How Cisco Could Become More Valuable

| About: Cisco Systems, (CSCO)

Summary

How can a company access capital?

What is the cost of equity and the cost of debt for Cisco?

Would it make sense to increase leverage?

Issuing debt in other currencies could be a good strategy as well.

Cisco (NASDAQ:CSCO) is a major tech company which is well known to many investors. In this article I'll not look at the growth outlook or dividend but rather at the company's capital allocation strategy.

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Cisco, as any other company, has two sources of capital it can access: Debt and equity. Access to new capital via equity offerings is generated by issuing new shares (or selling treasury shares). There are several ways to calculate the cost of equity, one of them is via the Capital Asset Pricing Model (CAPM):

The cost of equity is calculated by multiplying the company's beta (which measures the company's volatility relative to the broad market) with the equity risk premium and adding the risk free rate investors can get when not investing in the stock market. In Cisco's case this means we multiply the company's beta of 1.31 with the equity risk premium of 4.4% (the average stock market return over the last ten years of 6.3% minus the risk free rate of 1.9% - measured by US ten year government bonds). We then add the risk free rate of 1.9% and we get to the company's cost of equity of 7.6%.

Another way to look at a company's cost of equity is the so called earnings yield, which is the inverse of the company's PE ratio. A company trading at 14 times earnings thus has an earnings yield (and, according to this approach, a cost of equity) of 7.1%.

Both of these approaches do not give us the company's cash cost though, which would be calculated via the company's dividend: Cisco pays a dividend yielding 3.7%, thus the cash cost of financing the business via equity is 3.7% as well.

Cisco can, however, finance its business via debt as well, by issuing bonds or taking on long-term debt in other ways. The cost of debt is pretty clear - we just have to look at the weighted interest rate the company is paying and adjust this number for the company's tax rate (since interest payments are a pre-tax cost, unlike dividends, which are paid with after-tax earnings). The cost of debt also is the cash cost of debt. In Cisco's case, using a weighted interest rate of 2.5% and the company's tax rate of 20% gets us to a cost of debt of 2.0% [calculated as 2.5% * (1-0.20)].

We can thus say that Cisco's cost of debt is not only vastly lower than the company's cost of equity, it is even a lot lower than the company's cash cost of equity (2.0% for debt versus 3.7% for equity).

If Cisco would require new capital for its business, it would thus be opportune to finance these capital requirements by issuing debt instead of issuing new equity. Luckily Cisco is in a position where the company does not require new capital. Cisco is easily able to finance all of its capital needs (e.g. for capex) via the cash flows the company generates. Cisco even has substantial free cash flows left $11.3 billion in 2015. Some of this is paid out to investors via dividends ($5.2 billion annually at the current dividend of $1.04 p.a.), the rest is available for acquisitions, share repurchases or paying down debt. In Cisco's case, with the cash cost of equity being a lot higher than the cash cost of debt, it makes more sense to repurchase the company's common stock instead of paying down debt.

We can go even one step further and ask the following question: Would it make sense to increase the company's debt load and use the proceeds to buy back Cisco's shares? Let's look at an example: If Cisco took on $10 billion in debt, the company's after-tax cost for said debt would amount to $200 million (using the average after-tax cost of debt of 2.0% from above), or possibly even less: With its last bonds sale, Cisco locked in an average interest rate of 1.8% (which means an after-tax cost of debt of 1.5% [1.8% * (1-0.20)]. In order to be conservative here, let's still calculate with an average cost of 2.0% though.

With $10 billion in cash, Cisco could repurchase 353 million shares at the current share price of $28.30, which means that Cisco's (diluted) share count would be 4.74 billion. A reduction of 353 million shares means that Cisco saves $370 million in annual dividend payments. The company's cash flow situation would thus improve by making such a move: Cisco's interest expense would increase by $250 million, its net income and cash flows would drop by $200 million (and its tax expense would drop by $50 million), but its dividend payments would decline by $370 million. Cisco's free cash flows (after dividend payments) would thus improve by $170 million. This obviously is beneficial for the company as it means Cisco would have more money left over for acquisitions, (even more) buybacks or dividend increases.

At the same time such a move would improve Cisco's earnings per share, which ultimately decides each share's value: Cisco's net income would drop $200 million to $10.1 billion, but the reduced share count would mean that each share's portion of these earnings would grow to $2.13 from the current level of $2.02.

Such a move would thus be beneficial in two ways: The company's cash costs for its capital would drop by $170 million, which means higher available free cash flows (after dividends), and at the same time investors would see additional earnings per share growth, which makes each share more valuable.

Luckily Cisco's management knows about this and has repeatedly issued new debt over the last year (the last bond sale, in February totaled $7 billion). With Cisco's new $15 billion share repurchase program, which was announced in February as well, Cisco will be able to reduce the share count substantially (by eleven percent, or 540 million shares at the current price), which will lead to additional earnings per share growth of 12% and savings of $560 million in annual dividend payments.

Cisco could, as an alternative to bond sales denominated in dollars, sell bonds denominated in other currencies such as the Euro or Yen. This is a strategy other companies such as Apple (NASDAQ:AAPL) or Microsoft (NASDAQ:MSFT) have used in the past and it bears some advantages: First, debt in these currencies is, on average, cheaper than debt in dollars, due to the very low interest rates in Japan and Europe, which can be blamed on the ECB's and BOJ's lower rates relative to the Fed's rates.

As a second advantage, issuing debt in other currencies provides a hedge against unfavourable currency movements:

If Cisco sold bonds worth €5 billion and converted the proceeds to dollars, Cisco would get $5.6 billion which it could then use to buy back its own shares (or any other use). At the time of maturity the exchange rate can either be the same as right now (1.12), lower or higher. If the rate is the same, nothing happens. Cisco just would have the advantage of slightly lower interest expenses due to a lower interest rate.

If the Euro is higher, Cisco would have to pay more than $5.6 billion to get €5 billion to pay back the bond (which would be disadvantageous), but would benefit from higher income from its European business (due to higher revenues and earnings when calculated in dollars).

If the Euro is lower, Cisco would have to pay less than $5.6 billion to get €5 billion to pay back the bond, which would be advantageous. This would (partially) offset lower revenues and net income from Cisco's European business.

Thus issuing debt in other currencies can provide a hedge against unfavorable exchange rates and lower interest rates at the same time, I thus would not be surprised if Cisco followed other major companies and started issuing bonds denominated in Euros or Yen in the future.

Takeaway

Cisco's cost of debt is very low, lower than the cost of equity and even lower than Cisco's cash cost of equity (i.e. its dividend cost). It makes sense for the company to increase leverage and use the proceeds to reduce the number of shares. In recent months Cisco seems to make moves in this direction, issuing more debt at very low rates and increasing the buyback program.

Issuing debt in other currencies would be an option as well, since this provides even lower interest rates and has the added benefit of working as a hedge against unfavorable currency movements.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours.

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.