Cisco's Price Correction Is Far From Over: Part 2

| About: Cisco Systems, (CSCO)
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Last Wednesday, Cisco Systems (NASDAQ:CSCO) unveiled its 3rd quarter results for the 2013 fiscal year. In a press release, the company cited quarterly sales of $12.2 billion, GAAP net income of $2.5 billion ($0.46/share), and non-GAAP net income of $2.7 billion ($0.51/share). Additionally, its non-GAAP EPS beat the $0.49 estimate by roughly 4%.

CEO John Chambers was enthusiastic about the results, and he had the following to say about the company's Q3 performance:

"Cisco is executing at a very high level in a slow, but steady economic environment. We are especially pleased with our ninth consecutive record revenue quarter. We are starting to see some good signs in the US and other parts of the world which is encouraging."

In the five days following the announcement of results, the stock has increased by roughly 13%, and it is now valued at $23.95 as of Monday's close.

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Price chart from FinViz

Cisco shareholders have enjoyed a 60% return since the stock price bottomed at $14.96 in July 2012. However, many people are probably wondering if it's too late to buy into the company. Was too much value destroyed as a consequence of the price increase? Has CSCO become a stock that's too expensive?

In my first article, I gave some basic reasons as to why it's not. However, the 5-year P/E chart in my original article did not account for the price jump that followed the announcement of Q3 earnings. In order to give you an idea of how these changes have affected the stock's P/E, and how its new P/E compares with the earnings multiplier that it's traded at over the last 5 years, I've posted the updated chart below.

CSCO PE Ratio TTM Chart
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CSCO PE Ratio TTM data by YCharts

Although the chart captures the most recent price jump, it's important to note that it hasn't accounted for Q3 earnings in its calculations. The most recent P/E ratio should actually be 13.31, which as you can see, would still be relatively low by historical terms. Yes, the P/E is higher than it has been for the majority of the past year, but I view this as a positive sign. It shows that investors are beginning to appreciate Cisco's recent history of rapid earnings growth, as well as the company's ability to consistently grow TTM EPS in every quarter since the start of 2012. Based on these trends, I believe that Cisco's price will continue to increase, that investors will finally take the company's rapid earnings growth into serious consideration, and that the stock will rightfully be awarded with a higher P/E in the coming months.

Although understanding the changes in price in relation to earnings is important, this approach is too simplistic if you are looking to make a buy or sell decision on the stock. Now that Cisco's road to recovery is in full throttle, it's important to understand the health and stability of the company's fundamentals, dividend payments, and share repurchase program, among other things. I will cover these items in the following paragraphs.

Has Cisco become so undervalued that it passes a Benjamin Graham analysis?

Ever since the catastrophic burst of the dot-com bubble, investors have proceeded with caution when it comes to certain tech stocks. Sadly, Cisco's market value has fallen victim to this act. To put this into perspective, CSCO closed at $15.99 on Friday, May 20, 2003. Over the next 10 years, its price went on to grow at just a 4.2% effective annual rate, resulting in yesterday's closing price of $23.95. When considering the 10-year EPS growth rate--which averaged 14.6% annually--and a balance sheet that indicates anything but an unhealthy company, it's not difficult to see that Cisco has become a value play.

SA Contributor Tim Travis expressed a very similar sentiment in his recent article:

"Cisco trades at an extremely pessimistic valuation, despite a pristine balance sheet, and a very solid business with reasonable durable competitive advantages and growth prospects. As earnings continue to grow and the capital structure becomes more befitting to a mature technology concern, Cisco's stock should lead to above-average stock returns for the long-term investor."

If you haven't read Tim's article, then I highly recommend clicking on the link and reading his analysis. The reason why it's relevant to my article is because I, like Tim, have noticed that CSCO has crept close to Benjamin Graham's territory over the last 10 years. At the turn of the century, Cisco was the sexiest stock that was trading on the market. Following the burst of the tech bubble, people went running for the hills, and for the next 3 years it was the ugly duckling in the market. Over the last 10 years, investors have treated Cisco like the ugly sister in the family. However, the stock's 1-year performance has felt like the turning point in what is shaping up to be a Cinderella story. In the stock market, yesterday's losers are tomorrow's winners. History clearly shows that trends in the market can change quickly and dramatically. And for this reason, a stock should never be ignored simply because "it's boring and its price hasn't gone anywhere." That type of thinking is simple-minded, and it will only prevent you from considering some of the best investments out there.

In order to determine whether a stock was both a safe and attractive long-term investment, Benjamin Graham would conduct an analysis that involved 7 criteria. If the stock passed his criteria, he would deem it appropriate for initial consideration by the defensive investor. I conducted this analysis for Cisco, and my findings are displayed in the chart below.

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*Note: The second and third rows of the chart can be grouped together. Collectively, they should be viewed as Graham's criterion for a company's financial stability.

