Cisco: Why Does It Make Sense?

June 14, 2011
website: www.cisco.com
CMP: $15/Share; Value: $21/Share

Strongly advise Cisco, it is rare that such blue chips are available at large discounts but such are the whims of markets

Whats Cisco Into?
Cisco Systems is the world’s largest networking company and about 9 times the size of its nearest competitor Juniper Networks. The company designs, manufactures, and sells IP-based networking and other products related to the communications and IT and provides services associated with these products and their use. Cisco provides a broad line of products for transporting data, voice, and video within buildings, across campuses, and around the world. The firm’s products are designed to transform how people connect, communicate, and collaborate. Cisco’s products, which include primarily routers, switches, and other advanced technology products, are installed at large enterprises, public institutions, telecommunications companies, commercial businesses and personal residences.
Historical Performance
Exhibit: Historical Performance

During the previous 6 years, FY05 to FY10 Cisco has grown its business primarily led by acquisitions. During this period

• Sales grew at 11%
• Average EBIDTA from operating sources was 26%
• Operational Cash Earnings post maintenance capex was 28%
• Average ROCE (EBIDTA/Capital Employed) stood at 23%
• Average ROE stood at 33%

Quite impressive for a company of its size.
During this period,

• Cisco earned $ 55.8 Bn for its shareholders
• Raised $ 16.7 Bn through Debt

And

• Used $20.3 (28%) Bn for funding growth and acquisitions
• Repurchased stock worth $32.8 Bn (45%)
• Parked $19.5 Bn (27%) in Liquid Investments 

Cisco has a massive and strong balance sheet with ~$40 Bn in Cash and equivalents. It has started paying Dividends which at current prices yield 1.5% - Not bad!
Management
John Chambers has been at the helm since 1995. He has developed Cisco into a world-class firm under his leadership. Recently there were concerns about the succession plan. Cisco has about 6 executives who are CEO ready. But the problem it seems is that Chambers has announced that he will continue to run the company for another 3 to 5 years. It will be difficult to retain top talent for that long. And recently two of them quit to join other firms. Investors also want to see change at Cisco sooner than later. I don't know when the change will happen but two things gives me confidence. One, Chambers will not do much wrong till he is around and secondly, it has a strong line of CEO ready executives. So whenever it happens, it will be a positive discontinuity.
Prospects
Cisco is in a growing segment. Requirements for data transfer is only going to penetrate deeper going forward. New technologies will keep emerging so that more and more people and businesses can be on the network. Gartner, Datamonitor and like estimate significant growth in opportunities like global mobile video and cloud services. Cisco has operations in several emerging economies that are under-penetrated and expected to grow at significantly higher rates.
Recently, Cisco's margins were down - gross margin for Q3FY11 at 61.3% was lower than historical lowest for full year at 63.9% in FY09 since FY03. The two key areas that have been the biggest source of deteriorating gross margin are the switching and government businesses. The switching market is in transition as customers are moving up from 1G to 10G. For Cisco, this transition has meant customers moving from its erstwhile Catalyst 6500 product to the newer Nexus product. There was a glitch in this transition and Cisco acknowledges that Nexus has under-performed expectations. In response to that and increasing competition from HP it launched a series of new products. It has been one of the largest product refresh in its history. Cisco is ready as before to grow switching business. Another concern it has is cut down of government's budgets. But in order to bring in long term efficiency government will be forced to go in for increased digitization. Though, the present might appear bleak the outlook is surely encouraging.
I have used very conservative assumptions to project Cisco's financials.
Exhibit: Projections

Some of the key assumptions for making projections are

• Capital turnover rate of 60% as against 75% which means slower growth on new acquisitions
• Sales growth of 5% as against 11% during the previous 6 years
• Operating Cash Earnings at 24% as against 29% in the past
• Dividend growth rate of 10%; little is known about this at present

Valuation
Cisco is in the habit of repurchasing shares ($32.8 Bn during FY05-10) . Even in the ongoing FY, it has repurchased shares upwards of $5 Bn. I think investors should be neutral to repurchases. The reason being that though repurchasing increases stake it reduces claim to cash. Another aspect that I think makes sense to highlight is that not all cash and equivalents that Cisco carries on its books are lying in US. Part of the cash when repatriated to US will attract taxes. The impact of the same I have not worked out but I am assuming that through restructuring US investors will continue to have claim on a large portion of it.
Exhibit: Valuation

I have assumed that terminal growth rate is 0% which means that no new investment / acquisitions will be made to grow business. I have also assumed that company will return all that it earns to shareholders post attaining terminal growth. These are indeed conservative assumptions. Additionally, I have assumed that no repurchase will be effected. Even if it is done, shareholders should be neutral towards this.
The following appears basis above assumptions:

• Cisco's equity value at present is $83 Bn
• Cisco has cash and equivalents of upwards of $40 Bn
• Per share basis, Value is $21
• Margin of Safety is 30%, much higher than recommended 25%

Very Attractive Opportunity to Buy Shares of a Very Strong Company