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Cisco: A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: Chandan Dubey (IP Logged)
Date: August 2, 2012 10:12AM

Cisco went public in 1990 and the current CEO John Chambers is on the job since 1995.

Cisco has generated a lot of cash since 2002. The cash has been used to fund the acquisitions and buy back shares. Let us look at each of these uses of cash in detail and see how much they have been worth for the shareholders.

Share buybacks

Fiscal yearFree cash flow (in $ million)Shares outstanding (in millions)Dividends (in $ million)
20023,9467,4470
20034,5237,2230
20046,5087,0570
20056,8766,6120
20067,1276,2720
20078,8536,2650
200810,8216,1630
20098,8925,8570
20109,1655,8480
20118,9055,563658
TTM5,430


From the press release of the full year 2011 report:
Quote:
As of July 30, 2011, Cisco had repurchased and retired 3.5 billion shares of Cisco common stock at an average price of $20.64 per share for an aggregate purchase price of approximately $71.8 billion since the inception of the stock repurchase program.[/i]

Cisco has repurchased $71.8 billion worth of stock (worth market cap of two Hewlett-Packards at current prices of HPQ, i.e. $18) at an average price of $20.64 a piece for a total of 3.51 billion shares (repurchase program started September 2001). If on the other hand we look at the decrease in diluted shares outstanding during the period, it is (7447-5563=) 1,884 million. The discrepancy (3.51-1.89=) 1.62 billion shares went in the compensation. This is nearly (1.62*20.64/10=) $3.34 billion per year for the last 10 years which went to compensation. At the current market cap of $86 billion, the burn rate is 3.8% which is ridiculously high, compared to say Applied Materials (AMAT) (burn rate 0.85%).

A valid concern about the buyback is the following. Are the share buybacks being used to hide the outrageous compensation practices? Out of $72 billion used for the buyback nearly half ($33.4 billion) of the money has gone to the compensation. It is hard to calculate how much damage this has done to the shareholders. To understand it better, let us look at how the option compensation works. Let us say that an employee got awarded 100 options at strike price $20. If he exercises the options at a price of $30 then the employee gets $30-$20=$10 per option and the company gets $20 per share. So, for every option exercised, the company gets $20 and the share price obviously goes down as the existing shareholders get diluted. To calculate the damage, one needs the strike price of the every option exercised.

How much more dilution can we expect in the near term? Generally, a company has to declare how many options/shares it can award to its employees. The current plan which is running for Cisco was approved in 2005 and will expire on the day of the AGM in 2012. Without adding any new shares, the management was planning to extend the expiry deadline to 2021.

Quote:
As of September 30, 2011, Cisco had 602,045,424 options outstanding with a weighted average exercise price of $21.97 and a weighted average life of 3.15 years and 99,571,567 shares subject to restricted stock awards and restricted stock units.

So, nearly 700 million additional shares can be issued for compensation. This is not a small number. It is 12.5% of the current number of outstanding shares ! At current price of $16, the dilution will likely not affect the shareholders because the exercise price for the options which can be issued for the employees is $21.97, which is substantially higher than the $16 share price.

A few caveats need to be discussed here.
  • Average diluted number of shares in a fiscal year does not give a correct picture of the number of shares at the end of the year. The average number of diluted shares is calculated as follows: assume that the options, which are in the circulation, are exercised and the company uses the cash it gets to buy back shares at the current market price. So for example if an executive has 100 options with strike price $20 and the share is trading at $30 then the dilution is (100-2000/30=) 33 shares. If the share is trading at 40 then the dilution is (100-2000/40=) 50 shares. So, if the stock is going up in value then the dilution is increasing and vice versa. This exercise is just for showing how the dilution is calculated and we do not need that the executive actually exercise the above mentioned options.
  • If one looks at the cash flow statement of Cisco, we see that in 2011, the share based compensation expense was $1,620 million. In 2010, it was $1,517 million and 2009 it was $1,231 million. The stock based compensation expense is a different animal altogether. One needs to see how they are calculated before we make a judgement about whether they give a good picture of the dilution. When the options are granted, the fair value of the options are calculated using the Black-Scholes option pricing methodology. The options generally vest over a certain period of time i.e., they must be used within a few years. For Cisco this is 5 years and so the option value is amortized over that period. So, the $4.3 billion in stock based compensation expense does not correspond to the dilution over the last three years. They correspond to the dilution when they are exercised. A better measure is to look at the the “Issuance of the common stock” stub in the cash flow statement. But this is fraught with problems too ! A company may issue stock because of options being exercised and also due to sale of stock to fund acquisitions and sometimes to fund operations. Hence, this might not give a good picture either. On top of that, the “issuance of common stock” generally gives quite an old picture. The shares being issued for compensation in 2011 may correspond to options that were awarded in 2006 ! This means that their deleterious effects get pushed down in the future. If the company was generous in the past, it may get hurt a few years later when the options are exercised. A slightly outdated article (from 2004) about employee stock options by Cisco and how much they have hurt the shareholders can be found here.

