q2. That helped EPS a bit. Cisco bears were happy when the diluted share count rose a bit in Q1, which hurt EPS. Going forward, Cisco will need a solid buyback each quarter to offset dilution from executive options and other dilutive securities. The buyback may get the share count down a little, but you won't see a dramatic share count drop like Apple is seeing now thanks to its buyback. Intel right now is also having trouble getting it share count down with its current buyback. Microsoft's share count is coming down slightly.

That poses an interesting question going forward. Obviously, Cisco won't be spending $4 billion a quarter on buybacks. Perhaps $1 billion a quarter will be a fair rate, although that might not be enough to get the share count down year after year. If that is the case, Cisco might choose instead to focus more on the dividend. Through the first half of the fiscal year, Cisco paid out $1.81 billion in dividends, up from $1.487 billion in the year ago period. Of the four large cap names discussed in this section, I think Cisco and Intel will continue to rival each other in terms of dividend yields.

No growth = low valuation:

In today's market, investors love growth. If you have growth currently or are expected to have a lot of it in the future, you get a really high multiple. High growth names like Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB) can be trading for 25, 50, or even several hundred times current or future earnings. The social media space is a great example of high valuations, but those names do offer a lot of potential growth.

Right now, Cisco doesn't offer a ton of growth. Revenues and earnings are expected to decline in this fiscal year, with some level of a rebound next year. Thus, Cisco is not getting favorable treatment from the market. In the table below, you can see how Cisco compares against Apple, Intel, and Microsoft for their respective fiscal years, in terms of growth and valuation.

*EPS growth and P/E are non-GAAP.

When you convert Cisco's P/E to GAAP, it is either near Apple or slightly below Apple's value, depending on the conversion factor you use. Either way, the story is the same. Cisco's revenues and earnings are declining, and the street does not like that. Apple's valuation is being pressured because Apple's current quarter is expected to show basically flat revenues. Maybe once Cisco gets some of these cloud products going and revenues start to ramp up, the valuation will increase. Cisco actually closed at a one month high on Tuesday, so the valuation above is actually higher than it has been the last few weeks.

Short interest on the rise:

I wanted to briefly bring up short interest as it may be signaling negative sentiment for Cisco. We just got the latest update from NASDAQ on short interest. In the chart below, you can see short interest in the name going back almost two years.

You can see how in late 2013 and early 2014 there's been a sharp rise in short interest. On one hand, the nearly 74 million shares short is not large when compared to an outstanding share count of more than 5 billion. However, as you saw above, this is the highest short interest point since November 2012, about 16 months. Going into mid-March, that probably means sentiment was a bit low on Cisco. The next update could be rather interesting, as there might have been some short covering on the rally Tuesday. Cisco's rally continued throughout the day, outpacing the tech sector. For now though, short interest remains elevated. This is something to watch.

Final thoughts:

Cisco has announced plans to invest a billion dollars in the cloud. Shares rallied on Tuesday to one-month highs as investors digested the news. However, Cisco still is in the midst of a bad year with revenues and earnings declining. I don't see the cloud push moving the needle just yet, but it could be an opportunity down the road. For now, I think investors need to look at Cisco as more of a capital return giant and value play. Investors are getting a large dividend, one rivaling Intel for the top spot in large cap tech, and a decent buyback. For now, I would advise investors to accumulate Cisco at a 3.50% annual yield ($21.71) and higher (lower share price). I see this name as an income story for now, until revenues and earnings start to improve later this year and potentially into 2015.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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.