As you can see, Cisco passes five of Graham's criteria, while failing two of them. I'll begin by discussing the five that it passes.

  • Adequate size: The purpose of requiring sales that are greater than $340mm is to exclude smaller companies, which often display greater earnings variability than larger corporations. Of course, Cisco's annual sales are enormous when compared to the minimum requirement.
  • Strong financial condition: A current ratio that's greater than 2 indicates that a firm is more than able to pay off its short-term obligations. Additionally, if a company has less long-term debt than net working capital, then it has the ability to pay off all the debt on its balance sheet (it would pay off this debt by using its current assets). In Cisco's case, the company would have $21.2 billion remaining after paying off its debt. The company's strong financial condition indicates that Cisco shareholders are at a low risk of being invested in a firm that will go bankrupt.
  • Earnings stability: Cisco's last annual loss was in FY2001, which is obviously greater than 5 years ago. Companies that are able to maintain some level of earnings over a long period of time are considered to be more stable investments.
  • Earnings growth: The purpose of this requirement is to ensure that the growth of the company's profits will at least keep pace with inflation. Cisco's EPS has almost quadrupled over the last 10 years (291.3% growth to be precise), meaning it has grown much faster than the 33% required rate.
  • Moderate P/E: This requirement is meant to prevent investors from overpaying for the stock. The maximum allowable P/E is 15, which is the long-term average P/E of the Dow Jones Industrial Index. Cisco's P/E of 13.31 is below this figure, and as I mentioned earlier, it's also below its historical average. Additionally, Cisco's P/E is lower than that of the S&P 500 (which has a P/E of 16.8), the DJIA (which has a P/E of 14.8), and the industry average P/E of 73.0 (sources: Morningstar and Dow Jones Averages).

Although it'd be nice if Cisco passed all the criteria, it would have been a serious stretch, given Cisco's status as both a technology company and a member of the DJIA. However, the company came reasonably close to passing all seven criteria. Below I'll discuss the two criteria that it missed on, and why these "misses" really aren't all that concerning.

  • Dividend record: The requirement calls for at least 20 years of consistently paying dividends. This is meant to provide investors with reassurance that these cash flows will continue. Given that Cisco only started paying a dividend in FY2011 Q3, its history of dividend payments isn't long enough to warrant a "pass" on this requirement. I will further analyze Cisco's dividend program in a later section of the article.
  • Moderate Price/Book: As another means of not overpaying for a stock, Graham sought companies with Price/Book ratios below 1.5. However, a higher Price/Book is acceptable if, when multiplied by P/E, the resulting value does not exceed 22.5. Cisco's Price/Book is 2.27; when multiplied by its P/E, the result is 30.2. This indicates that Cisco has failed the requirement. However, rather than taking this result at face value, I decided to see how the current Price/Book compares to both its historical Price/Book and the industry Price/Book. Below are the results of my findings.

CSCO Price / Book Value Chart
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CSCO Price / Book Value data by YCharts

The chart above represents Cisco's Price/Book ratio over the last 10 years. Again, YCharts hasn't accounted for Cisco's Q3 earnings yet, so the most recent Price/Book shown is slightly misstated. However, the difference is so insignificant (it should just be 2.27 rather than the stated 2.30) that the chart remains an equally useful tool in our analysis. As you can see, Cisco's Price/Book is near its long-term low. If the chart had tracked the metric over the maximum possible time frame (i.e., from its IPO in 1990 up until today), then the current Price/Book would seem even smaller, given that it's near the bare minimum of an awfully wide range of values (it consistently hovered between 10 and 20 between 1993 and 2000). When the ratio dropped below 2.0 back in 2011, it was a first-time occurrence. In the two years since, Cisco's Price/Book has grown to a level that's on par with the industry average of 2.4 (source: Morningstar).

Dividend History

On March 17, 2011, Cisco declared its first-ever quarterly dividend payment of $0.06/share. Last month, the company paid a quarterly dividend of $0.17/share, which is almost three times as large as the original amount. The chart below shows Cisco's 2-year history of quarterly dividend payments.

CSCO Dividend Chart
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CSCO Dividend data by YCharts

Of the eight possible quarters, Cisco has already raised its dividend three times. These increases were significant, given that its average dividend growth rate is 14.4% per quarter. After annualizing its most recent dividend payment, Cisco's annual dividend comes out to $0.68/share. The current dividend yield (2.84%) is more than double the yield two years ago, when Cisco's first dividend was declared. The growth of the dividend yield is shown in the chart below.

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As you can see, Cisco's dividend yield currently lies in the upper echelon of its historical range. Like the trend displayed in its earnings, Cisco's dividend has grown at a faster rate than its price. Again, this plays into the stock's valuation, considering that an investor who buys CSCO today would receive an additional 1.43% return (in dividend income) than those investors who bought the stock just two years prior. Altogether, these trends would be normal for a company that doesn't have a bright future, isn't expected to grow in the coming years, and has a dividend that is considered to be unsustainable. However, these characteristics do not describe Cisco by any stretch of the imagination.

