Cisco CSCO
March 10, 2011 - 7:04am EST by
abra399
2011 2012
Price: 18.12 EPS $1.36 $1.60
Shares Out. (in M): 5,528 P/E 13.2x 11.4x
Market Cap (in $M): 100,167 P/FCF 11.0x 11.0x
Net Debt (in $M): -25,000 EBIT 9,164 8,705
TEV ($): 75,224 TEV/EBIT 8.2x 8.6x

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Description

Cisco (CSCO) is the #1 networking equipment company with high market share in its key businesses, high margins (mid 60s gross margin, mid 20s operating margin), and growth (revenue and EBIT have grown 11% and 12%, respectively, since 2003).  About half the company's revenues are outside of North America, providing investors with significant geographic and currency diversification. 

Street EPS estimates for the year ended 7/31/11 and 7/31/12 are $1.60 and 1.76 respectively.  The company has $4.47 in net cash per share.  At the current $18 stock price, netting out an estimated value of $3.65 for the excess $4.47 per share in cash, CSCO is trading at 9x 2011 Street EPS estimates.  If we adjust the Street estimates for stock option expense and add back non-cash amortization expenses, the shares are trading at about 10x 2011 EPS.   In comparison, the S&P 500 currently trades for over 15x 2011 EPS.

The company is facing macro-economic headwinds and increasing competitive pressures which are likely to impact margins and growth.  However, given the company's long history of profitable growth, the diversity of the business in terms of product and geography, and the company's high margins/market share in a growing industry, the valuation today is attractive.

For our target price, we apply a 14x multiple to the $1.60 of 2011 earnings and add back $3.65 of cash.  Our target is $26, up over 40% from today.  At today's price, we view our downside potential at around $15, for an attractive upside/downside ratio.  

The company has repurchased ~$65B of stock in past decade. Even after adjusting for an $11B of cash stock expense due to issued shares over this period of time, the amount of substantial.  Last November, they authorized an additional $10B for buybacks.  The company places buybacks front and center in its press-releases, which is a good sign in our view.  From the most recent earnings release: "During the second quarter of fiscal 2011, Cisco repurchased 89 million shares of common stock under the stock repurchase program at an average price of $20.15 per share for an aggregate purchase price of $1.8 billion. As of January 29, 2011, Cisco had repurchased and retired 3.3 billion shares of Cisco common stock at an average price of $20.81 per share for an aggregate purchase price of approximately $69.3 billion since the inception of the stock repurchase program. On November 18, 2010, Cisco's board of directors authorized up to $10 billion in additional repurchases of its common stock under the stock repurchase program, increasing the authorized amount of aggregate stock repurchases to $82 billion. The remaining authorized amount for stock repurchases under this program, including this additional authorization, is approximately $12.7 billion with no termination date."

The company is planning a new dividend.  While they have not had one in the past, they are planning to initiate a 1-2% dividend yield in 2011.  This may be a mild positive for the company.

There is abundant research on the company which we suggest you review.  We provides some of our notes below, but would welcome any comments or questions as this is one of the prime advantages of VIC.

Notes:

General notes:

  • Notes on cash - $37B of $40B in cash is outside the US.  The company, along with others, is trying to get the US government to allow for the repatriation of cash at a low tax rate.  The US allowed repatriation at 5.25% tax rate in 2004 to help stimulate the US economy and the US dollar.  There's a good chance this will happen again.  To estimate fair value of the cash we take 60% chance that it is taxed at 10%, and 40% chance it is taxed at 35%, for an estimated fair value of about $3.65. 
  • Well-known investors such as Passport Capital, First Eagle Advisors, Appaloosa, Pennant all hold positions, and this is the largest addition to ESL (Eddie Lampert's fund) in the most recent quarter.  Readers of this website will also appreciate the fact that CSCO is one of the cheapest large cap "Magic Formula" stocks. 
  • It's interesting to think that when VIC was started in 1999, CSCO had a $200B market cap, little cash, sales of 12B, EBIT of ~3.5B.  Back then it earned 40-50c per share and traded up from the $20s in 1998 to $80 at the peak in March 1999.  Ten years later, sales are up to $42B, the company has $25B in net cash, EBIT is up to $9B, and the market cap is half of what it was ten years ago. 

