Cisco Systems, Inc (CSCO) is the leading maker of networking equipment for business/enterprise applications. With a 70% share in the ethernet switching market, Cisco is well-positioned to take advantage of the continued growth of data transfer via networks and the internet. The company's dominant position translates to stellar free cash flow generation and its balance sheet is rock-solid, with nearly $5 in net cash per share. At its current share price of $17, CSCO may be an opportunity in a generally overpriced stock market.
Cisco specializes in the core infrastructure of data networks, with market-leading share in Ethernet switches and routers. While most consumers have a vague grasp of routers via their home wireless networks, businesses and their IT departments absolutely depend on Cisco's high-performance devices to transmit their data. Because businesses cannot afford to risk any disruption to their data flow, they are hesitant to make drastic changes to their networks, giving Cisco a somewhat captive client base. These dominant businesses account for 60% of Cisco's revenues.
Like other companies dominant in profitable but slow-growth industries, Cisco has attempted to branch out into new areas such as servers, TV set top boxes and consumer networking, with mixed results. The company has made a steady string acquisitions to broaden its business profile, from a 2006 $6.9B transaction for Scientific-Atlanta (set top boxes) to 2010 $3.3B for Tandberg (video communication).
As the once frontier tech industry settles into a mature state, stories of once-darling giants struggling to find new areas to conquer are becoming common (see Microsoft (MSFT), Google (GOOG)) and less than compelling. What is compelling, however, is Cisco's valuation.
In the five years from 2006 - 2010, Cisco's free cash flow (FCF) generation ranged from $7B to near $11B, with an average of $9B annually. Starting from a base of $9B FCF, we are paying 10x FCF at its current share price around $17. Assuming 3% growth, I would value CSCO at $25 per share solely on its business operations. Taking a pessimistic view, using a $7B FCF base and 0% growth, I arrive at a fair value near its trading price of $17. Note this assumes Cisco will never grow again and in fact, would shrink a bit as its TTM free cash flow was $9.2B through Q2 2011. I view this as the most plausible downside risk scenario.
The company does face competitive concerns as companies that have traditionally partnered to offer complementary services and expertise begin to encroach on each others' territories in search of growth. It is facing challenges in both of its core markets, with Hewlett-Packard (HPQ) pushing hard in the switches market and Juniper Networks (JNPR) a steady rival in routers. It is impossible to foresee how this all turns out but it is difficult to imagine Cisco eradicated from either market in the near future. In any case, my valuation above takes some market loss into account.
Other concerns involve management's regard for creating shareholder value. Like many tech companies, Cisco provides overly generous stock and option grants to its employees, minimizing the impact of stock buybacks. CEO Chambers' efforts to establish new beachheads may risk the company's capital on ill-fated ventures. A look of the numbers seems to validate these concerns. In 2006, Cisco churned out $7B FCF on $43B of assets, a rate of 16.5%. Five years later, the asset base has nearly doubled to $81B but FCF has increased to only $9B, a much less efficient rate of 11.3%.
However, the company's recent move to initiate a 1.4% dividend suggests management may shift some attention to shareholder concerns. Cisco's balance sheet also holds nearly $5 net cash per share -- it is difficult to imagine Chambers and his team squandering all of it despite their spending proclivities. Crediting it with some portion of this cash horde, I would put CSCO fair value at $25 - $30 per share, with downside risk to be lingering at its current level of $17, a risk somewhat mitigated by the new dividend.
These valuations do not attempt to predict Cisco's future business prospects in either its core enterprise-networking field or the other areas the company has moved into. As a value investor, my investing success is predicated not on predicting the future but ensuring there is a proper margin of safety to buffer unfortunate outcomes. At $17 per share, I believe that margin of safety is present.
With noted value investors such as Bill Miller and Eddie Lampert recently opening positions, it is clear CSCO is now a value stock. Whether it turns into a value trap remains to be seen but with its still-strong business position and solid balance sheet, that risk is well worth taking at these prices.
Disclosure: I am long CSCO.