Cisco Systems, Inc.: Profitability Analysis

| About: Cisco Systems, (CSCO)

My analysis on large cap tech stocks that offer a good return on investment for a value investor continues. My analysis here is based on the profitability ratios in the financial statements of Cisco Systems, Inc. (NASDAQ:CSCO) over the last 5 years.

When a firm has strong profitability ratios, it portrays to an investor that it provides a good return on his or her investment. The profitability numbers that I came across for Cisco were very encouraging. Keep in mind, however, that this is just one of the many ways to analyze a stock.

Cisco Systems is on a roll coming off a patent victory and many Wall Street analysts are upgrading the stock's price target. This article is further proof as to why CSCO is a great addition to your portfolio.

A profitability analysis of a company involves looking at a class of financial metrics to determine a firm's capacity to generate profitable sales from the resources it has. Typically, higher ratio numbers translate to a higher investment value for the firm.

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Source: Cisco annual reports.

Gross profit divided by net sales gives you the gross profit margin. Cisco's gross profit margin took a dive from 2010 to 2011 and from 2011 to 2012. The gross profit margin is lower than the 2008 level.

Operating income divided by net sales is the calculation used to obtain the operating profit margin. The operating margin has beaten the industry average 3 out of 4 times in the last 5 years. Furthermore, the operating margin has jumped back over 20% in 2012 which is a very encouraging sign.

Net income divided by net sales gives you the net profit margin. The net profit margin has also beaten the industry average 3 out of 4 times in the last 5 years. It is heading back up to the 20% mark and that is a really good figure.

The profitability ratio industry averages for 2012 are still being calculated and they may take another month to get updated. The Cisco fiscal year ends on July 28 and this is the reason why its profitability ratios for 2012 are listed here already. (I promise to put in the industry averages on the comments section to this article when they become available.) Anyway, it's safe for investors to assume that the 2012 industry averages will be lower than the CSCO values.

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The Return on Investment ratios aren't as impressive when compared to the industry as a whole, but they are much better than Cisco's closest rivals like Juniper Networks, Inc. (JNPR) and Alcatel-Lucent (ALU). That should be all investors should really be concerned about.

The Return on Equity [ROE] ratio is arrived at by dividing the net income by the shareholders' equity. The ROE has declined from 2010 to 2011, but then increased from 2011 to 2012. Yet, it is nowhere near the 2008 level.

As for the Return on Assets [ROA], it is obtained by dividing the net income by the total assets. Even the ROA has been generally lower than the industry average over the last 5 years, but it has not been considerably lower like the ROE.

Income Statement:

Cisco Systems has an impressive income statement, as is shown in the table below. The income statement numbers are far superior to its closest rivals Juniper and Alcatel-Lucent. Juniper's operating profit margin (9.72%) and net profit margin (8.39%) lag far below Cisco's for 2012. Furthermore, Alcatel-Lucent actually has negative values for its operating profit margin (-21.85%) and net profit margin (-35.08%) for the year ended 2012.

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Note: U.S. dollar in millions.

Balance Sheet:

Cisco Systems has a fairly strong balance sheet. The numbers used to arrive at the profitability ratios listed in the 'Return on Investment' table are shown in the table below.

As you might have expected, Cisco has the upper hand in this area as well when compared to its competitors. Juniper's ROE of 2.62% and ROA of 1.87% in 2012 are much lower than Cisco's numbers and this has been the case for the past 5 years.

As for Alcatel-Lucent, it has managed to turn around its ROE over the last 2 years after some rather large negative values since 2008. The 2012 ROE has averaged 27.77% and this is considerably higher than Cisco's ROE. Nonetheless, the ROA of Alcatel-Lucent has been lower than Cisco's ROA over the past 5 years.

Note: U.S. dollar in millions.

Cash Flows

10. Free Cash Flow = Operating Cash Flow - Capital Expenditure

Free cash flow is a measure of financial performance that must be taken into account. It is calculated as operating cash flow minus capital expenditures. Free cash flow [FCF] represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

Over the past five years, Cisco's free cash flow has remained positive. Still, it must be noted that negative free cash flow is not necessarily a bad thing. When the free cash flow is negative, it could be an indication that a firm is making large investments. This could work out very well for a company in the future if these investments earn a high return.

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Note: U.S. dollar in billions.

The extremely high positive cash flow is a sign that Cisco has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.

11. Cash Flow Margin = Cash Flow from Operating Activities / Total Sales

A high cash flow margin can indicate that a company is efficient at converting sales to cash, and may also be an indication of high earnings quality.
On the other hand, a low or negative cash flow margin means that a firm will have to borrow money or require a large influx of outside capital in order to keep on operating.

As Cisco's cash flow margin is positive, it can continue operating without any foreseeable cash problems.

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Note: U.S. dollar in billions.

Conclusion: CSCO is definitely a buy

CSCO is currently trading at $21.92 and it has very attractive valuations. The profitability ratios are sound and even the price action is encouraging for bulls.

The stock is up 30% over the last 3 months and it hit a two-year high of $21.98 last week. This has resulted in the price climbing over its upper Bollinger Band and there could very well be a pullback in the near-term.

Anyway, a close examination of the fundamentals and some technical analysis shows that Cisco offers great value to investors.

All material is sourced from Morningstar and MSN Money.

Disclosure: I am long CSCO. 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.

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