Business quality - margins, market share, growth

  • High Stable Gross/Operating Margins:  
    • Gross Margins: 60-70% the past decade; currently down to 62-63% from 65% last year. 
    • Operating Margins: 25-31% since 2003; currently 25%, down from 29% last year.
  • High Market Share/Margins in Core Switching/Router Businesses:
    • Ethernet Switch: Currently 72% of ~$18B market = 13B (32% of 2010 revenues).  Market share grew from 63% in 2001 to 75% in 2007; has declined to 72% since. 
    • Service Provider Router: Currently 48% of $7.6B market = 3.7B (9.7% of 2010 revenue).  Was 72% of $4.5B market in 2001; flat share last 2 years but otherwise declined since 2001.
    • Enterprise Router: Currently 83% of $3B market = 2.5B (6.3% of 2010 revenue).  Was 92% of $4.6B market in 2001, but flat past few years. 
    • Switching/Routing: 47% of 2010 revs + the majority of the 7.6B (20%) of service revenues.
  • Regarding margins: Switching thought to be ~75% and routers 65-75% gross margins.
  • High historical growth in revenue and earnings:
    • Revenue and EBIT have compounded by 11% and 12%, respectively, since 2003, 8% and 9% compounded since 2000.  ($20B+ in acquisitions has driven significant part of growth).
    • EPS has grown 15% compounded since 2003.  
  • Growing recurring service revenues: ~21% of revenues; support contracts generally over life of product.  15% growth past decade and increasing growth/gross margins (67% currently).
  • Company growth estimates: 
    • 12-17% long term revenue growth targets; this proved too optimistic and was reduced to 9-12% (low end) for 2011 in latest quarterly release.  
    • Significant growth opportunities were noted.  Some of the growth opportunities include:
      • Market expected growth: 9-10% (Switching: mid-single digits, Routing: high single digits, Services: low double digits, Advanced Technology/Other: low teens); 3rd party estimates.
      • Gain in share of wallet: 3-4% due to Virtualization/Cloud/Collaboration/Video.
      • Emerging Countries: 0-1% and Market Adjacencies: 0-2%
    • Other notes on growth drivers:
      • Video: Video is expected to increase IP traffic by 4x from 2009 to 2014.  Video will make up 90% of traffic by 2013.  400% increase in web-enabled devices.
      • Virtualization/Cloud: 25% of network IT growth driven by virtualization through 2014.  $50B addressable market over next 3-5 years (~37B in FY10).
      • Collaboration: $38B market opportunity in 2 years; 108% CAGR from 2009-2014.
    • Before hitting recent speed bumps the past two quarters John Chambers said he was the most optimistic he's ever been due to the many opportunities for growth.

