The Simple Case Against Cisco

| About: Cisco Systems, (CSCO)


Using a DuPont Analysis, I'll break down the metrics of ROE. The change in its tax rate is particularly interesting.

Cisco's asset turnover has been trending down, but it's not as bad as it looks.

The operating margins haven't been trending down, but leave a bit to be desired compared to Microsoft and Intel.

Cisco (NASDAQ:CSCO) is a huge technology company with many investments in other firms outside of the United States. The company is fairly complex, and there are bright people arguing for and against the stock. Rather than try to bring in every positive and negative factor, I'll be examining the company through a DuPont Analysis. The analysis is backward-looking, meaning there will be absolutely no mention of any new products. In Table 1, I'll break out the ratios for the company and then explain them one at a time.

Tax Burden

Cisco has had some variation in its effective tax rate. "Tax Burden", ironically, is a measure of how much money the company keeps after paying taxes. Cisco tends to keep around 80%, or in other words, have an effective tax rate around 20%. However, we can see that in 2013, the company paid significantly less in taxes. The DuPont Analysis doesn't tell us why it was paying less; it just lets us identify when it happened and how much it impacted the company.

So how did the company get such a low effective tax rate? To find out, we begin a new search. The search starts with the transcripts of the earnings call for the end of its fiscal years in 2013 and 2014. I didn't find enough information about the cause for the change in tax rates there, so it is time to open up the search. We can get a little insight from this article on Business Insider. The short version is that the CEO has been battling the U.S. government in regards to taxes on profits earned abroad.

Some readers may want a more rigorous discussion of the tax situation. I'm open to having that discussion in the comments, but I don't want to derail other readers. Here is the very simple version of what Cisco is arguing about. The U.S. government wants to charge taxes on corporate income. If the income is earned from operations in other countries, the U.S. still wants to tax it.

What is the logic behind taxing income that is earned abroad?

Cisco would like profits earned abroad to be hit with exactly zero dollars in U.S. taxes. Obviously, Cisco wants to reduce its tax rate. So why should the U.S. tax profits earned abroad? In a word: Accounting. Profits that are earned abroad are not necessarily even from operations abroad. How? The company can create internal transactions that allow it to shift revenues and expenses between locations. Between 2005 and June of 2011, Cisco had reduced income taxes by roughly 7 billion (yes, with a B) by having the profits occur in a small subsidiary near the Alps. The investigation by Bloomberg can be seen here. When the article was written, Cisco had 100 employees at that subsidiary where it was booking such large profits. It had 35,000 in the United States.

Every investor is free to have their own ideas and opinions about what would be ideal for the laws. However, Cisco is one of many companies that have proven that the laws were not working. For the record, I do not agree or support the decision to move profits overseas through creative accounting. Discussing whether income that is actually earned abroad should be taxed is one discussion. Whether income earned in America should be immune to taxes on the basis of having a decent accountant is an entirely different discussion. Unfortunately, most people refuse to keep those questions separate.

Interest Burden

Cisco's "Interest Burden", higher than a hundred percent, demonstrates that Cisco is bringing in "Interest Income" and "Other Income" that more than offset its costs in the field of "Interest Expense". In short, you could say Cisco's debt is overstated, because it has significant interest income. Technically, it has all of those debts, but some of those debts are financing the company while it invests its money in purchasing other debts. If you compare Cisco's line item for "Total Liabilities" to its line item for "Investments", you'll find the numbers are very similar.

As of the end of July, Cisco had $45.3 billion in investments and $48.473 billion in total liabilities. Given that some of those liabilities are deferred revenues, it's reasonable to say Cisco is in a very strong position relative to its debts. For reference, deferred revenue is currently $9.5 billion.

Operating Margin

The operating margins have been fluctuating a bit, but not enough to make me very concerned. The R&D expenses are not showing a clear trend; it seems the company is expensing relatively similar amounts in each period. By removing R&D as an expense, we can see the margins are really significantly better than they first appeared. They aren't on the same level as Microsoft (NASDAQ:MSFT) or Intel (NASDAQ:INTC), but they aren't too bad either.

Asset T/O

The asset turnover ratio is going down, and took a significant drop last year. Part of that is a reduction in sales, as shown above in Table 2. The other part is an increase in assets. During the last fiscal year, the company's total assets went from $101.2 billion to $105.1 billion. It is bad at using its new assets to generate new sales? Not so much, the "investments" account we talked about earlier grew from $42.7 billion to $45.3 billion. So the decrease in asset turnover isn't as bad as it looks. Yes, it went down, but not as much as it appeared.

Leverage Ratio

The company's leverage ratio's using book values just aren't helping us. The company isn't really that highly leveraged. The first issue, as we stated before, is that the value of liabilities includes a substantial amount of deferred revenues, which isn't really the same as debt. It is a liability, but it isn't the same. The second problem is that the company's investments exceed the value of the rest of its liabilities, if we were to exclude unearned revenue.

Using Table 3, we'll look at those liabilities a little more.

By comparing the market cap of the company with the value of the liabilities, we get a feel for how the company is financed. From this table, we would think the company was using debt for a little over a quarter of its operations. From the value of investments and the amount of interest the company has coming in, I'd treat the company as having significantly less leverage. A lesson for all new investors is that the financial statements can be a little misleading. Looking only at the ratios without knowing what accounts were behind them would lead to incorrect conclusions about the leverage Cisco is using and how efficient it is with its assets.


Cisco an enormous company, and many investors will have exposure to it in one way or another. I don't mind having exposure to it through index funds, but I'm not sold on the company. There are plenty of analysts that do like the company, and many of them have great reasons. I would encourage anyone considering an investment to look through the articles for and against. My concerns about the company are simple:

  1. I'm not a fan of having my money invested in the tax dispute. That doesn't mean I would never invest in a company dealing with those issues, but I would need to be sold on the company.
  2. Given the amount of income Cisco is producing from interest income and other income, I'd like to see it use a little more debt to leverage the returns to shareholders.
  3. The operating margins aren't bad, but I'm more comfortable with INTC and MSFT as investments in huge technology companies. Intel, for instance, is producing not only higher margins excluding R&D, it is also investing a significantly higher percentage of its sales into R&D.

Overall, these factors make me bearish on the stock. I wouldn't short it, but after looking at its history, I'm not sold. No disrespect to the bulls, some of whom make great arguments.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.