The Reports of Cisco's Death Are Greatly Exaggerated

By: SumZero Staff | Published: October 08, 2012 | Be the First to Comment

Full cisco systems
Cisco, Inc.

"The reports of my death are greatly exaggerated."

Cisco has multiple hallmarks of a high quality business: a huge installed customer base, high margins, strong returns on invested capital, a solid balance sheet, and prodigious free cash flow generation. Net of its cash, Cisco today trades for roughly 7x EPS (or, inversely, a 15% free cash flow yield). Something here has got to give. Either Cisco's earnings (and free cash generation) are unsustainable, or shares will be revalued as the market gains confidence in Cisco's ability to continue delivering.

Over a 20+ year time frame, Cisco has continued to reinvest its capital at after-tax rates well in excess of 20%. That's what you call a money machine. This past success, though, has hamstrung the Company. Faced with the law of large numbers (>$45bn in current revenue), and market shares in its primary verticals of 50-70%, management finally capitulated to reality recently and took its long-term top line guidance from 10-15% organic growth down to a more reasonable 5-7%.

Skeptics have cried foul, frantically pointing to everything from technology paradigm changes to irrational price competition. These concerns shouldn't be dismissed outright, but I believe that they miss the larger picture. Given its current size, Cisco has necessarily become a proxy for global technology spending trends, give or take a couple of hundred basis points for company-specific execution and technology differential. At 7x EPS, i.e. less than half the market multiple, with virtually every meaningful financial metric (ROIC, ROE, margins, working capital intensity, balance sheet strength) for the Company vastly superior to the broader market, this is an investment that I'm very comfortable with on either an absolute or relative basis.

I don't expect to impress anybody with proprietary insights into the competitive threats posed by software defined networking and virtualization. I don't have anything new to add to the hundreds of sell-side notes routinely posted on every facet of Cisco's financial performance. I'll leave all that to the so-called experts, and let the Company's financial performance speak for itself.

Beware of the nattering nabobs of negativity, whom collectively wring their hands, obfuscate with techno-babble, and proclaim that the Company is losing its competitive edge. Cisco's operating margins, which are north of 24%, and its return on invested capital, which is north of 40%, are both indicative of a business with a sustainable competitive advantage. Moreover, both of these metrics have improved over the trailing 2- and 4-year periods; further evidence that the Company is not losing its competitive edge.

Cisco's size provides it with scale advantages that competitors can not match. Its annual R&D budget of over $5 billion is a multiple of what many of its competitors generate in actual sales. It's spending over 5x what competitors Juniper or Hewlett-Packard are spending to develop competing business lines. With over $30 billion in net cash on its balance sheet, and another $10 billion being generated annually, it can easily afford to purchase disruptive early-stage technologies that it does not develop in-house.

Cisco's management team, led by long-time CEO John Chambers, has done an admirable job transitioning the Company from it's early days of rapid growth to today's slower growth environment. Dividend payout rates have more than doubled over the past 12 months, and management has publicly committed to return at least 50% of the cash that the Company generates to shareholders through either share repurchases or dividends.

At less than 7x current fiscal year earnings, net of its cash, any reasonable combination of continued growth and disciplined capital allocation should drive meaningful multiple expansion going forward.

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