Keeping these in mind, I ran the calculations as I did. I looked at the total amount spent on buybacks in a long period of time i.e., 10 years and also looked at the reduction in the number of diluted shares over the same period. Although not accurate, this probably will give a good estimate of the amount of money which has gone to the employees and not the shareholders.

Acquisitions

Cisco has mostly grown by acquisitions. It has followed a strategy of buying companies in the field it wants to expand and then developing their products. The problem with the strategy is the high failure rate as most of the acquired companies do not even have a product when they are bought. It also means overpaying by an egregious amounts in some cases.

Cisco has bought six companies each in 2011, 2010, 2009, five in 2008, twelve in 2007, nine in 2006, twelve in 2005, eleven in 2004 and an astounding forty one during 1999-2000. Before the tech bubble in 2000, Cisco wasted a lot of money on stupid acquisitions. For example: Cisco acquired Monterey Networks, an optical routing startup with no revenue, no products and no customers but millions in losses since its startup in 1997, for an astounding half a billion dollars in 1999. Within days of the deal, all three of Monterey’s founders left the company and eighteen months later Cisco shut down the business altogether by taking $108 million write-off (Source: Bloomberg Businessweek article Cisco shopped till it nearly dropped). Another example was Cerent Corp, a maker of optical networking devices. Cisco paid $6.9 billion for the company even though it had never made any profit and had an accumulated deficit of nearly $60 million. During the entire life of Cerent it had booked a revenue of only $10 million (Source: Cisco pays up for Cerent).

After these egregious mistakes it seems that the CEO learned a bit and the acquisition rate slowed considerably to just two purchases in 2001. The CEO said that he now wants to acquire a company when they have a product and this will dramatically reduce the risk of making a losing acquisition.

According to Dealogic, Cisco has spent $22 billion during 2002-2009 on acquisitions. Additionally, during 2010-2012 Cisco has spent at least $9.4 billion to acquire five of the thirteen acquisitions it has made. For others the buy price is not known. So, more than $32 billion has been spent since 2002 on acquisitions.

We look at ten most expensive acquisitions by Cisco after 2002 and see what their situation is at the moment. This I hope will give us some idea about the failure rate of Cisco’s acquisitions. Given that Chambers has been the CEO since 1995, I hope to see a learning curve which favors better and better companies for acquisitions.

  1. Scientific Atlanta (Nov 2005, $6.9 billion) is a company that makes gears for Cable TV companies, starting from the fiber optic network equipment to the digital set top boxes. It was acquired in 2005 for a price of $6.9 billion. When the company was acquired, it had sales of $1.9 billion. Cisco paid more than three times the revenue for this company. If we look at sales of Cisco according to the segments it puts the products in, most of the revenue from this company will be classified under the segment “service provider video”. This segment had total sales of $3.48 billion in 2011. This business seemed to be slowing and the orders decreased 15% (transcript from Feb 2011) with $1.6 billion in sales.
  2. NDS Group (Mar 2012, $5 billion) develops software solutions for the pay TV industry. Cisco acquired it in Mar 2012 for $5 billion. NDS was taken private in 2009 for $3.6 billion and in 2008 has sales of $830 million, which were growing quite fast (around 30% yoy). With two of the biggest acquisition in the TV space Cisco is planning to become a leader in this market segment. As NDS was acquired quite soon, I do not know how this will affect the value of the company.
  3. Tandberg (April 2010, $3.3 billion) is a manufacturer of video-conferencing systems. In 2008 the company had revenue of $808 million. Telepresence is reported under the segment “Collaboration” and had sales of $4 billion in 2011.
  4. WebEx (Mar 2007, $3.2 billion) offers on demand meeting, web and video conferencing applications. It had $380 million in sales when it was acquired. The revenue from this company goes to the “Collaboration” segment as in item 3.
  5. Starent Networks (Dec 2009, $2.9 billion) was a provider of infrastructure products that enabled mobile operators like Vodafone and Orange to deliver multimedia services like video, games, internet access, VoIP, e-mail, mobile TV to their subscribers. This comes under “Wireless” segment and had $1.4 billion in sales.
  6. Andiamo (Aug 2005, $2.5 billion) was a developer of intelligent storage switching products for the storage area networking (SAN) market. This was a clear fit to the Cisco’s core business which has sales of over $14 billion in 2011.
  7. IronPort (Jan 2007, $830 million) was best known for anti spam filter and email security appliances. This was integrated into the security business unit which has sales of around $1.2 billion in 2011.
  8. Nuova Systems (Apr 2008, $678 million) made high end networking gears for data center markets. A good fit for the core Cisco business.
  9. Pure Digital (Mar 2009, $590 million) was the maker of Flip Video and after being ignored by Cisco was shutdown in Apr 2011 only after two years. It was argued that the patents from this unit could have proved valuable for Cisco’s teleconferencing segment and also that Cisco could have easily have sold this unit to someone as it was still profitable. It seems that Chambers offered it as a sacrifice to the shareholders to show how serious he was about the turnaround plans for the company.
  10. Linksys (Mar 2003, $500 million) makes home and office networking products like routers, ethernet switches, VoIP systems, network storage etc. Arguably the most successful Cisco acquisition.


