Cisco Should Be Upgraded, Not Downgraded

| About: Cisco Systems, (CSCO)
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Barclays wrongly downgraded Cisco to equal weight with a $23 price target.

The dividend and buyback will support shares at current levels, and Cisco can return $50+ billion over 4 years.

There is evidence of a turnaround with stabilization at legacy units and growth in security, wireless, and cloud units.

Investors should buy now before the turnaround becomes self-evident and the good news is priced in.

On Tuesday, Barclays (NYSE:BCS) downgraded shares of Cisco (NASDAQ:CSCO) to equal weight with a price target of $23. Shares were previously rated overweight with a $25 target (details available here). The stock shrugged off this news to finish higher by about 0.56% on the session perhaps because that downgrade is not all that negative. Shares currently trade at $21.63, meaning there is 6.3% price upside. Combine that with a 3.5% yield, and investors would generate a solid, if unspectacular, return over the next 12 months. Essentially, shares of Cisco are so incredibly cheap on traditional valuation metrics that it is hard to see the price falling over the next 12 months. With so much negative sentiment, Cisco remains a very attractive long.

In 2010, Cisco did not pay a dividend, but it now pays out $0.19 every quarter for that solid 3.5% yield. As a consequence, some income investors will own Cisco as a bond equivalent stock. This should provide some support for shares going forward. Importantly, Cisco is only paying out a portion of earnings as it should earn about $2.00 per share in this fiscal year (all financial and operating data used in this article is available here). Cisco is only paying out 38% of its earnings power. After years of dilutive options, Cisco has finally gotten serious about share repurchases. It had previously authorized a $15 billion buyback, and it bought back about $4 billion just in the last quarter.

Over the next nine months, I expect Cisco to complete this share repurchase, which would cut the share count by 12% on a gross basis. Under $23, Cisco has been aggressively repurchasing shares, which should provide further support at these levels. Importantly, Cisco has the financial strength to return this much cash to shareholders. As of last quarter, it held $47 billion in cash against $17 billion in debt, though most of this cash is trapped overseas. As a consequence, Cisco has been selling debt to repurchase shares. Share repurchases are cutting Cisco's $30 billion net cash hoard by adding debt rather than eating away at gross cash.

Given low interest rates, this is a feasible strategy. In fact with a 3.5% dividend yield, it can be cash accretive as interest expense is tax deductible. As long as Cisco is borrowing at less than 5.4%, this strategy will actually be cash accretive. Its recent $8 billion offering saw yields of 1.1-3.625% (details available here). With solid credit ratings (AA- from S&P and A1 from Moody's), Cisco will be able to borrow at a cash accretive level for the foreseeable future. Once the U.S. modernizes its tax code, Cisco can bring its offshore cash back to the U.S. to pay any debt. While I do not expect tax reform in the next 12 months, I do expect it within the next five years.

Given its excessive net cash position, Cisco can certainly afford to add to its debt to buy back stock and cut the share count with the price so low. Importantly, Cisco will also generate $11 billion in global free cash flow this year, so its net cash position will only decline by about $6-8 billion over the next twelve months. Between the dividend and buyback, Cisco is returning about $18 billion this year. It could maintain that pace for over 4-5 years before becoming a cash-neutral company. Even then, its strong free cash flow generation will permit very large capital returns. Over the next 4 years, Cisco is poised to return at least $50-60 billion to shareholders or about 50% of its market value. These actions will provide significant support and upside to shares.

In the current world, investors are gravitating towards growth and not cash flow generation or valuation. As long as that persists, Barclay's could be right that Cisco is range bound. Barclays believes that Cisco faces secular headwinds and that investors should wait for the company to turn around and profit from its investment in cloud products. By the time this happens though, shares will be higher, likely $25 per share. On an ex-cash basis, Cisco is trading at roughly 8x earnings. If the company completes a successful turnaround, shares will command a significantly higher multiple. Simply put, if you believe Cisco can complete its turnaround, you want to buy shares while there is still some bad news. At the same time, investors do have to be concerned Cisco is dragged down by legacy businesses and can never grow revenue again.

While Cisco is certainly in the midst of its transformation, the evidence suggests its business is improving. Admittedly, the set-top box unit is a disaster with revenue down 22% last quarter and orders down 20%. Cisco is diversifying away from this business, but it will likely never turn around. Otherwise, future orders are outpacing revenue in its switch and router businesses, which suggest they should bottom sometime around the summer to fall. Commoditization is a concern with product gross margins down to 48.7%, but Cisco's growth units are taking off with orders at the security unit up 30%. Meraki is doubling in size, which should push wireless revenue up over 10% while data center revenue is up over 30% thanks to market share gains. Cisco has also shown more emerging market resiliency than peers though NSA revelations have dragged down everyone. Orders were down 3%, which is a significant improvement from the previous quarter's 12% drop.

Cisco's operations continue to be a mixed bag; that is why shares are 8x earnings. However, there are signs we are approaching a turn. Legacy businesses are starting to near a bottom (with the exception of set-top boxes) and growth businesses like wireless, security, and cloud are showing substantial growth prospects. While risks remain especially if there is an unexpected drop in global growth, Cisco is starting to get its house in order. With large capital returns, a strong balance sheet, solid free cash flow, and a very cheap multiple, Cisco is an attractive risk/reward investment here.

The time to downgrade Cisco was a year ago, and Barclays is late to do so now. By the time Cisco's turnaround takes hold, shares will be appreciably higher and could command a multiple of at least 12x. Investors do well to buy before all the good news is evident. Cisco's aggressive dividend and buyback policy should provide a floor for shares in the $21 region while further improvements in its operations will push shares back towards $25. Now is the time to buy, not sell, Cisco.

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.