The last of the stocks in my portfolio is the once-mighty Cisco (NASDAQ:CSCO). It was the highest priced company in the world at one point with a market cap of a staggering $500 billion! Today it sits at a lowly $96.5 billion valuation and is valued as if it were 2009 all over again. Expected margins for 2Q are 61% and FY of 62%. These are much lower than most expected and the stock price has been unfairly punished. The products that Cisco sells have not changed and they are going to be around for a long time, with demand staying flat or increasing in the future. I don't generally like a dividend but I like the $0.24 dividend (paid quarterly) for about a 1.4% yield.
I believe Cisco's future is only looking up from here. Future dilution will likely stop (unless the share price increases 30%) since the average exercising price of the 732 million pending option shares for employees is $21.39, with nearly half of those options exercisable at prices 15% higher than current prices. This is good for outstanding share count as Cisco has approved up to $10B for buybacks on the current program. The company has bought back over $62B in shares in the company's history.
Cisco is similar to GE (NYSE:GE) in that over 80% of profits are from overseas (good accountants) so its effective tax rate of 17.5% will likely increase to the average of 20% but will not likely climb beyond that and only cost Cisco approximately $200M. This is against $2.7B in tax benefits yet to be claimed and can be considered future cash on the balance sheet. All in all, Cisco is a cash cow. One of the best programs for Cisco is the IT certification program to service Cisco systems. This service revenue has increase substantially since inception and is now nearly 20% of total revenue with higher margins than products. If this trend continues, expect gross margins to increase in the future, thus increasing net income.
One thing is clear, Cisco has an amazing balance sheet with $5B in cash and $40B in total cash and liquid assets. The $35B in securities is nearly entirely invested in government securities (either U.S. (85%) or abroad (15%)). The company's interest income completely covers all interest on debt of approximately $17B and total Liabilities of $36B. Enterprise value is $90B or the price we pay for Cisco, for all intents and purposes.
Going by the latest annual report, Cisco should require about $1.5B in working capital (expenditures and acquisition costs, although FY10 was much higher) going forward. For the last three fiscal years, cash from operations have been $10B, $10B, and $12B for FY10, 09, and 08 respectively. This gives FCF's of $8.5-10.5B giving us a midpoint of $9.5B, which is a conservative estimate for a DCF analysis.
The past three years have significantly altered observed growth rates, so a "reasonable" long-term forward growth rate will need to be applied. (Such as one much smaller than the previous 14% growth over the prior 10 years and even higher for 15 and 20 years.) I applied a reasonable long-term growth rate of 8%, which should outpace inflation (as we would expect for Cisco). The current 30-year rate is 4.35% (Warren Buffett recommends never adjusting the 30-year but let's attempt to stay conservative and apply an 8% rate as well). The 20-year DCF method gives a price of $35.71 for Cisco or a margin-of-security of 51% on Cisco! This implies future upside of 105%. Using today's actual 30-year Treasury we arrive at a discount of 63% of intrinsic value.
Finally, we will use a valuation technique that Buffett personally employs. Instead of FCF, we have owners earnings equal to net income + depreciation and amortization - capital expenditures (use average or "normalized" values for each figure). With D&A at approximately $2.25B and net income at $7.5B, we have owners earnings roughly equal to FCF and thus what Warren Buffett calls a maturing, consistent business. This qualifies it for a similar discounting as the DCF method calls for, and we arrive at a similar projection of $35.00 for instrinsic value of Cisco stock.
I also see brand names in Cisco and Linksys that more than make up for the reported goodwill and intangibles reported on Cisco's balance sheet. With the property owned by the company being undervalued, in my opinion, I believe a 2 p/b ratio is likely conservative.
I think Cisco has the opportunity to become a cornerstone of my portfolio and a permanent holding, just as Warren Buffett described Coca-Cola (NYSE:KO) in 1990. The internet is constantly evolving and Cisco is by far the market leader in the area of routers, switches, and other advanced technologies. For example, the pending 4G build out the market for switches, which is Cisco's main source of revenue, looks to grow at 10% rates observed in the past.
Cisco's goal is to eventually hold the dividend at 2%. At $35 intrinsic value, this is a dividend of $0.70 annually (which represents a responsible present dividend) for a yield of 4% on today's prices. I believe we can look forward to this kind of yield in the near-term future by buying Cisco under $19. I personally have a 15% position in Cisco and am considering purchasing more before earnings (which I think will go very well).
Disclosure: I am long CSCO.