Cisco’s mad acquisition strategy seems to be driven by constant need to grow. This need has not taken a backseat even after the high flying days of the tech bubble. Two recent areas where Cisco is trying to expand: Collaboration and Video.

In 2007, Cisco acquired Five Across, a platform to connect and build communities. This was followed by $3.2 billion acquisition of WebEx, a market leader in teleconferencing software. The grab of Pure Digital (Flip maker) can be seen as an extension of this strategy. This particular expansion has been partially successful.

Expanding into social and collaboration oriented environment, Cisco is trying to push deeper into video (providing teleconferencing capabilities to its enterprise and business customers). A slightly deeper strategy has been that more and more video will lead to better routers and switchers, leading to an overhaul of the current internet infrastructure. This will make Cisco very happy. The problem with the acquisitions after 2002 has been price. Cisco continues to pay up for the acquisitions it makes.

Unlike the sad state of the affairs with Share buybacks, I walk away with a feeling that the acquisition strategy has come far away from its awful days 10 years back although they still need to negotiate better for the deals (CEO should do his job better). Cisco has a lot of work on its hands in the area of compensation and treatment of the copious cash it generates.


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: Adib Motiwala (IP Logged)
Date: August 3, 2012 09:05AM

Good stuff. 50% of buybacks are hiding dilution from options and/or expensive m/a deals. Sums up capital allocation pretty darn well.

From your study, has this behaviour changed over the last 2 years? Do you have the multiples that were paid for sales and profits on the last 5 deals since 2010? And has option issuance reduced?


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: cdubey (IP Logged)
Date: August 3, 2012 09:37AM

@Adib: I am going to look at the management compensation.

With the usual caveat the stock based compensation has gone up. The cash flow statement says $1.2 b in 2009, $1.5 b in 2010 and $1.6 b in 2011.

I have already mentioned what I know about the NDS acquisition. BNI was privately held and it is difficult to find their profit/sales.

AXIOSS software which was acquired for $31 million, probably has sales of around €2 million.

Inlet Technology, which was acquired for $95 million had sales of $7.6 million in 2009. Revenue for 2010 doubled as compared to 2009.


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: Jose Vasquez (IP Logged)
Date: August 3, 2012 09:48AM

There is an incentive for the stock to go up otherwise most of the options will expire.


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: cdubey (IP Logged)
Date: August 3, 2012 09:53AM

@Jose: Yes, you are right. The average exercise price for the option is $21.94. This is nearly 37% upside. Does this relate to the stock based compensation during 2009-2011 ?



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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: Jose Vasquez (IP Logged)
Date: August 3, 2012 10:04AM

See comment 1 here : [investing.kuchita.com]


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: cdubey (IP Logged)
Date: August 3, 2012 10:10AM

@Jose: Do you know exactly how the RSUs and the option compensations work ? My smaller brother works for Qualcomm and they let him buy stocks at 15% below the market price, every year. Is the management not going to be awarded new options (for say 2012 compensation) which are priced around the market price ? How about RSUs ? I have not looked at the proxy yet, and I should. But this is something I worry about.


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: Jose Vasquez (IP Logged)
Date: August 3, 2012 10:10AM

Hi Chandan, I cannot see your portfolio page on your blog: http://utrifin.wordpress.com/portfolio/


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: Jose Vasquez (IP Logged)
Date: August 3, 2012 10:20AM

Sure its all explained in the SEC fillings. I've been granted options on the companies I worked before.

If you get an option to buy at 10 and the stock is at 12 at the expiry date then you have to pay only 10 and receive a stock that is worth 12 or you can exercise it immediatly on the strike date and sell it for a 2 dollar profit or hold.

Yes some companies offer employees to buy shares at a discount for savings programs, incentives, etc...


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Re Cisco A Tale of Overcompensation and Overpaying for Acquisitions
Posted by: cdubey (IP Logged)
Date: August 3, 2012 10:24AM

Sorry, my existing page sucked ! I had a html file and it is becoming increasingly difficult to maintain it. I will find something to replace it this weekend.

Meanwhile: I am long Roche, ArcelorMittal, ABB, Tesco, France Telecom, E.On, Munich Re, Aviva, Transocean, HewlettPackard, Santander, Halfords, Applied Materials. I also have options exposure to Siemens, Alcoa, and BP.


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