Monday, November 29, 2010

Dominant and Cheap: Cisco Systems

Over the last 10 years, shares of Cisco Systems (CSCO) are down over 60%. But that's not because the company has been eroding shareholder value. Cisco earned $1.33 per diluted share in 2010, whereas it earned 36 cents per share in the year 2000. Yet the stock fell over this 10-year period because it had a P/E of 140 back then; today, Cisco has a P/E (adjusted for its net cash position) of just 10.

Companies with P/E ratios in the single digits or low double-digits usually generate low returns on capital as a result of having no competitive advantage. This is not the case with Cisco, as borne out by the following return* on invested capital (ROIC) data over the last few years:

Before panicking at the apparent downtrend, consider that 1) the absolute numbers are still high, and 2) numbers will be weaker during a recession. These high returns do suggest that Cisco has a moat. Further analysis of the company's core products reveals that Cisco dominates several product lines, in some cases delivering market share numbers north of 70% and even 80%. These kinds of numbers will help Cisco maintain and grow its moat, as it is able to spread R&D spend over a much larger number of units than are its competitors.

Sometimes, companies will also trade at low P/E's because a company's industry is in secular decline (e.g. the newspaper industry). This, too, is hardly the case for Cisco. In fact, it may be just the opposite. Networking needs continue to grow worldwide as populations continue to seek higher and higher bandwidth connectivity for a multitude of devices. Cisco is at the forefront of the network hardware architectures required to make this happen.

Finally, companies also trade at low P/E's because of negative short-term sentiment. That appears to be what's happening here. The company's latest quarterly guidance was below estimates, as Cisco expects just 3-5% year-over-year revenue growth next quarter due in part to government budget cuts, as state and local governments look to bring their fiscal houses in order. This caused the stock to fall some 20% over the last two weeks. But annual revenue growth is still expected to come in between 9 and 12%, suggesting the business is still sound, growing and undeserving of such a low P/E.

Cisco's board agrees, as it has now authorized the company to buy back almost 14% of its outstanding shares. A look at the company's cash flow statements shows that Cisco has been quite willing to return cash to shareholders in this manner, and recent management comments suggest this will continue:

"If you look at what we do, we always purchase the stock during periods when we see it sliding a little bit."

When a company with a sustainable and proven competitive advantage trades at a low P/E, opportunity knocks. Investors with an eye for the long term are likely to do well going long in such situations.

Disclosure: Author has a long position in shares of CSCO

* As there are many formulas to choose from when calculating ROIC, it should be noted that here, ROIC is calculated as OpIncome(1-tax)/(Debt+Equity-Cash)


Water Investor said...

You can say the same thing about Microsoft, and it's even cheaper.
High ROIC, ROE coupled with low EV/Free Cash Flow and low investor sentiment make good risk reward bets.

trevor scott said...

Yes I agree with you here. You might also find Microsoft interesting. Unloved (low PE), great balance sheet, tremendous long term growth historically.

another value investor said...

Thanks for the idea. I do not know much about CSCO but from reading various news sources casually I learn that the company issues considerable amount of stock options to execs and employees. How does the company share buyback compare against stock issuances due to ESOP?

Investments said...

i don't find such large-cap companies which are the core of the wall-street back and forth to provide much in the way of value to a retail investor.

there are far too many preferable investments in the mid-cap/small-cap world which are better suited to the goals of any retail investor than companies like Microsoft and Cisco.

Just my .02

Saj Karsan said...

Hi Water and Trevor,

You guys beat me to the punch; tomorrow's post is about Microsoft.

Hi another,

First, it's important to note that options are expensed, so they reduce the profit numbers quoted already. Second, in the notes to the financials, you can see all the options outstanding, and subtract their value from your valuation of the company. To directly answer your question though, you just have to look at how many shares Cisco has now versus a few years ago (depending on whatever time period you choose). There are currently 5.54B shares outstanding, whereas in 2005 there were 6.33B.

Anonymous said...

Returning equity via dividends is much more shareholder friendly. The buybacks prop up the share prices giving a disproportionate benefit for employee share options.

Anonymous said...

One issue that seems to come up relates to vendor financing (i.e., CSCO inflating sales numbers by financing those sales to customers). This was a big issue during the dot-com years. I'm not sure how to track down the info, however. Was it an issue for you?

Saj Karsan said...

Hi Anon1,

There's a lot of issues at stake between dividends and buybacks. On the other hand, dividends are usually taxed to the investor, so buybacks are more tax-friendly.

Saj Karsan said...

Hi Anon2,

You are right, revenue recognition has been brought up about this company before. But it seems to be a small part of their overall revenue. Anymore, more on that here.

Jay said...

Thanks for the excellent post, as always.
I'm not seeing how you're coming up with your ROIC numbers. Looking at the annual numbers from July of this year (from Morningstar):
Total equity = 44b
Debt (which I think you mean total liabilities-current liabilities) = 17b
OpIncome = 9b

Which gives you a ROIC of ~15%, which is still pretty nice, but not the 30% number you have in your chart.

Saj Karsan said...

Hi Jay,

Note the formula I use (stated in the last line of the post). I think the main difference between our calculations is that I am not including cash as part of the "invested capital".

Nell said...

hi saj,

did you adjust roic for low (-> unsustainable) tax rate?

best wishes,


Saj Karsan said...

Hi Nell,

I used a 22% tax rate, rather than the 17.5% Cisco experienced in 2010. Is the 2010 rate the "unsustainable" rate you refer to, or did you mean something else (e.g. Brazilian operations etc.)

nell said...

yes, i think that we should adjust tax rate at cisco to a normal level (~35-40%) ..i dont think that very low taxes like in irland are sustainable longterm.. furthermore it is a bit unfair to tax one firm with 35% and one firm with 22% ..lets see if we get a material difference:

equity = $44,285
longterm debt = $12,188
excess cash = ~investments = $35,280

opincome = $9,164
tax rate = 40%

roic = $9,164 * 0,6 / ($44,285 + $12,188 - $35,280) = ~25%

anyway, i did a calculation with incremental roic ..FY2009/2010 roiic = ~75% ..looks like very good and profitable growth ;-) is a buy ;-)

nell said...

just as a side note.. "quantitative strategies for achieving alpha" by tortoriello is a great book! ;-)

best wishes,


Rookie said...


I agree. I am long on CSCO since last fall myself. The price is even lower at the time, which offers a continued opportunity in my opinion.

Alistair said...

What about all these management changes? Will Chambers's stabilize this company? See

JP Malone said...

I'm a "IT Architect", and enjoy investing as a hobby. For Value Investors, tech companies can be difficult to valuate & many have offerings that can easily be replicated & improved (e.g. does anyone remember GeoCities, Netscape, Palm, AOL, Gateway, Nortel, etc...).

Cisco; however, jumps out to me as a business with a durable competitive advantage. They truly run the "backbone of the Internet" & no one even comes close to providing competition in the networking world. Now they are poised to take advantage of the inevitable adoption of Cloud computing & for the first time, they have entered the server space, released an impressive lineup that is (IMO) going to take away significant market share in the server space away from IBM, HP, & DELL. As you guys have already mentioned, the ratios & price look good.

As a techie, I'm not as high on MSFT, because virtualization & Cloud are going to make it easy for enterprises to easily switch to alternate operating systems (e.g. MacOS, Google, Linux), mail systems (e.g. Google Apps, Amazon EC2), & cloud will render a ton of MSFT's supporting applications irrelevant.