Bear case

  • The bear case is that the weakness in the past two quarters is a sign of permanent decline in margins/growth rate.  To put this into context we have the following thoughts:
    • What happened in Q1: Lowered guidance for FY2011 from 12-17% rev growth to 9-12% as Q2 will be weak due to "air pocket" in Public Sector and Service Provider (Cable/Set-Top Boxes).  Expect weakness in cable set-top boxes in US and Canada to continue for several quarters.
    • What happened in Q2: Guidance for FY2011 will be at low end of 9-12% growth; wouldn't comment on long-term growth rates.  Product gross margins were down 290bps quarter on quarter in the past quarter with switching contributing 100bps of this; 7% drop in switching revenue.  Guided to continued weakness in Q3/Q4; 62-63% gross margins, down from 65%+.  Weak public sector: Expect a rapid decrease in discretionary IT spending in the majority of governments. 
  • The decline in the margins is due to increasing competition from HP/Juniper/Huawei/etc. which will continue to erode the business.  Some analysts are arguing that there is a paradigm shift underway to having "best-of-breed" devices in network instead of end-to-end architectural solution.  
    • HP: has gained some share in switching, but it is primarily in low-end low margin solutions for colleges and small businesses and doesn't really compete with Cisco's high-end high-margin switches and routers.
    • Juniper: has some high-end products, but lacks an end-to-end solution/architecture. 
    • Huawei: has made some inroads, particularly in Service Provider Routers, and will likely continue to be a threat as a price-focused competitor, but primarily plays in the low end market; Cisco grew Asia-Pacific by 27% year-over-year which is Huawei's strongest area.  
    • Public sector weakness: Public sector spending has always been unpredictable in the short term; can have rapid decreases in discretionary IT spending by govts/municipalities when there is economic weakness; however Cisco is not losing market share and generally experiences a "catch-up" period following pullback, as the networking equipment is necessary.
    • Router/Switch Weakness: Cisco is undergoing a number of product transitions to new generation at once, which is causing lower margins during this period; new products have higher price performance (double the performance for same price) and thus lower margin during early life.  CSCO hsa never had this many products transitioning at once.
    • Best-of-breed versus end-to-end architecture: Some argue that standardization is driving an adoption of best-of-breed products, resulting in an unbundling effect for Cisco.  However, networks are getting more complex and require a full architectural solution.  Cisco generally has many-year relationships with its customers and works closely with them in determining their product/architectural roadmaps, incorporating requested features into designs.  Proof of this is the rapid growth in service revenues (now 21% of revenues) in recent years; this wouldn't be the case if networking devices were becoming "plug-and-play."
  • Our overvall view of the bear case is that it is legitimate, but currently reflected in the stock price.

Catalyst

  • Continued stock buybacks and dividends
  • Gross margin decline stabilizes and reverses as router/switch margins grow following ramp up of new product lines
  • US allows repatriation of offshore at a low tax rate; would likely be precursor to large share buyback and dividend increase
  • Increased public sector spending following next couple quarters of weakness.
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    Description

    Cisco (CSCO) is the #1 networking equipment company with high market share in its key businesses, high margins (mid 60s gross margin, mid 20s operating margin), and growth (revenue and EBIT have grown 11% and 12%, respectively, since 2003).  About half the company's revenues are outside of North America, providing investors with significant geographic and currency diversification. 

    Street EPS estimates for the year ended 7/31/11 and 7/31/12 are $1.60 and 1.76 respectively.  The company has $4.47 in net cash per share.  At the current $18 stock price, netting out an estimated value of $3.65 for the excess $4.47 per share in cash, CSCO is trading at 9x 2011 Street EPS estimates.  If we adjust the Street estimates for stock option expense and add back non-cash amortization expenses, the shares are trading at about 10x 2011 EPS.   In comparison, the S&P 500 currently trades for over 15x 2011 EPS.

    The company is facing macro-economic headwinds and increasing competitive pressures which are likely to impact margins and growth.  However, given the company's long history of profitable growth, the diversity of the business in terms of product and geography, and the company's high margins/market share in a growing industry, the valuation today is attractive.

    For our target price, we apply a 14x multiple to the $1.60 of 2011 earnings and add back $3.65 of cash.  Our target is $26, up over 40% from today.  At today's price, we view our downside potential at around $15, for an attractive upside/downside ratio.  

    The company has repurchased ~$65B of stock in past decade. Even after adjusting for an $11B of cash stock expense due to issued shares over this period of time, the amount of substantial.  Last November, they authorized an additional $10B for buybacks.  The company places buybacks front and center in its press-releases, which is a good sign in our view.  From the most recent earnings release: "During the second quarter of fiscal 2011, Cisco repurchased 89 million shares of common stock under the stock repurchase program at an average price of $20.15 per share for an aggregate purchase price of $1.8 billion. As of January 29, 2011, Cisco had repurchased and retired 3.3 billion shares of Cisco common stock at an average price of $20.81 per share for an aggregate purchase price of approximately $69.3 billion since the inception of the stock repurchase program. On November 18, 2010, Cisco's board of directors authorized up to $10 billion in additional repurchases of its common stock under the stock repurchase program, increasing the authorized amount of aggregate stock repurchases to $82 billion. The remaining authorized amount for stock repurchases under this program, including this additional authorization, is approximately $12.7 billion with no termination date."

