Cisco is a great company.  It is dominant in a large and growing market, albeit a mature one.  It sports very high ROIC (>100% little book definition, and 40%+ including intangibles) and cash flow conversion (>100% net income).  It has a rock-solid balance sheet.  And in my opinion, it is significantly undervalued (6.6x Ebit, 5.2x Ebitda, 5.7x Ebitda-Capex –all TEV/ltm metric).

Thesis

+ Cheap on an absolute and relative basis

+ Substantial scale and scope advantages

+ Leader in a market with net favorable secular growth trends

+ No imminent threat to its market dominance

+ Top notch management team, whose interest is well aligned with that of shareholders

+ Rock-solid balance sheet ($32b net cash)

+ Strong cash flow generation, majority of which goes to share repurchases and dividends

+ Continued share repurchases to meaningfully contract share count in light of a rapidly diminishing stock of options outstanding

Leader’s moat

CSCO is the 800lb gorilla in the switching & routing market.  As such, it enjoys significant economies of scale and scope.  In my view, the most significant is the amount of resources it can afford to channel every year into R&D.  This (and its acquisition capabilities) is what enables CSCO to stay at the leading edge of technology.  Importantly, its R&D budget is a multiple of all of its competitors combined:

R&D expenditures (most recent fiscal year)

CSCO $5.8b

JNPR $1.0b

HPQ $0.7-0.8b (estimate based on rev, op margin, and 3com historical)

BRCD $0.35b

Its installed base ($200b, 50m devices, 6m annual customer interactions) and partner/distributor ecosystem is unrivalled.  More IT people are familiar with CSCO, standards setting, “you won’t be fired for buying CSCO”, etc.

Services are not only a fast-growing and high-margin recurring revenue stream but also an avenue to further its competitive position.

Strong competitive position

CSCO has 70%+ market share.  HPQ and JNPR are relatively distant #2 and #3 respectively.  Further down the food chain, you see BRCD and other niche players.  In Gartner’s magic quadrant matrix (Enterprise LAN), CSCO is clearly the leader.  The leader in this matrix is the most visionary with the strongest execution capabilities (and not necessarily the largest player). HPQ is the only other company in the “leaders” quadrant.  Tellingly, the whole matrix is pretty empty.  It seems to me that a mostly empty matrix combined with HPQ as your major competitor is a relatively benign situation.

Despite recent hiccups, CSCO has not really ceded market share.  If you compare the growth rate over the last few years of the four major players, it is hard to argue that CSCO has lost market share.

The service provider (e.g. telecom) segment’s competition includes Huawei, and ZTE.  These two Chinese companies are relatively new entrants.  CSCO recognizes them as aggressive price competitors in some markets.  In the long term they could become a not insignificant threat.

Despite meaningful competitive pressure, a relatively recent product transition, corporate restructuring, and not insignificant exposure to Europe, fy12 will be a record year for CSCO.

Strong corporate governance

+ The CEO, John Chambers, is the single largest individual shareholder.

+ For all practical purposes, the company stopped granting options four years ago.  Instead, most of management’s compensation is in the form of restricted stock (>90% fy11).  For example, the CEO’s salary is $375k.  The remainder of his compensation is in the form of restricted stock ($12.5m fy11).  This, obviously, is a much better way to align management’s interest with that of shareholders.

+ It initiated a dividend in fy11 and increased it in fy12.

+ It has repurchased large amounts of stock.

