Cisco Systems: The Lost Quarters

| About: Cisco Systems, (CSCO)

Cisco Systems - The Lost Quarters

This is the second in a series of my articles on Cisco Systems, Inc. (NASDAQ:CSCO). The link to the first article, titled "Cisco, Left for Dead" is here. I hope to pen a third and final article to complete my thoughts on Cisco, soon. Although the articles are independent of each other, I would recommend the reader to read them all, to fully understand the thesis.

Cisco Systems, Inc. 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.

Some people have this opinion that the investors in Cisco's common shares have witnessed a lost decade as its price since the dot com era has followed a flat trajectory. I hope to express my thoughts about the so called "lost decade" in my next article.

In the meantime, what's up with the lost quarters? Well, we shall see in a short while. As in the previous article on Cisco, I am again going to make some draconian assumptions and see if Cisco is still undervalued with those assumptions.

For technology companies, having a massive war chest (cash in the vault) and strong free cash flow are extremely important because with these, they can acquire the growth, bleed their competitors to death or pay back the cash to their shareholders. Cisco is a very profitable free cash flow machine. Cisco's FCF margin has never dropped below 21% in the last 10 years. In the table below, I have calculated FCF/share for the last 7 years based upon the diluted number of outstanding shares, not just the outstanding shares.

Table I:

Price of Cisco's common stocks, on July 20, 2012 = $16.36

Fiscal year

2005

2006

2007

2008

2009

2010

2011

Revenue

24801

28484

34922

39540

36117

40040

43218

Free Cash Flow

6876

7127

8853

10821

8892

9165

8905

FCF Yield

28%

25%

25%

27%

25%

23%

21%

Diluted WA shares outstanding

6612

6272

6265

6163

5857

5848

5563

Diluted FCF per share (FPS)

1.04

1.14

1.41

1.76

1.52

1.57

1.60

FCF Multiple based upon FY2011 diluted-FPS

10

7 years average FCF multiple for Cisco

16

Click to enlarge

All the figures in are in USD, except per share and shares outstanding.

First Observation: As we can see in the table above, Cisco's current FCF multiple at 10, based upon the diluted shares outstanding, is at 37% discount to its 7 years FCF multiple of 16. That's a substantial discount. When Cisco's FCF multiple expands to (and in my opinion, the question is not if it expands to but when it expands to) its 7 years average FCF multiple, we will be looking at a possible return of over 50%. Now, even if the multiple expands to somewhere in the middle, we are still looking at a return of 25-30%. Don't forget that Cisco shares were trading at $21 in its FY11-Q3, barely few months ago. The events that have happened since then are the broad market decline caused by the macroeconomic environment and the usual bearish trend in the market during the summer, not much company specific. So whether the multiples expand or the rising tide lifts all the boats, in my opinion, a return of 25-30% is not far-fetched in the next 12-18 months.

Well, still not with me. OK, let's raise the bar a little bit higher. Now we shall find out the FCF/share for the last 7 years and average it out. For any non-declining business, this will usually be a lower number, compared to the current FCF. We shall then calculate Cisco's FCF multiple based upon this 7 years average/normalized FCF and compare it to the 7 years average FCF multiple for Cisco, to see if Cisco is still undervalued. The following table does precisely that. Let's see what we discover.

Table II:

Fiscal year

2005

2006

2007

2008

2009

2010

2011

Diluted FPS

1.04

1.14

1.41

1.76

1.52

1.57

1.60

7 years average Diluted FPS

1.43

FCF multiple based upon 7 years average diluted FPS

11

7 years average FCF multiple for Cisco

16

Click to enlarge

All the figures in are in USD, except per share and shares outstanding.

Second Observation: As we can see from the table above, Cisco's average FCF/share for the last 7 years comes to $1.43. Using this and the current price, the FCF multiple comes to 11. Cisco's 7 years average FCF multiple is 16. Hmm, so looks like that Cisco's 7 years normalized FCF multiple is still at a huge discount of 31%, to its 7 years average FCF multiple.

You must be saying, OK, we heard that but whatever happened to the "Lost Quarters." Thanks for reminding. Let's address that now.

