Cisco Systems Looks Good At First Glance, But A Second Look Makes It Look Great

What if you turned on your computer or smart phone to check an important piece of data …such as your last bank deposit or brokerage account balance … and found that you are unable to access any information? Then imagine your reaction if you switched to another device and experienced the same result. Just ask yourself this question: “What would I do if the Internet didn’t work?”

Fortunately, this is a very unlikely outcome as there are multiple businesses that develop the technology and manufacture reliable equipment to make sure the Internet does work. And we have structured our lives around the assumption that it always will. Today, we have the opportunity to own one of these businesses and, at first glance, it appears we can buy it cheap as well.

Cisco Systems (CSCO, Financial) is often referred to as the “plumber of the Internet” due to the fact that it makes the routers, switches and storage products that allow our data to flow seamlessly through the “pipes” that carry our information from one point to another. Once again, as I love to do, I have found a business that provides a product or service that is essential to our way of life. And it looks like it is inexpensive.

How cheap is Cisco Systems at first glance?

In determining the “fair value” of a business, we can compare it to average market valuations and/or its valuation compared to its industry. When performing this evaluation, it is wise to consider whether the business under scrutiny provides products and services that are “accessories” or crucial to maintaining our way of life.

Major market indexes are a mix of businesses that supply us with virtually everything we use in our lives from the most basic necessities to the most extravagant luxury items imaginable. Some of these businesses could cease to exist tomorrow and most of us would never notice. The absence of others would be impossible to overlook instantly. I like to focus my attention on the latter when it comes to investing. They are the ones that have real staying power and are more than just a passing fad.

However, as a value investor, I like to compare the current valuation of critical businesses to the valuation of the “average” business as it begins the process of building my moat of protection for my capital. If a critical business is valued at a lesser range than the average business, it indicates that the market is overlooking the essential need for its products and the lack of consideration of that aspect of the business provides me with unseen protection against downside risk.

How is Cisco Systems valued compared to the average business in the market and the average business within it industry? The table below provides us with a summary of Cisco compared to some of its key competitors.

The first thing that jumps off the page is the dominance of Cisco’s total market value in comparison to its competitors. Its current market capitalization is 2.4 times that of Hewlett-Packard (HPR), the second-largest player in the sector.

The second item that catches my attention in a dramatic way is the number of employees each of these businesses has relative to their total revenue. The ratio of revenue/employee at Cisco of $685,759 dwarfs its closest competitors: Juniper Networks (JNPR, Financial) at $525,778 and Hewlett-Packard at $364,702. These are striking numbers if Cisco is merely valued the same as these direct competitors. They certainly encourage me to dig a bit deeper.

We all know businesses cannot survive without sales. However, a business exists to make a profit, not to sell products. Large sales numbers without profits to accompany them are worthless. So, high revenue per employee is a good sign; but, net income per employee is where we find the real proof of value. Based on the table above, Cisco Systems’ employees produced net income of $123,374/employee. Hewlett-Packard is the only competitor to have produced positive earnings over the last 12 months and generated only $16,391/employee.

So, when it comes down to the number that matters the most in terms of assessing value, each employee at Cisco Systems produces $7.52 of net income for shareholders for each dollar of net income being produced by each Hewlett-Packard employee and the other competitors are generating losses. This metric should make it abundantly clear that Cisco Systems produces actual results that are far superior to any of its direct competitors while providing products that are essential to our modern existence and way of life.

Yet, despite this massive outperformance delivered by Cisco compared to its direct competitors, when we look at the current valuation assigned to Cisco Systems it trades at a very reasonable 16.68 times its trailing 12-month earnings compared to a multiple of 12.48 times trailing 12-month earnings for Hewlett-Packard a mere 33% premium for a business who’s employees each generate 7.52 times as much profit as their nearest competitor. This seems pretty inexpensive to me.

The present value looks good; what about the future?

While it is important to enter a new investment at an attractive, if not compelling, valuation, investing is about how a business will perform in the future. We achieve a portion of that determination when we focus on businesses whose products or services fulfill a necessity in our lives. This is what assures future consumer demand and we have determined Cisco meets this criteria.

However, we also need to establish how the business is currently valued in relationship to its future prospects within its industry and the overall market. Once again, as a value investor, I want to find suppliers of necessities that are trading at or below the value of their competitors and the market in general.

The table below shows that the analysts cover the stock of Cisco Systems expect it to expand its earnings at an annual pace of 9.40% over the next five years while the industry is expected to grow at 16.02%/year.

On the surface, this might make Cisco seem expensive. However, value based investing is about looking a bit deeper than what might appear to be evident on the surface. Looking further down the table, we find that for the current year, Cisco is valued at a Price/Earnings ratio of 13.24 while the rest of the industry is valued at 25.23 and the S&P 500 is priced at 22.34 times earnings.

Also, if we look at the last line of the table, we see that Cisco’s current valuation is 1.41 times its projected earnings growth rate (PEG) compared to the overall industry’s valuation of 2.08 times growth. We have previously described how Cisco’s business performance outshines its direct competitors and now we see how the market currently values the future growth of those same competitors more highly than the growth of the dominant player in the market. This is a great example of the kind of anomaly that I am always hoping to find.

