12 Years After The Bubble - Cisco Is Ripe For The Taking

| About: Cisco Systems, (CSCO)

Since the bursting of the dot-com bubble in March of 2000, investors have found themselves willing to pay less and less for the future free cash flow streams for some of the dominant companies of the era such as Cisco Systems Inc. (NASDAQ:CSCO), Microsoft Corp (NASDAQ:MSFT), and Intel Corp (NASDAQ:INTC). It is somewhat amazing that even in the rapidly changing technology sector, these three behemoths were correctly identified as the leaders moving into the next decade and beyond, but because expectations had become so irrational as shown by obscenely high valuations, long-term investors felt nothing but pain if they held on to these stocks. In the year 2000, Cisco earned $0.37 per share for the year and at various times, the stock traded well over 125 times earnings. For fiscal year 2012, the company earned $1.49 per share, meaning GAAP earnings have grown by over 300% during the last 12 years, yet the stock trades at less than 1/3rd of its 2000 high. This type of dismal long-term shareholder performance, combined with the emergence of the current dynamos of technology such as Apple Inc. (NASDAQ:AAPL) and Google Inc. (NASDAQ:GOOG), has caused Cisco's shares to trade at levels where just reasonable future performance should lead to substantial gains for the stock.

At $17.35, Cisco has a market capitalization of about $93 billion. The company has $48.71 billion of cash and short-term investments, and long-term debt of $16.3 billion, creating a net cash position of $32.41 billion. Based on 5.353 billion diluted shares outstanding, the net cash position is equal to $6.06 per share. This means that at current prices, investors are paying about $60 billion or $11.29 per share for a company that in the past 12 months has generated in excess of $10 billion in free cash flow. Net of cash Cisco offers a free cash flow yield of 16.67%, which obviously looks quite attractive with the 10-year treasury yielding 1.8%. While there is no doubt that technology is constantly changing, one saving grace for the dominant firms with large cash balances is their ability to pile money into R&D, and acquire emerging technologies, which could pose threats to their competitive position. Cisco expenses over $1 a share or in excess of $5 billion annually for R&D, which gives the firm a significantly greater capacity to keep pace with technological evolution, in comparison with the majority of the company's competitors in the areas of data networking equipment and software.

Capital allocation for Cisco has been absolutely atrocious, highlighted by overpriced acquisitions and buybacks at non-accretive prices. Today's announcement of a new capital allocation plan could be a turning point for better things to come. Cisco increased the quarterly dividend by 75% to $0.14 per share, which is equivalent to a 3.2% current dividend yield. The company also plans to allocate 50% of free cash flow to dividends and share buybacks moving forward. This reduces the chances of the company overpaying on a large acquisition, and it allows shareholders to benefit from the prodigious and growing free cash flow streams that the company is generating. This should ultimately result in a higher valuation for the company, as the certainty of the cash flow reaching the investor has increased substantially, unless executives intend to make liars out of themselves. The company will continue making tuck-in acquisitions, as it is essential to leverage the balance sheet to maintain and grow market share in key businesses.

On August 15, Cisco reported very strong fourth-quarter financial results despite a very difficult global environment. Sales and GAAP net income of $11.7 billion and $1.9 billion were up 4% and 56%, respectively year over year. Adjusted income increased 15% from the prior-year period to $2.5 billion or $0.47 per share. For the fiscal year 2012, Cisco posted sales of $46.1 billion and GAAP net income of $8 billion, which were up 7% and 24%, respectively, from 2011. Adjusted net income was $10 billion or $1.85 per share. Cash flow from operations was $3.1 billion in the fourth quarter and $11.5 billion for the fiscal year 2012, which were up from $3 billion and $10.1 billion,respectively.

