Routers and Switches combined accounted for less than 50% of Cisco's (NASDAQ:CSCO) revenue during fiscal 2011, ending July 30th. New Products and Service together were 50.2% of revenue, and grew at over 14% for the year. This article explores the company's new product groups, finding some support for the idea that growth in areas such as Collaboration and Video may compensate for reduced growth in the better known Router and Switch groups.
Back in September, at Cisco's Annual Financial Analyst Conference, management presented a 3 year financial model, calling for CAGR of 5-7% for revenue, and 7-9% for EPS. If realized, this model would support a higher valuation for the company's shares. To meet these objectives, strong growth in the new product groups will be required. This analysis suggests that such growth is possible, leading to the conclusion that Monday's closing price of $17.69 represents a buying opportunity.
Sales by Product Group
Here's a snip from my workbook on Cisco:
As mentioned above, the two items highlighted in yellow represent more than 50% of revenue, and grew over 14% during fiscal 2011. As a complexity, during fiscal 2010 Cisco acquired Starent, which had annual sales of approximately $279 million, and Tandberg, with sales of $903 million. Neither the 10-Q nor the 10-K provides pro forma information, on the grounds that the acquisitions were not material to the financial statements.
In order to develop the growth rate on a pro forma basis, I estimated the revenues for 2010 as if the acquisitions had occurred at the beginning of the year. Annual growth on that basis was 5.7%. If extended forward for three years, the compounding of the new products and service would provide total revenue growth of 6.2%, at the midpoint of the 3 year model's range. Based on recent history, the 5-7% growth objective for revenue is realistic. Here's the worksheet:
EPS to Grow Faster than Revenue?
Is it realistic to expect EPS to grow 2% faster than revenue? The simplest answer is, Cisco's share counts have decreased an average of 2.6% per year for the past 10 years. All other things being equal, if share counts go down 2%, EPS will go up 2%. Management has stated the intention of returning money to shareholders by doing buybacks, and they have ample resources available for the purpose.
As of 10/29/2011, Cisco's current ratio stood at 3.28, well above the 2.0 which I consider prudent. Counting anything over 2.0 as excess, the company has $4.16 per share available to deploy in ways that increase shareholder value. Long term debt stands at 25% of equity, very manageable, and $4 billion of it expires in 2039 and 2040. That debt is trading to yield around 4.35%, illustrating excellent access to credit markets.
The company has the resources to make EPS grow 2% faster than revenues, providing margins remain unchanged.
In the process of restructuring, management took $1 billion of annual cost out of the system. $1 billion of cost divided by $43 billion of revenue is a 2.3% increase in margins. Within limits, margins can be controlled by cutting costs.
Research and Development
Cisco's R&D expense has been approximately 13% of revenue for the past 5 years. The financial statements and presentations don't provide any detail as to concrete results in the form of patent counts or new product introductions. As a practical matter, the efficacy of R&D will manifest itself in profit margins, as value added.
For the past 5 years, net income as a percentage of revenue has averaged 18.55%. This suggests that R&D expense has added value well above and beyond what would be available by just providing commodity products. My impression is that most of this R&D expense arises from meeting customer needs, as defined by the customer. It's a question of finding out what the customer needs and then extending the technology to provide it.
The ability to budget over $5 billion annually to R&D is a competitive strength. It should be noted that a concern with the management by committee structure as it existed prior to the shake-up was that it hampered responsiveness and agility. To the extent that the reorganization and restructuring has empowered employees to respond more effectively to customer demand, it should build on the fundamental strength of the engineering staff.
Cisco has a steady history of acquisitions, mostly small, although Starent and Tandberg in fiscal 2010 were $2.6 and $3.3 billion respectively. The wide variety of devices that can be connected, the popularity of wireless, and the proliferation of video and voice data that needs to be exchanged and controlled, has created considerable complexity in meeting the networking needs of large and medium-size businesses. Building out from a dominant position in switches and routers, Cisco has been leveraging that strength to grow into areas such as collaboration and video conferencing. When acquisitions meet this strategic objective, Cisco has the resources to do them.
A Closer Look at Product Groups
For FQ1 2012, ending 10/29/2011, Cisco revised its presentation of product groups. Here's a snip of the current information:
At the previously mentioned analyst conference, management conducted breakout sessions on Collaboration, Data Center, Video and Services, as well as Switching, Routing, and Transformational Accounts. Sessions lasted slightly less than an hour each, and the audio and slides are available on the company's website.
I reviewed parts of several sessions, developing the impression that Cisco has meaningful market share in many of the new product areas, often #1 or #2, and is bringing substantial resources to bear on developing these opportunities. As mentioned earlier, the demands on networks are increasing rapidly due to the proliferation of devices and the demand for video, and Cisco is responding effectively.
After reviewing the above information, I think Cisco can earn $1.50 per share, on a GAAP basis, and grow EPS at 7% per year. Applying a midpoint P/E of 17, consistent with the company's 5 year history, I arrive at a target price of $26. Cisco has traded at a P/E above 17 at some point during each of the past 5 years.
Strategy and Tactics
The company has received a number of upgrades, and analyst opinion is developing favorably since the restructuring. It's possible that CSCO has put in a bottom. Market conditions are uncertain, given the ongoing debt crisis in Europe: investors who have an opinion on the the trajectory of that drama will want to gauge their entry points accordingly. Investors who buy CSCO at today's prices have a realistic expectation of receiving a dividend of 1.34% and eventual share price appreciation.
Accumulate and monitor makes sense here. The growth thesis requires that services and new products grow 10% annualized, or better, since routers and switches appear to be reaching a plateau. The 10-Q provides a breakdown of year over year revenue growth by product group, to include service. I plan to monitor this information as it comes out, and adjust my opinion accordingly.
CSCO is optionable, to include LEAPS. There is substantial open interest and the bid/ask spreads are tight. The strategy of using deep in the money LEAPS as a substitute for the shares, and selling covered calls against the position, makes sense to me here. I'm long the Jan 2103 12.5 calls and short an equal number of Jul 2012 21.0 calls.
Disclosure: I am long CSCO.