    The company is planning a new dividend.  While they have not had one in the past, they are planning to initiate a 1-2% dividend yield in 2011.  This may be a mild positive for the company.

    There is abundant research on the company which we suggest you review.  We provides some of our notes below, but would welcome any comments or questions as this is one of the prime advantages of VIC.

    Notes:

    General notes:

    • Notes on cash - $37B of $40B in cash is outside the US.  The company, along with others, is trying to get the US government to allow for the repatriation of cash at a low tax rate.  The US allowed repatriation at 5.25% tax rate in 2004 to help stimulate the US economy and the US dollar.  There's a good chance this will happen again.  To estimate fair value of the cash we take 60% chance that it is taxed at 10%, and 40% chance it is taxed at 35%, for an estimated fair value of about $3.65. 
    • Well-known investors such as Passport Capital, First Eagle Advisors, Appaloosa, Pennant all hold positions, and this is the largest addition to ESL (Eddie Lampert's fund) in the most recent quarter.  Readers of this website will also appreciate the fact that CSCO is one of the cheapest large cap "Magic Formula" stocks. 
    • It's interesting to think that when VIC was started in 1999, CSCO had a $200B market cap, little cash, sales of 12B, EBIT of ~3.5B.  Back then it earned 40-50c per share and traded up from the $20s in 1998 to $80 at the peak in March 1999.  Ten years later, sales are up to $42B, the company has $25B in net cash, EBIT is up to $9B, and the market cap is half of what it was ten years ago. 

    Business quality - margins, market share, growth

    • High Stable Gross/Operating Margins:  
      • Gross Margins: 60-70% the past decade; currently down to 62-63% from 65% last year. 
      • Operating Margins: 25-31% since 2003; currently 25%, down from 29% last year.
    • High Market Share/Margins in Core Switching/Router Businesses:
      • Ethernet Switch: Currently 72% of ~$18B market = 13B (32% of 2010 revenues).  Market share grew from 63% in 2001 to 75% in 2007; has declined to 72% since. 
      • Service Provider Router: Currently 48% of $7.6B market = 3.7B (9.7% of 2010 revenue).  Was 72% of $4.5B market in 2001; flat share last 2 years but otherwise declined since 2001.
      • Enterprise Router: Currently 83% of $3B market = 2.5B (6.3% of 2010 revenue).  Was 92% of $4.6B market in 2001, but flat past few years. 
      • Switching/Routing: 47% of 2010 revs + the majority of the 7.6B (20%) of service revenues.
    • Regarding margins: Switching thought to be ~75% and routers 65-75% gross margins.
    • High historical growth in revenue and earnings:
      • Revenue and EBIT have compounded by 11% and 12%, respectively, since 2003, 8% and 9% compounded since 2000.  ($20B+ in acquisitions has driven significant part of growth).
      • EPS has grown 15% compounded since 2003.  
    • Growing recurring service revenues: ~21% of revenues; support contracts generally over life of product.  15% growth past decade and increasing growth/gross margins (67% currently).
    • Company growth estimates: 
      • 12-17% long term revenue growth targets; this proved too optimistic and was reduced to 9-12% (low end) for 2011 in latest quarterly release.  
      • Significant growth opportunities were noted.  Some of the growth opportunities include:
        • Market expected growth: 9-10% (Switching: mid-single digits, Routing: high single digits, Services: low double digits, Advanced Technology/Other: low teens); 3rd party estimates.
        • Gain in share of wallet: 3-4% due to Virtualization/Cloud/Collaboration/Video.
        • Emerging Countries: 0-1% and Market Adjacencies: 0-2%
      • Other notes on growth drivers:
        • Video: Video is expected to increase IP traffic by 4x from 2009 to 2014.  Video will make up 90% of traffic by 2013.  400% increase in web-enabled devices.
        • Virtualization/Cloud: 25% of network IT growth driven by virtualization through 2014.  $50B addressable market over next 3-5 years (~37B in FY10).
        • Collaboration: $38B market opportunity in 2 years; 108% CAGR from 2009-2014.
      • Before hitting recent speed bumps the past two quarters John Chambers said he was the most optimistic he's ever been due to the many opportunities for growth.