Never confuse good with good enough

Businesses that provide goods and services that are necessary to our lives are nice, but there are lots of them in just about every case of crucial goods and services. Finding the dominant supplier in those industries is a relatively easy task as well and dominant doesn’t always mean the business is run well. A dominant business in a industry providing critical products that is well run and cheap compared to its industry and the overall market is good. But, good is not always good enough.

I want as much assurance that a stock is undervalued as I can get. So, not only do I want to find a business that supplies products or services necessary to maintaining our way of life that are trading at a discount to their particular industry and the market as a whole, I want a business that is priced well below its own historic valuation. Once again, Cisco Systems clears the bar with ease.

The chart above shows the current share value of CSCO stock as the green line. It further displays what the share price would currently be if the stock were trading at its historic mean valuation in terms of P/E multiple (blue line), which would price the shares at $59.40, and Price to Book (red line), that would price the stock at $54.60. Currently the stock sits at $27.92 and is obviously well below its historic level of valuation based on these two key metrics. To trade at just the lesser of these two historic measures, the stock would have to rise over 95% from the current price.

So, we have now established that CSCO is undervalued within its own industry in particular and the broad market in general. We have also seen how the stock is undervalued based on its own historic valuations. This information builds a pretty compelling case for an investment opportunity. But, I have rarely run across a bullish stock evaluation that could not have been even better and the same case exists here.

There are several ways a business can reward shareholders. It can pay and raise dividends which provides shareholders with a taxable event; but, a taxable event that is taxed at a lower rate than regular income. It can increase earnings which will eventually drive the share price higher and reward shareholders with long-term capital gains upon the sale of the stock. Long-term capital gains also receive preferred treatment when it comes to paying federal income taxes.

The third and, in my view, most effective way of rewarding shareholders (when properly executed) is for a company to use its cash to purchase and retire existing shares. The reason I stipulated that I prefer this approach only when it is “properly executed” is that I only want to see this approach implemented when the shares of a business are drastically undervalued in the open market.

Prior to its recent upward surge that pushed the stock beyond that level in November, Cisco System’s shares made their 5-year high of $26.85/share in April 2010. So the stock has very recently been even more undervalued than it is today. Interestingly enough, during the last four quarters of financial statements, this $142.5 billion market capitalization business has reported share repurchases in the open market of $9.462 billion or 6.64% of its entire current market value. This has been effectively returned to shareholders by increasing the percentage of the business that their existing holdings represent against the lower number of total shares outstanding. Even better, they bought the shares in the market when they were seriously undervalued; thus enhancing the value of their actions for the remaining shareholders. Smart move.

But CSCO’s management did not stop there, over the past 12 months of reported results, the company also paid out $3.796 billion in dividends producing a yield of about 3% on the share price. Coupled with the share repurchase, these actions have returned just under 10% to shareholders while only creating a reduced tax liability on 3%. Extra smart move.

It just doesn’t get much better than this … does it?

Well, actually it does. I am sure you are all familiar with the famous saying from those corny infomercials: “But wait! There’s more!” Guess what; there’s more, and it does get even better.

A cursory glance at the balance sheet of Cisco Systems for the quarter ended in January 2015 reveals a position in cash and short-term investments $53.022 billion or 37.34% of its current market value. And you just thought it was undervalued before! This business could retire another 30% of its outstanding shares and still have $10 billion of cash left over to cover the float of its already quite profitable operations.

For those like me who always like to get that little something extra for our investment dollar, I think $53 billion in extra cash should fill the bill.

Would it be greedy to ask for more?

I think, at this point, most will agree that the shares of Cisco Systems represent a compelling value for new investors at the current price. Many would even go so far as to consider it greedy to attempt to extract an even better value. For those who do, you will be hard pressed to find a more compelling value than shares of Cisco Systems today. In my mind, this is one of the most compelling values in the market today for long-term investors. Buy it now!

But, I have been known to be pretty shameless when it comes to squeezing every cent of value I can out of a stock position. I am pretty sure there are others out there like me who are not ashamed to try and get an even better deal than what the market is offering today. For those who share my tendency of always looking for more, I have a potentially interesting alternative approaches for you.

For each 100 shares of Cisco Systems stock you wish to buy, you can consider selling (1) uncovered put option with a strike price of $27 and an expiration date of May 15, 2015 at a limit price of $0.45. Before commissions and fees, this trade would generate an immediate return of 1.67% (approximately 20% annualized) on the $27 strike price at which you would be obligated to purchase the shares should CSCO be trading below that level on May 15 and reduce your potential purchase price of the stock by 3.28% from the current level. I like the concept of making a 20% annualized return on my money while waiting to buy something I want to own at a discount to the current price. If the shares fall even more in value than where they are now, this approach would lower your net entry cost into the shares to $26.55 ($27 purchase price - $0.45 premium collect for selling the put options). This event would put you in shares of CSCO at a discount of 4.91% to the current market price.

Let there be no doubt that Cisco Systems is a compelling opportunity with two compelling ways to potentially open a new position in the stock.