Cisco's recent focus on its core businesses of switches and routers has really begun bearing fruit despite an extremely competitive landscape. Switching revenue was up 3% for fiscal year 2012 and gross margins have largely stabilized. Routing revenue grew 2%, wireless assisted by LAN upgrades and deployments were up 19%, and security revenue was up 12% from 2011. Service provider video revenue was up 11% and the data center business showed explosive 87% year-over-year growth. This performance highlights management's focused approach on its key businesses, as opposed to the empire building ventures to consumer businesses over the past decade, which allowed competition to eat away at Cisco's moat.

Cisco continued to be an aggressive buyer of its own stock, purchasing 108 million shares in the fourth quarter at an average price of $16.62. For the full year, the company bought back 262 million shares at an average price of $16.64. The company still has approximately $5.9 billion left on its authorization for share buybacks, which at current prices would be extremely accretive to intrinsic value. For the fiscal year 2012, Cisco returned about $1.5 billion to shareholders through dividends, which will obviously be a much larger number in 2013 buoyed by the 75% dividend increase.

When Cisco's stock tanked in 2011, it seems that CEO John Chambers' pride was hurt, and he really has taken steps to right the ship. He has cut costs as seen through the fact that operating expenses as a percentage of revenue were down to 34.8% in 2012, from 37.1% in 2011. Cisco has been aggressive in competing in its core businesses and has a solid deferred revenue backlog of $12.88 billion. Access routing market share is around 85% and switching market share is around 50%, highlighting Cisco's continual dominance in its key business franchises. The security and data center businesses offer Cisco wide open growth platforms, which are well suited to the company's core competencies. Business is recovering nicely in North America, but is understandably weakening in the Emerging Markets and Europe due to macroeconomic pressures. Large Asian economies such as China and India will likely become significantly larger markets for Cisco's spurring growth throughout the next couple of decades, just as North America and Europe spurred growth over the last couple of decades for the company. Gross margins are lower in the Emerging markets and are difficult to forecast into the future with much precision.

Management projected Q1 revenue growth to be in the range of 2-4% on a year-over-year basis. Non-GAAP gross margins are expected to be in the range of 61-62%, while non-GAAP operating margin is expected to be in the range of 26.5-27.5%. Non-GAAP earnings per share are expected to be between $0.45-$0.47 per share, which would represent 5-9% YoY growth. Cisco has been such a popular stock for so long that analysts seem to focus far too much on quarter-to-quarter numbers and forecasts, as opposed to really looking at the longer-term picture of what the business is actually worth.

International Business Machines Corp (NYSE:IBM) has already performed the ideal case study on how large-cap technology companies transition from growth, to maximizing shareholder value, and companies like Cisco and Microsoft would be silly not to follow in its footsteps. Management must be honest and open with a key focus on ROI on any capital allocation outside of dividends, while stock buybacks must be executed with an eye on the price being paid to reduce the share count. Non-core businesses should be divested when feasible while the companies leverage their fortress balance sheets to protect market share, and to invest in key growth initiatives. At some point in time, it is very likely that Cisco will find a way (perhaps by issuing low-cost debt) to pay a large one-time dividend to shareholders with the company's excessive cash position, which happens to be largely held overseas. We believe Cisco can grow revenue over the next decade by a minimum of 3-6% annually, and with aggressive buybacks there is no reason the company can't compound earnings by a minimum of 10% per annum. By the end of the decade, this would put Cisco's non-GAAP earnings per share at well over $4.00 per share, and free cash flow would likely be similar.

We certainly don't believe it will take that long for the market to increase the valuation allotted for this leading cash flow generator, particularly if management sticks to its word by returning those cash flows to shareholders, and if the company were valued at just 10 times free cash flow net of cash, the stock would increase by about 40%. Even in the worst-case scenario where the valuation stays at the currently depressed level, we would expect Cisco's stock performance to mimic long-term EPS growth of 10% per annum moving forward, which is certainly a favorable result considering most market participants' dismal expectations for stock market performance. Therefore, Cisco offers a compelling and conservative, yet attractive, opportunity for those with patience, and the ability to distance future stock performance from the recent past.

Disclosure: I am long CSCO, MSFT, GOOG.