    Bear case

    • The bear case is that the weakness in the past two quarters is a sign of permanent decline in margins/growth rate.  To put this into context we have the following thoughts:
      • What happened in Q1: Lowered guidance for FY2011 from 12-17% rev growth to 9-12% as Q2 will be weak due to "air pocket" in Public Sector and Service Provider (Cable/Set-Top Boxes).  Expect weakness in cable set-top boxes in US and Canada to continue for several quarters.
      • What happened in Q2: Guidance for FY2011 will be at low end of 9-12% growth; wouldn't comment on long-term growth rates.  Product gross margins were down 290bps quarter on quarter in the past quarter with switching contributing 100bps of this; 7% drop in switching revenue.  Guided to continued weakness in Q3/Q4; 62-63% gross margins, down from 65%+.  Weak public sector: Expect a rapid decrease in discretionary IT spending in the majority of governments. 
    • The decline in the margins is due to increasing competition from HP/Juniper/Huawei/etc. which will continue to erode the business.  Some analysts are arguing that there is a paradigm shift underway to having "best-of-breed" devices in network instead of end-to-end architectural solution.  
      • HP: has gained some share in switching, but it is primarily in low-end low margin solutions for colleges and small businesses and doesn't really compete with Cisco's high-end high-margin switches and routers.
      • Juniper: has some high-end products, but lacks an end-to-end solution/architecture. 
      • Huawei: has made some inroads, particularly in Service Provider Routers, and will likely continue to be a threat as a price-focused competitor, but primarily plays in the low end market; Cisco grew Asia-Pacific by 27% year-over-year which is Huawei's strongest area.  
      • Public sector weakness: Public sector spending has always been unpredictable in the short term; can have rapid decreases in discretionary IT spending by govts/municipalities when there is economic weakness; however Cisco is not losing market share and generally experiences a "catch-up" period following pullback, as the networking equipment is necessary.
      • Router/Switch Weakness: Cisco is undergoing a number of product transitions to new generation at once, which is causing lower margins during this period; new products have higher price performance (double the performance for same price) and thus lower margin during early life.  CSCO hsa never had this many products transitioning at once.
      • Best-of-breed versus end-to-end architecture: Some argue that standardization is driving an adoption of best-of-breed products, resulting in an unbundling effect for Cisco.  However, networks are getting more complex and require a full architectural solution.  Cisco generally has many-year relationships with its customers and works closely with them in determining their product/architectural roadmaps, incorporating requested features into designs.  Proof of this is the rapid growth in service revenues (now 21% of revenues) in recent years; this wouldn't be the case if networking devices were becoming "plug-and-play."
    • Our overvall view of the bear case is that it is legitimate, but currently reflected in the stock price.

    Catalyst

    • Continued stock buybacks and dividends
    • Gross margin decline stabilizes and reverses as router/switch margins grow following ramp up of new product lines
    • US allows repatriation of offshore at a low tax rate; would likely be precursor to large share buyback and dividend increase
    • Increased public sector spending following next couple quarters of weakness.

