Cisco's Investment Considerations
• Cisco (NASDAQ:CSCO) sells Internet Protocol based networking and other products related to the communications and IT industry. The firm provides a broad line of products for transporting data, voice, and video. It is #1 or #2 across a wide variety of architectures. It was founded in 1984 and is headquartered in California.
• Cisco has been acquisitive as of late. Instead of targeting suppliers to help its gross margin, the firm's M&A strategy will be focused on disruptive technology and software and cloud acquisitions that will positively impact gross margins.
• We like that Cisco is aggressively buying back stock. In fact, the firm intends to return a minimum of 50% of annual free cash flow to shareholders via dividends and buybacks. Since its share repurchase program began through the end of January 2016, the firm has repurchased more than $95 billion in shares, and has nearly $17 billion remaining authorized for share repurchases.
• Future revenue growth at Cisco is now expected to be in the range of 3%-6% during the next 3-5 years. This is down from 5%-7% annual growth expectations it set during its conference in 2011. The firm must continue to adapt to evolving markets and meet the changing demands of customers.
• Cisco continues it transition to a software-based business model. Lack of top-line growth may have some investors concerned, but a large cash position and solid execution have given us full confidence in the company.
• Though Cisco reported modest top-line growth of 2% in its second quarter of fiscal 2016, excluding the impact of its SP Video CPE Business--which was divested--strong execution drove non-GAAP earnings per share up 8% on a year-over-year basis to $0.57, beating the consensus mark of $0.54 per share. The company grew its quarterly dividend 24% after the quarter.
• Cisco had an incredible $60.4 billion in cash and cash equivalents at the end of the second quarter of its fiscal year 2016. Such a cash hoard gives it tremendous financial flexibility to pursue value creating acquisitions and/or significantly increase the dividend. We don't think investors should worry about the cash domicile of the dividend. Cisco can monetize such cash tax free in the even of foreign acquisitions. Full credit should be given to its cash hoard within the valuation context.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Cisco's 3-year historical return on invested capital (without goodwill) is 63.7%, which is above the estimate of its cost of capital of 10.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Cisco's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 2.6 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Cisco's free cash flow margin has averaged about 23.4% during the past 3 years. As such, we think the firm's cash flow generation
is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Cisco, cash flow from operations increased about 7% from levels registered two years ago, while capital expenditures expanded about 13% over the same time period.
In the first six months of fiscal 2016, Cisco reported cash flow from operations of ~$4 billion and capital expenditures of ~$6.7 billion and capital expenditures of ~$600 million, resulting in free cash flow of ~$6.1 billion. This represents a 27% increase from the first six months of fiscal 2015.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Cisco's shares are worth between $30-$44 each. Shares are currently trading at ~$28, below the lower bound of our fair value range. This indicates that we feel there is significantly more upside potential than downside risk associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $37 per share represents a price-to-earnings (P/E) ratio of about 24.9 times last year's earnings and an implied EV/EBITDA multiple of about 13.6 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 2.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 2.9%. Our model reflects a 5-year projected average operating margin of 28.4%, which is above Cisco's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Cisco, we use a 10.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $37 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Cisco. We think the firm is attractive below $30 per share (the green line), but quite expensive above $44 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Cisco's fair value at this point in time to be about $37 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Cisco's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $45 per share in Year 3 represents our existing fair value per share of $37 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Cisco is a free cash flow generating machine. Free cash flow came in at $6.1 billion through the first half of the fiscal year, with second quarter results released in February, representing a solid free cash flow margin of ~25% of revenue. Cisco also added $15 billion to its buyback program, and announced a 24% increase in its quarterly dividend, staying true to management's goal of returning a minimum of 50% of annual free cash flow to shareholders via dividends and buybacks.
Though Cisco reported modest top-line growth of 2% in its second quarter of fiscal 2016, excluding the impact of its SP Video CPE Business--which was divested--strong execution drove non-GAAP earnings per share up 8% on a year-over-year basis to $0.57, beating the consensus mark of $0.54 per share (GAAP earnings leapt 35% on a year-over-year basis in the quarter). The firm is making positive progress in its shift to a more software-focused business model that will continue to be made up of an increasing percentage of recurring revenue, a transition that should position it well in the current challenging macro environment.
Productivity initiatives helped margins for Cisco as well, and management expects this kind of strong execution to continue as it works to integrate a number of acquisitions it closed in the quarter--four companies in the security, data analytics, and video markets (moves consistent with its strategy to enhance innovation and R&D investment in growth areas). Cisco also announced the acquisition of Jasper Technologies, a provider of a cloud-based Internet of Things software-as-a-service platform, in the quarter; the Jasper deal is expected to close in the third quarter of fiscal 2016. We like the deal-making, and it is not stretching the balance sheet at all.
Cisco is a holding in both of our Best Ideas Newsletter and Dividend Growth Newsletter portfolios. The company currently registers a 7 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.