A mountain of options is mostly in the rearview mirror

One common criticism of CSCO is that its share count has not decreased in proportion to its massive share repurchase program.  It is a fact that dilution has mitigated to a significant extent the benefits of share repurchases.  However, this is mostly in the past.  Over the last few years, the company has had to issue large quantities of stock to satisfy the mountain of options that resulted from the late 1990s/early 2000s collective delusion that argued that options/stock-based compensation is not an economic cost.  The number of options outstanding peaked in 2006 (~23% of diluted share count).  With the elimination of option grants (and a lower share price), it has naturally seen a steeper decline since July 2008.  As of April 2012 options outstanding are <10% of diluted share count.  Looking forward, about half of the options outstanding as of July 2011 expire within the next year or so (and the last batch of options expires in 2016).  Notably, all of top management’s options outstanding have exercise prices at least 10 percent higher than the current stock price; and the vast majority above $20.  Clearly, a higher stock price is in the interest of senior management.  And for all practical purposes, management “won’t see a dime” before a long position at the current price sees a nice ROI.

A layman’s view of secular trends

Perhaps the two most important trends in the switching & routing market are exponential growth of data traffic and cloud computing.  Obviously, data traffic growth is a positive.  It seems to me that cloud computing is a net positive for market leaders.  On one hand cloud computing adds nodes (data centers) to the network.  This is a positive because each new node needs equipment, a meaningful portion of which is high-end equipment.  On the other hand, data centers not only purchase and use equipment more efficiently but also reduce the equipment intensity of non-datacenter nodes.  In summary:

+ increased volume,

+ premium on leading edge technology

- pricing pressure,

- less favorable mix in aggregate,

Why is it trading at these levels?

There has been a meaningful adjustment to growth expectations and some gross margin compression.  Coming out of the depths of the 2008/2009 financial crisis, management was targeting mid-double digit+ revenue growth.  Recently the growth rate was lowered to 5-7%, for at least for the next couple of years.  The European crisis and weakness in the public sector are the main external factors behind this downward adjustment.  Aggressive competition primarily and a product transition are the main factors behind lower gross margins.  Management expects the competitive environment to remain aggressive.  In turn, it has adjusted its business model to 60-62% gross margin, compared to the 64%+ of the previous decade.

Naturally the stock has been punished.  I don’t think CSCO was priced to grow 15%+ prior to the downward adjustment in guidance.  Notwithstanding, the result of punishment on top of an undemanding valuation has created the current opportunity.

Importantly, the company has mostly completed a restructuring initiative centered on refocusing on its core markets and lowering it expenses.  As a result, operating margins have moved upwards and are pretty much of par with those preceding the financial crisis.  The same is true for “ebitda-capex” margins.

A word on relative valuation

In my view, CSCO is clearly undervalued in absolute terms.  Its FCF yield is 17% ($10b cash from ops-capex/$60b TEV).  It is also inexpensive on relative terms.  It trades at a multiple (of ebitda-capex) that is a fraction of JNPR or BRCD.  Compared to other large tech companies, it is trading at a similar level to HPQ on an ebitda-capex basis, and at a huge discount on FCF yield.  This is clearly myopic.  The quality of the company, its competitive position, the competitive pressures, etc are completely different.  I would argue that a better comp would be INTC; although it is not necessarily cheap and faces much more significant competitive threats.

It seems to me that taking it all into consideration, fair value in this market is somewhere around $25.  This would still be below 10x ebitda-capex and FCF/TEV ~10%.

In terms of macro downside, even if the euro went to US$1.0, I don’t see how the cash generation power of this company would warrant a price below $20.

Additional risks

Key man risk.  I think John Chambers is a top notch CEO.  While the record is not stellar, in balance I think he is in the top 2% or so of CEOs worldwide in terms of bang for the buck.  It is hard for me to name another non-founder/owner CEO of a sizeable company whose cash compensation is <$500k and the rest is restricted stock.  For instance, I have a hard time finding a better CEO among the DJIA components, especially adjusting for amount and structure of compensation.

Service provider consolidation is a negative; especially in accounts susceptible to competition from Huawei et al.  If one considers significant further service provider consolidation a meaningful risk, then shorting AMT could well serve as a hedge to this risk.

Most of the cash pile is outside the US and subject to tax if repatriated –an issue common among large tech companies.

Consistent execution in the form of earnings and guidance (Aug 15 - Q4 and FY12 earnings).