    Messages


    Subjectgocanucks and shoshin
    Entry03/11/2011 01:17 PM
    Membercxix
    I'm not an expert on the networking industry by any means, but where do you guys think "normalized" margins for Cisco will fall to? Will they halve? The way I see it, you have a 99bn market cap company with more than 25bn in net cash generating 10bn in cash flow a year, buying back 7-8bn in stock a year. So say that cash flow halves gradually over the next 10-15 years. At what stock price does that still result in a decent IRR? Even declining businesses in today's market trade at 8x earnings. And is it even realistic to say that cash flows will halve when the overall network equipment market is growing at 8-10% a year and management is targeting at least that level of top-line growth?
    Also, can you explain why your competition-related arguments wouldn't affect Juniper equally? Juniper runs gross margins even higher than Cisco, and yet the market gives it a 36x earnings multiple. Is there any reason to believe that Juniper is cost-advantaged in manufacturing vs. Cisco over the long-run? Or otherwise advantaged?
    Thanks.  
    Full disclosure: I don't own a position here but am obviously sympathetic and sniffing around.

    SubjectMoat
    Entry03/11/2011 02:13 PM
    Memberstraw1023
    I was surprised to see people giving this idea a 3, and I would like to hear from the bears about the moat. As cxix gets at, in order to be short this at 8x, you must believe the moat is going to collapse, not simply fade away.
    I see Cisco where MSFT was a few years ago (when stock was at $20). My feeling is that the demise of their moat is greatly exaggerated on their core (router/switch) product line. Yes, you can buy alternative solutions for a fraction of the price, but this has always been true of almost all digital moats. And has certainly been true of routers/switches since their inception.
    Isn't the key that if you are a medium-to-large enterprise, you rely on interoperability and system management. If your IT staff knows Cisco, you will buy Cisco. You could get an alternative system for free, but the total cost of ownership would be so high, the Cisco solution would be cheaper. If you are a small enterprise that is technically savvy, this might not be true. But the loss of these customers would be insignificant.
    This challenge frequently happens with technology moats. The core product lines of MSFT (Office, client Windows, server Windows) have been sub-standard from a standalone technology veiwpoint for decades. Unix and Linux were supposed to take out server Windows because IT guys could work through the complexity of interop and learning a new OS. And Linux solutions were supposed to slash software costs (not only is the OS almost free, but the apps are cheaper too!) Did not happen. Will not happen. Certainly, top-notch computer guys switched (many of whom worked for MSFT previously), but most IT guys are not that smart or ambitious. And there was a critical mass of IT guys that knew Windows. The switching costs are huge and if you are a CIO (or similar), the career risk in these decisions is not worth it even if the expected value of the switch is positive. CIOs are inherently risk-averse people and their payoff structure is such that they get fired if the transition goes badly but merely a "good job" if things go swell.
    I do not think this point can be over-stated. Why do boards choose Goldman Sachs to do their investment banking. why not force price competition and go with lower priced solution? Wouldn't most people agree that this would increase value from an expectations perspective? But board is not incented that way. Nobody looks stupid choosing Goldman Sachs. A lot of moats are based on this principal-agent principle.
    As well, unless you think Chambers is lying, there has not been significant deterioriation in the margin of the core biz. There certainly has been pressure in the non-core biz. As well, overall margins have fallen simply as the mix has changed and the core biz has shrunk in terms of percent of revenue.
    I think the margin will hold and I think the stock will slowly turn around as tech/growth investors flee and value investors enter. This transition took a long time in the case of MSFT.

    Subjectacquisitions
    Entry04/29/2011 10:56 PM
    Memberdanarb860
    one issue I wrestle with in relation to CSCO is that it spends large amounts of its FCF (or EBIT, EBITDA or whatever measure one likes) for acquisitions.  So it seems in practice that the reinvestment in the business required to maintain/grow earnings has been quite large, calling seriously into question the profitability/ROIC of the company.

    SubjectUpdated thoughts?
    Entry05/12/2011 12:22 PM
    Memberstraw1023

    abra,

    What do you think after q3 numbers? My defense of company rested on enterprise router and switch biz remaining strong. However, these numbers clearly point to weakness in the switch business. They appear to be cannabalizing their high-end switches with lower-end switches. I doubt they are cannabalizing for no reason. They are cannabalizing because if they do not, competitor will take the biz.

    what do you think?

    thanks


    SubjectRE: Author Exit Recommendation
    Entry07/19/2013 10:03 AM
    MemberSpocksBrainX
    any reason as to why?  thanks....
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