M&A Speculation, Trump And What It All Means For Cisco's Future

| About: Cisco Systems, (CSCO)

Summary

Cisco’s revenues have been tepid in recent years largely as a result of slower corporate IT spending.

Cisco may be attempted to goose its growth through the acquisition of players in growth markets like hyper-converged infrastructure.

This would be a mistake that could spur a price retrenchment – and an opportunity for investors to buy the stock cheaply.

Ultimately, the real "growth" from Cisco may come from an old-fashioned tax cut. In our view, the market has yet to bake-in Trump’s planned tax cut.

Analysis

Can Cisco Buy Itself Out of a Rut?

Cisco (NASDAQ:CSCO) has been in a bit of a rut these past 12 months: its revenue has contracted by 0.2% due to a slowdown in corporate IT spending. Moreover, Cisco's top line has grown by just 4.2% in the last five years, which is less half the growth rate of 10.8% in the five years preceding that.

Things aren't expected to get immediately better either: Cisco's guidance for is fiscal Q2-2017 (the results of which it will report in mid-February) is for its top line to fall by 2% to 4% compared to the same period a year earlier.

With HP Enterprise (NYSE:HPE) acquiring SimpliVity, a former tech "Unicorn" at a "discounted" price of $650 million (that is, compared to SimpliVity's 2015 valuation of $1+ billion), there is speculation that Cisco might put in a bid for Nutanix (NASDAQ:NTNX) in order to give its fledgling hyper-converged infrastructure segment, HyperFlex, a leg up on the competition. HyperFlex was expected to generate close to $2 billion in revenue for Cisco in 2016 and to $4.8 billion by 2019.

A Top Dividend Yield

Despite its recent revenue slowdown, astute dividend investors view Cisco differently. Cisco just happens to be the second-highest yielding stock among Dow Jones Industrial Average components with an expected annual dividend yield of 3.5%.

This yield not only compares favorably to the average of the Dow Stocks (current around 2.75%), it is also significantly higher - nearly double - the yield of the S&P 500, which also includes Cisco among its components. Investors are thus looking at $400 in passive annual income from holding $10,000 worth of Cisco stock - compared to earning just $206 from an S&P500 dividend-tracking ETF.

To Nutanix and Beyond?

Nutanix has reported around $307 million in revenue in the past two quarters (it listed in September 2015) and reported $445 million in fiscal 2017. Its revenues have grown by an average of 87% in the last two years but its Q1 revenues were at $167 million, which works out to $668 million on an annualized basis (for 50% growth).

Nutanix has a market capitalization of $4 billion so if Cisco bought it at market, it would be paying around 6-times Nutanix's forward revenue. That would be a huge premium to the industry median of around 2.3 price sales. There's also the elephant in the room - why pay 6-times forward revenue for a company when your own competing product already generates around 3-times revenue? In short, why should Cisco pay $4 billion for the privilege of adding 25% in revenues to a product line that accounts for no more than 5% of the company's overall revenue?

Given this, a Nutanix investment is probably a non-starter for Cisco - the price is too steep for an incremental boost to revenue - even on a purely additive basis, Cisco would only be looking at a 1.35% revenue pick up based on Nutanix's annualized first quarter numbers. Even if its revenues were to grow to $1 billion this year, that would only represent a 2% sales addition for Cisco - barely enough to cover the low-end of its revenue decline guidance. This would be a waste of shareholders' capital.

In our view, investors should be very skeptical of talk regarding Cisco and Nutanix - at this point, it doesn't make much sense from a business perspective and smacks of "me too" in the face of HPE's acquisition of SimpliVity. That being said, if Cisco were to buy Nutanix and subsequently fall in value, it could represent an opportunity for investors to buy the stock cheaply.

The Trump Effect

Cisco's stock is off to an inauspicious start to 2017, with the stock down by over 1% in the early going. Unlike companies in the oil and financial services industries, there's seemingly no immediate positive effect for Cisco from a Trump presidency - in fact, it's been down by over 4% since Trump won the election.

Of course, this overlooks the impact that Trump's tax plan could have on Cisco. In its fiscal 2017 first quarter, Cisco reported that its effective tax rate was 22% - and its forward guidance provisions for a 21% tax rate - but this includes other taxes on revenues from other jurisdictions (40% of Cisco's revenues are from outside the United States) so it's highly likely that a cut in its US tax rate could bring its effective down by 300 to 400 basis points.

Cisco reported pre-tax income of 2.95 billion in its fiscal 2017 first quarter and taxes of $631 million. A 300-basis point reduction in its effective tax rate would have meant tax savings of nearly $89 million - or roughly $0.017 in additional earnings - that equates to an annualized earnings-per-share (EPS) bump of nearly $0.07 per share. While that seems inconsequential, it's anything but that from the perspective of Cisco's investors. To wit, the current average analyst's estimate for Cisco is for EPS of 2.37 per share in the current fiscal year - or just $0.01 better than the previous fiscal year. Thus, if our estimate proves accurate Trump's tax plan could have the effect of increasing Cisco's EPS growth seven-fold.

Conclusion

Cisco is currently trading at an attractive 14.4-times trailing earnings and given its tepid earnings outlook for 2017, its forward ratio is the same as its trailing ratio. This means that Cisco is trading at a discount to Dow and S&P 500, both of which are trading at around 18-times their forward earnings estimates.

However, if we consider the potential tax savings for Cisco, we could see a scenario where its earnings rise to $2.43 just from a more favorable tax rate. If we apply a 15-times ratio to this, we get a target price of $36.45 per share, which is 21% better than the current market price. In absolute terms, our price target is only somewhat higher (around $3 per share) than the 1-year consensus target of $33 per share.

Ultimately, even in "steady state" where the only "earnings" pick up comes from lower taxes, Cisco represents good value for dividend investors. They're looking at a blue chip that has a dividend yield of 3.5% that, with just a slight tweak to taxes, could provide a total return of 25%. What's not to like?

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

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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.

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