Cisco Systems, Inc. (CSCO) designs, manufactures and sells Internet Protocol based networking and other products, related to the communications and information technology industry and provides services associated with these products and their use.
On July 20, 2012, the common stocks of Cisco closed at a price of $16.36. Let's take a quick look at it to determine if it is a good long-term investment.
Cisco has the cash per share in the amount of $8.9. Approximately 87% of this cash is held in the foreign subsidiaries. The companies usually retain their overseas income in the foreign subsidiaries where they enjoy a lower (or sometimes zero) tax rate. When they decide to repatriate this cash back to the USA, they become liable to pay the U.S. taxes (minus the foreign tax credits, if any) usually at the corporate tax rate, which in many cases may be 35% or more. Trust me; neither Cisco nor any of the other mega cap companies, which collectively have $1 - $1.5 trillion in the overseas cash, are going to bring all this cash to the USA (and hand over hundreds of billions of dollars to Uncle Sam) unless there is a tax holiday or some other kind of favorable tax treatment for the repatriation. In Cisco's case, if it repatriates all its overseas cash ($42.3 billion), it may need to fork over a check with an amount north of $14 billion to Uncle Sam. For the sake of the argument, let's assume that Cisco decides to repatriate this cash back to the USA and to be ultra conservative, let's also assume that it pays a corporate tax rate of 35%. This leaves Cisco with the cash per share in the amount of $6.2, net of the taxes. Here is how:
Total cash/share = $8.9
Foreign cash/share = $7.7 (87% of $8.9)
Foreign cash/share, net of the taxes = $5 (after applying a tax rate of 35% to $7.7)
Domestic Cash/share = $1.2 (13% of $8.9)
Total cash/share to become available domestically, after repatriation, net of the taxes = $6.2 ($5 + $1.2)
Note: Cisco has a long-term debt of $16.2 billion. Instead of the cash/share for this exercise, I could opt to use the net cash/share by taking its debt into consideration. The reason, I'm ignoring the debt for now, is because with a massive free cash flow run rate of $9 billion/year, Cisco can easily pay off the debt very quickly, if it chooses to do so.
With that said, what you have now is a company that is selling at $16 and has over $6 in cash. As an investor, the first thing you want to know is what you get when you purchase something for $10, net of the cash. In fact, let's try to find out under what circumstances, does such a price make sense for Cisco.
One way to value a business is by estimating how much cash flow it is going to generate in the future. So, I did a reverse Discounted Cash Flow (DCF) analysis to essentially see what all was needed to justify a price of $10.
What I find is that the only way such a price for Cisco is justified is when I make the following ridiculous assumptions:
First assumption: Cisco is going to grow its free cash flow per share at a compounded annual growth rate (CAGR) of only 1% for the next 5 years. Just for reference, the 10-year U.S. Treasury note has a yield at ~ 1.5%, 50% higher than my assumed FCF growth rate. The U.S. treasuries are arguably the safest investments in the world. Let me also add that the inflation rate (which is 1.7%) has grown at three times higher CAGR during the last 65 years, compared with my assumed FCF growth rate. So for Cisco, I'm assuming a 5-year FCF growth rate that is one-third of the long-term inflation rate, 50% below arguably the safest returns possible and quite frankly a kind of growth rate that should result in massive restructuring of the executive management and the board.
Second assumption: After 5 years, Cisco goes into a Financial and technological coma and just stops growing its FCF i.e. I'm assuming the FCF CAGR of 0%, ad infinitum.
Third assumption: All this while, you, the smart investor, can grow your money at a CAGR of 16% elsewhere without taking any risk. Needless to say, by achieving such returns, you will end up registering your name in the history books as a legendary investor. So to honor you, I'm assuming a risk free discount rate of 16%)
Fourth assumption: For FY2012, in all likelihood, FCF/share should be $1.7 or so (in the 3 quarters it has already logged ~ $1.4) but I am not going to use it in the DCF calculation. Rather, I'm going to use a conservative 5-year average FCF/share, which is ~ $1.60.
Starting FCF (5-year average) $1.6
Discount Rate 16%
CAGR next 5 years 1%
CAGR afterwards 0%
Estimated future FCF
Present Value of future FCF
6 onwards growing at 0% CAGR
All numbers are per share numbers.
Price justified by DCF analysis, based upon my assumptions = $10.38
Current price, net of the cash = $10.2
As you can see that only after making draconian assumptions and using a conservative average FCF/share of the last 5 years, you come anywhere near the current stock price, net of what would roughly be post-tax cash after repatriation.
Just to let you know that Cisco's actual FCF CAGR for the last 10 years is 13%. During and after the 2007 financial crisis, which resulted in the largest recession, after the 1930 depression, it still grew its FCF by 6-7%.
Other valuation metrics: Cisco is trading almost at its lowest earnings multiple in the last 5 years. It's trading at substantial (35% to 60%) discounts to its earnings, book value and free cash flow 7-year average multiples. The EV/EBITDA multiple is 4.46, which translates to 22% cash-on-cash return. It's an extremely profitable business with an average return on equity over 21% and an average ROI of over 13%, during the last 7 years. Its current earning and the FCF multiples are substantially below the Tech sector. It's also trading at a discount to the broad market.
Stocks usually go in the deep value territory for a reason. One of the most common reasons causing the price fluctuations, especially in the short term, is a direct result of how the results compare with the market's expectations. I believe that after going through some operational missteps, earnings/guidance debacles, Cisco realized its mistakes (CEO John Chamber's famous Mea Culpa), underwent some meaningful mid-air course correction and appears to be on the right track now. I see a very bright future for Cisco during the upcoming and inevitable boom in the internet traffic caused by the data, apps, video/audio streaming, TV and cloud-based computing.
Price wise, it has made a trip to $13 in the past 12 months, due to the market's overreaction and also due to the broad market decline. It may again go down that path for the same (or other) reasons but I'm comfortable buying at this price. I believe that this is the kind of price level for starting an accumulation would make sense for a long-term investor.
As for the competition, despite some inroads made by Hewlett-Packard (HPQ), Dell (DELL) and Juniper (JNPR) in Cisco's territory, I believe that Cisco will do just fine, the margins though may come down a bit in the next few years. There will still be enough food for everybody. When and if a market-leading company as massive as Cisco does fall behind the curve in a game-changing innovation or paradigm shift, it can rely on its massive war chest and get into the game by acquiring the hot and happening new kids on the block. A quick reminder, Oracle Corporation (ORCL), which you would barely have called a major player in the cloud space a year ago, is now a cloud leader, second only to Salesforce (CRM) primarily by making some serious acquisitions in the last year or so.
In my opinion, Cisco should be valued north of $25, if not $30, so I'm a buyer at this price level.
Also, stay tuned for a second part on Cisco.