In a recent Forbes article, author John Dobosz makes the case for additional increases in the dividend:

"[Cisco's] earnings also provide room for additional dividend hikes, with current payout ratio just 34% of expected EPS. Free cash flow per share of $1.55 over the past 12 months also helps, as does a cash pile of $46.4 billion, or $8.70 per share."

After adjusting some of these numbers for Q3, Cisco's payout ratio (as a percentage of expected EPS) remains 34%, while its cash* per diluted share stands at $8.80. Considering its cash per share increased, in spite of the $0.03 increase in its dividend, I would have to concur with John that Cisco is definitely in position to continue increasing its payouts in the future.

*Note: In order to calculate "cash," as John did, I added Cisco's short-term investments to its cash and equivalents. This is normal in practice, considering that "short-term investments" can be quickly and easily exchanged for cash.

Stock Buyback Program

In its Q3 press release, Cisco had the following update on its share repurchase program:

"Cisco repurchased approximately 41 million shares of common stock under the stock repurchase program at an average price of $20.85 per share for an aggregate purchase price of $860 million. As of April 27, 2013, Cisco had repurchased and retired 3.8 billion shares of Cisco common stock at an average price of $20.35 per share for an aggregate purchase price of approximately $77.7 billion since the inception of the stock repurchase program. The remaining authorized amount for stock repurchases under this program is approximately $4.3 billion with no termination date."

The chart below has tracked the shares outstanding over Cisco's lifetime. This should give us some insight on the rate and consistency that Cisco has been repurchasing its shares.

CSCO Shares Outstanding Chart
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CSCO Shares Outstanding data by YCharts

Note that the left half of the chart represents Cisco's shares outstanding prior to the start of the buyback program. As of Q3, Cisco has 5.361 billion diluted weighted average shares outstanding (YTD for FY'13). Taking dilution into account, there are 1.835 billion less shares (a decrease of 25.5%) since the program began in FY'02. At CSCO's current price, the program's $4.3 billion remaining authorized amount is enough to buy back 179.5 million shares, which would have an anti-dilutive effect of 3.3%.

Although shares outstanding have decreased by 1.835 billion, this number is roughly half (48% to be exact) of the 3.8 billion shares that the company has repurchased during the program's lifetime. Perhaps what's even more disturbing, is that despite spending $1.36 billion on share repurchases during the last two quarters, Cisco's shares outstanding have increased by 53 million shares. Although this dilution only amounts to 1%, investors should keep a keen eye on the company's compensation practices, which have been the primary reason for the offsetting effect on shares outstanding.

Cisco needs to prove that the purpose of its multi-billion dollar buyback program is exactly what is advertised -- to benefit the shareholders. Although the program has certainly created value over its lifetime, more than half of the potential value creation was eaten away, leaving investors wondering if the program's purpose is to act as a buffer for the fattening wallets of Cisco's top-tier employees. The Quarterly Report for FY'13 Q2 revealed a balance of 419 million stock options outstanding. Of the total amount of options outstanding, 295 million have an exercise price below $25, meaning that most of these options will likely be exercised in the coming months. Unless Cisco decides to ramp up the authorized amount for its stock repurchases, the buyback program currently seems like a hedge against the risk of over-dilution, rather than a way for the company to return cash to its shareholders.

What are the experts saying?

Last week, CSCO's price target was increased by a number of different analysts. Below is a screenshot of the analyst activity that took place.

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Screenshot from FinViz

Looking at both the ratings and price targets, it's not difficult to see that analysts are becoming increasingly bullish on Cisco. One item of particular interest is Barclays' new price target of $28. This represents a $4 increase from the $24 price target that was active prior to April 1.

Some of the pros haven't exactly been shy about their love for the stock either. Two weeks ago, money manager Ken Fisher wrote a column in Forbes that explained why Cisco is fundamentally cheap:

"Cisco Systems is an overblown, 1990s-highflier, takeover-crazy tech wreck that is now a big, cheap, value stock--growing moderately with technology solutions spinning virtually everything we do in communications. Without it we don't grow. With a $116 billion market cap, 72,000 employees and $46 billion in revenue, it sells at a mere 11 times my July 2013 earnings--with a 2% dividend yield."


Although Cisco has been largely ignored for much of the past 10 years, the market is finally starting to show signs of recognizing the value of the industrial giant. And despite a post-Q3 "pop" of nearly 13%, I believe its value is far from being fully recognized. Considering its undervaluation, expected earnings growth, and a dividend that will likely continue to grow, Cisco is a great buy for patient, long-term investors.

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.