In previous articles I have described my EPEE valuation methodology. It attempts to approximate private market value by separating the balance sheet cash from the actual operations of a company. I have applied this methodology to Cisco Systems, Inc. (NASDAQ:CSCO) and the stock seems to be very, very cheap.
The EPEE methodology subtracts net cash (cash and investments minus debt) from market cap to produce "Enterprise Price" - the price an investor is paying for the operating company itself. It then backs out the earnings from the balance sheet cash by subtracting net interest income from earnings to produce "Enterprise Earnings" - the earnings of the operating company. The ratio between Enterprise Price and Enterprise Earnings is the EPEE and can be a useful metric in calculating what a reasonable private investor would pay for the company as a whole.
In the case of CSCO, using Friday's closing price of $17.14, I then calculated that CSCO had $40.2 billion of cash and investments and $15.2 billion of debt producing net cash of $25 billion. Using January 2011 share count of 5.533 billion, I calculated that the net cash constitutes $4.52 per share and so the Enterprise Price is $12.62 a a share. I then determined that CSCO has no net interest income. In fact, CSCO appears to have roughly $20 million a year of net pre-tax interest expense (CSCO must pay much higher interest rates on its debt than it collects on its cash). I, therefore, used Barron's consensus 2011 earnings of $1.63 a share without adjustment as Enterprise Earnings. This produced an EPEE of 7.7.
CSCO's EPEE is very low and really would be appropriate only for a company staring at a relentless and virtually irreversible decline in its business. There are pharmaceutical companies with major patent expirations on the horizon that have higher EPEEs. The tobacco sector does not, to my knowledge, typically feature EPEEs in this region. My initial reaction is that CSCO is very, very cheap at this price.
I have delved further into CSCO's balance sheet and it is possible to make various judgments which would result in changes to the EPEE. For example, CSCO provides financing for some of its customers and the customer obligations to CSCO are carried as "financed account receivables." This number - $5.7 billion - could be added to cash and we would wind up with a lower Enterprise Price and a lower EPEE.
Conversely, CSCO, like many tech companies, has a large liability($11.8 billion) for "deferred revenue." This arises when CSCO is paid cash or generates an account receivable but does not really "earn" the money in the relevant reporting period and thus does not treat the receipt as income. For example, if CSCO provides a three year software license and gets paid for the entire license up front, some of the payment is not really "earned" until the three years have elapsed. The relatively large amount of deferred revenue on CSCO's balance sheet (and on the balance sheets of a number of other high tech companies) may help explain why tech companies generate a lot of cash in relation to their earnings. Its calculation must involve some judgment and this makes me a bit skeptical of attaching too much importance to minor fluctuations in earnings since judgment as to be exercised in determining which receipts actually constitute current earnings.
At any rate, I am not sure exactly how to treat this item for my purposes. Some of the $11.8 billion probably represents expenses CSCO will have to incur in the future (for example, fulfilling its obligations under multi-year service contracts) and for which there will be no future payment.
However, the actual expense to be incurred is likely to be much less than the deferred revenue amount because of things like multi-year software contracts. From an investor's point of view, it would be very helpful if the accountants broke deferred revenue into subcategories which would permit an investor to estimate the likely future expense a company would have to incur in order to recognize the future revenue. At any rate, including a percentage of deferred revenue as debt and subtracting it from balance sheet cash would still result in a very low EPEE.
CSCO has spent a great deal on share repurchases and there have been some investor complaints about the issuance of large option awards to management. The metric I follow most closely is share count to determine whether the net effect of share repurchases and option awards is increasing or decreasing the total number of shares. On this basis, CSCO's share count has declined in the last six months by some 122 million shares or more than 2 percent. They have not been reducing share count as fast as WMT but they have certainly been moving in the right direction.
I also look at capex to determine whether a business is likely to produce free cash flow. In recent years and quarters, CSCO has generally had depreciation substantially in excess of capex which explains why it has built up so much cash and has been able to repurchase shares. The one caveat in this area is that CSCO has, in the past, made some large acquisitions. These tend to be "lumpy" and make it hard to project a consistent free cash flow number.
CSCO has commenced paying dividends and while this probably has no effect on private market value, it does make the stock more attractive for retail value investors. First of all, the retail investor gets "paid for waiting" in an atmosphere in which there is certainly no assurance as to when the price of CSCO stock will go higher. Secondly, the dividend is a sign of shareholder orientation on the part of management and that is important from a retail investor's point of view.
On balance, I think that CSCO's current market price reflects investor "revulsion" similar to the appetite diners currently have for Fukishima spinach. This is always a good sign for a value investor. I remember a time in the 1990's when I asked my broker whether he had any research on F and he said that they didn't "bother" to cover it any more. That turned out to be one of the best buying opportunities I can remember. I had a similar experience with Chrysler bonds in the early 1990's when the revulsion against high yield bonds was at its zenith.
I cannot call a bottom because I am not a market technician, but from a value investor's perspective, this is beginning to look like a fat pitch.