I purchased shares in Cisco (NASDAQ:CSCO) at around $29 (to include transaction costs) in March 2015. Shares have fallen back to $22.51 as of Wednesday's market close. I have lost about 22.5% on this investment in capital terms.
On Wednesday, Cisco released its latest quarterly results. The earnings were good and after hours trading pushed the price up to $24 and my loss reduced to around 18%. As of late Wednesday morning in New York, CSCO is up nearly 9% at $24.46.
My initial reason to buy Cisco was its market dominance in the IP networking and router market, its superb cash-rich balance sheet and attractive dividend and buyback package that is easily covered by free cashflows. Cisco is a stock that resonates with my conservative investment nature and has surpassed negative sentiments since I have owned it. Management is making reasonable progress despite the strong USD.
Is Cisco a good Value Investment?
Let's think about this in a hypothetical way. Assume I was wealthy enough to buy out Cisco at a market cap of roughly $117B. Once I owned the business I could pay off all the debt (so I really owned it!) of $27.5B using the $60B cash on the balance sheet. After that I would pay myself a $32.5B dividend using up all the spare cash on the balance sheet. Therefore to get full control of Cisco on a debt-free basis would only cost me $84.5B.
Think about that.
You are paying $84.5B for a business that pays a $11-$12B in free cash flow per year to its new owner: you!
Put in another way and a much smaller scale. You are investing $7,000 to generate $1,000 per year. We would all take this deal …. All day and every day of the year.
I appreciate this is hypothetical. OK. Let's bring this down to Earth. If you buy a share of Cisco for $24 then it really only costs you $18 because $6 is sitting on the balance sheet per share doing nothing after all debt is paid off. And on top of that you get $1.04 annual dividend and about another $0.50 per share through buyback returns. Your $18 share yields you $1.50 or 8.3% per year. So, in reality, you are investing $12,000 for $1,000 yield.
Not quite as good $7,000 for $1,000 but then that's the consequence of diluted ownership.
Is Cisco a good income investment?
At the earnings call Cisco announced a massive 24% dividend increase from $0.84 per year to $1.04 per year. Cisco now comes with a very attractive 4.5% yield.
This may of course sound too good to be true. Can Cisco afford such a big hike in its dividend?
I firmly believe Cisco's free cashflow will come in between $11B-$12B. Cisco paid dividends of $2.13B over the last six months. If we annualize this and apply 25% on top for the new hike we get $5.3B. The FCF payout ratio is a reasonably attractive 50%. Spare change is available in the FCF to grow the dividend in the future, make share buybacks or perform acquisitions.
And don't forget Cisco has $32.5B in loose change sitting on the balance sheet that could be returned to shareholders at some point in the future.
I believe Cisco is quite a good income investment. Even at my own elevated cost price of $29 I will be receiving a 3.6%.
So what's wrong with Cisco?
Cisco's financial statements are pristine. Perfect in so many ways but lack the one thing that can lead to out-sized returns: growth.
Revenue growth has been static over the last few years. It's always north of $45B but can't break through the $50B mark. Fortunately Cisco has big margins and 20%-25% of these margins are typically converted into operating cashflow that easily cover capex, dividends, acquisitions and buybacks.
The buyback policy at Cisco is not productive as it could be. Cisco throws a lot of cash at buybacks. It spends as much, if not more, on buybacks as dividend payments. However, the share count is only falling at about 2.3% per year. I estimate it should really be nearer 4% per year for the money spent. The buyback policy is not efficient because of the generous share options that are issued to management which in turn dilute the potency of the buyback and general share pool.
But if we one considers the buyback yield plus the dividend yield then you are still talking about a business that returns 6.8% to shareholders per year. And don't forget the 25% cash per share that sits on the balance sheet.
Another lesser concern is the revenue diversity of Cisco. Cisco has 30% of its revenue tied to its switching business and 15% of its revenue tied to its routing business. The market seems to regard this large chunk of revenue as being prone to competition yet:
- the overall gross margin of Cisco stands at 64%,
- its operating margin at 31%
- and Cisco has grown its revenue a little bit in recent quarters despite its exposure to the USD
The above suggests that Cisco has dominance and pricing power in its markets.
In my mind, it is not worth the pain for large organizations to switch out Cisco networks that have been built up over years and possibly decades. I believe this business is quite sticky for the medium term.
I really like Cisco and will consider buying more at these levels.
Disclosure: I am/we are long CSCO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.