What if we make a draconian assumption now that Cisco had a complete shutdown for one whole quarter in each of the last 7 years? In other words, one of the largest technology companies of this generation came to a grinding halt for one fourth of a year in each of the last 7 years. Think about how many days off you have in a year and then imagine if you have one whole quarter off. If you are aware of how many extra hours and weekends on an average, the employees have to work in most of the technology companies, in order to show the results they show, you would surely appreciate the feeling these employees will have to get one whole quarter off. So much leisure time, so much time to learn the new skills, so much time to try out the new things, so much time to think about long term goals and to fulfill a long cherished dream, to spend time with the family, and so on. That's what one whole quarter of shut down can do for the lives of Cisco's newly rejuvenated employees and yet for Cisco the company, this assumption brings nothing; no direct revenue or the income.

I know Cisco did not have any such shut downs but for the sake of the argument, let's assume that it did. Now since Cisco's business, as any other tech business, undergoes the usual seasonal trends, it would not be easy to decide on which of the 4 quarters in each year was shutdown? So to make it somewhat simpler, I shall average out the quarters and then essentially remove 25% of the free cash flow in each of the last 7 year. In other words, I shall adjust Cisco's annual free cash flow at 75% of the stated value.

With this assumption, let's see how the numbers look. As you recall from Table II, Cisco's 7 years average diluted FCF/share is $1.43. Valued at 75%, the adjusted number comes to $1.07 (75% of $1.43), as shown in Table III below.

Table III:

Fiscal year

Valued at

2011

7 years average diluted FPS

1.43

7 years average diluted FPS

75%

1.07

FCF multiple based upon 75% of 7 years average diluted FPS

15

7 years average FCF multiple for Cisco

16

Click to enlarge

All the figures in are in USD, except per share and shares outstanding.

Third Observation: Using the current share price and the 7 years average/normalized FCF/share at 75% valuation, the FCF multiple comes to 15, still below Cisco's 7 years average FCF multiple of 16. Wow! A Cisco with only three quarters under its belt is still undervalued.

To recap, what we have discovered are the following:

1. Cisco's FCF multiple based upon the FY2011 FCF, is at a substantial discount of 37% from its 7 years average FCF multiple and

2. Cisco's FCF multiple based upon its last 7 years average/normalized FCF, is still at a substantial discount of 31% from its 7 years average FCF multiple and

3. Even if Cisco lost one full quarter in each of the last 7 years and we use average/normalized FCF for the last 7 years, it's still trading at a discount to its 7 years FCF multiple.

Can the Cisco share price go any lower? Sure. Theoretically, any stock price can go to the zero. No one has any crystal ball to know the future. How many people would have thought before the hyperinflation period in 1923, that it would become cheaper to burn paper bills to start a fire instead of buying the real firewood? Yet it happened. The point is that you never know for sure what the future has in its store for you.

To summarize, unless you can predict and buy something at its absolute bottom, if you think that the share price is substantially below what you estimate as its intrinsic value (and it helps a lot if you make the conservative assumptions to reach your conclusion), you should consider buying. After all, given a certain price, it does not matter which side of the "V" you buy it at.

Update: Cisco is down 5-6% since I wrote the article, mainly due to the following reasons:

  1. They announced to lay off 2% of their workforce, which many think indicates a softness in the business, at least in the short term.
  2. VMWARE (NYSE:VMW) announced that it's acquiring virtual networking software maker, Nicira for $1.3 Billion. Again, with VMWARE's scale, Nicira may have some impact on Cisco's business, but I don't think that it's happening anytime soon.
  3. The continued deterioration in the macroeconomic environment, specially in Europe, reduced Government spending and a continued slowdown in BRIC countries.

I am not worried about any of these events, at least not in the long term. I do not think that Cisco's businesses are in any terminal decline. Product refresh cycles are a different thing though.

The present decline in Cisco's price is due to the ageless supply and demand equation. Remember a legendary investor's words: "In the short term, the market is like a voting machine and in the long term, it is like a weighing machine."

I remain a buyer of Cisco at this price level.

Sources:

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