Cisco Systems Inc. (CSCO, Financial) is not your typical value investment. It is among the very largest of the large-caps, draws considerable media and analyst attention. (Yahoo Finance shows 36 brokers following the company!), and it has nearly 1600 institutions that hold its shares. It is unlikely that there are any information asymmetries (Rajaratnam is in jail now, right?), and so it can be expected that, with this level of scrutiny and the number of people weighing all of the public facts, the resulting market price of the company would be relatively accurate of the company’s intrinsic value.
Fortunately, expectations aren’t always reality. While we may expect the company to be properly priced, we would be wrong in this case.
First, as always, I’ll start with the company’s historical returns. While I do not blindly extrapolate past returns, I believe our expectations of the future should at least be informed by our observance of the past. A company capable of generating strong return characteristics through good times and bad, should be given the benefit of the doubt going forward. For these companies, I start with a rebuttable presumption that the company will be able to earn returns in the range of what they have been historically able to earn. The following graph shows CSCO’s return characteristics.
Cisco Systems Returns, 1994 - 3Q 2011
What we see from this graph, is that during the early years (pre-2000), there was a great deal of volatility, specifically in terms of ROIC. The dot com bubble burst around 2000, and the company took a massive $1.17B restructuring charge shortly thereafter. For the remainder of the decade up until the recession, the company’s ROE and ROCE continued to grow, and remain largely stable.
You might be looking at the chart and wondering why ROIC is so much higher than ROE and ROCE. I’ll get to that in a bit. Suffice it to say that I believe this is the more accurate representation of the company’s operating performance.
We now know the company has generated strong returns historically, with double digit ROCE, ROE and ROIC for the last eight years (the averages for these figures over that time period are 16.2%, 20.3% and 52.4%. Quite impressive), but it is important to also look at whether the company has been able to grow the top line, and whether or not margins have been contracting.
Cisco Systems Margins, 1994 - 3Q 2011
This chart shows how CSCO has been able to grow revenues consistently over the period, and (impressively) maintain its margins in a fairly tight range. CSCO groups its revenues into two different categories: products and services. The following graph shows the company’s growth in each category since 2000, as well as the COGS for each.
Cisco Systems COGS, 2000 - 3Q 2011
From this we can tell that the company’s services revenues have been growing steadily every year with the added benefit of gross margin expansion. Product revenues have been more volatile and present a degree of seasonality, but that margins have been holding up pretty well throughout the recession.
One of the primary concerns expressed by media and analysts is that the company’s margins will erode due to increased competitive pressure. This is clearly not the cast for services, but we see that over the last few quarters the company’s COGS for product revenue has increased, signalling some discounting may be occurring. Make note of this because it is definitely something to take into account when building a valuation model. We’ll get to valuation shortly, but first let’s take a quick look at the company’s cash conversion cycle for negative trends (for those who have read Financial Shenanigans, you’ll know not to skip this step!).
Cisco Cash Conversion Cycle, 1994 - 3Q 2011
Here we see that, on an annual basis, the company has maintained its ability to take raw inputs and convert them into cash in between 54 and 68 days (excluding the outlier in 2002). Though this isn’t as attractive as Dell, I take solace in the fact that three of the company’s best years have been the last three years, and that this has been achieved not by punishing vendors (on the contrary, days’ payables has declined to its lowest point in history), but rather through improved inventory management, as Days of Inventory has declined significantly.
The quarterly data paint a different picture, with the Cash Conversion Cycle trending upwards. There is a greater amount of volatility in quarterly figures, so a note should be made to watch future developments to see if this trend continues. If it does not, and the company is able to reduces the number of days it takes to generate cash (in this case, by continuing its long-term trend of reducing inventory and by collecting on its receivables), we can count on improvements in cash flows…. which brings me to my next point.
Free cash flow. This is what it’s all about. How much cash can the company generate in excess of the cash it needs for the continued operating of the business? If a good business is marked by the ability to generate a significant amount of free cash flow, then Cisco Systems is a damn fine business indeed.
Cisco Systems Free Cash Flows, 1994 - 3Q 2011
Comparing this chart with the second chart presented above, we see that CSCO has been able to grow free cash flows roughly in line with revenues. This, combined with the company’s consistent returns (the first graph), is a good sign. It shows that management effectively grows the top line without compromising on the returns and quickly turns the growth into free cash flow (by not growing into capital intensive businesses) (here’s another business that has been successful in doing this). Also, if we look at the red line which indicates the ratio of Free Cash Flows to Net Income, we see that the line stays close to the 1.0 mark, meaning that free cash flows and net income track relatively closely, which readers of Financial Shenanigans will know is a good sign, since it indicates the company is not improperly capitalizing regular operating costs.
You might be looking at this chart thinking “Frank, this shows Free Cash Flows in the $8 Billion range. That’s hardly impressive for a company trading for $85 Billion (as of 6/24). That’s only a 9.4% free cash flow yield.”
You are right a 9.4% yield wouldn’t be very impressive. Thankfully, this is vastly understated. In order to get a better picture of the yield, we should look at the company’s capitalization.
Cisco Systems Capitalization, 1994 - 3Q 2011
WOW. Look at the red line shoot upward. Looks like the company is taking on massive debt, right? Well, their debt is growing, but the more relevant consideration would be to compare the difference between the purple line (cash) and the blue line (debt), for the net cash figure. Just by eyeballing this, you can see that net cash has been growing since the company took on debt for the first time in 2006. This net cash figure represents cash and securities that the company carries. Why keep so much cash (currently nearly $45 Billion, or more than 1/2 of the company’s market cap) and add debt? Tax arbitrage. The company holds the bulk of this cash offshore, and it faces high tax rates if it repatriates that cash. So until the government eases business tax rates, or creates another repatriation holiday for corporations, that cash will stay offshore.
For our purposes, we will take an owner’s perspective of the business and subtract net cash from the current market capitalization. We do this not because we believe the cash will immediately come back to investors (Though, CEO John Chambers has been leading the charge in Washington for a repatriation holiday that would allow big businesses to bring cash back into the United States and put it to work, so there is reason to believe the cash may come back in the short term), but because we want to get an idea of what free cash flows the company’s assets are generating relative to the market cost of buying those assets (net of excess cash). When we do this, it is important to remove from Free Cash Flow those cash flows that are the result of the excess cash (interest and gains/losses, which averaged just ~3% of free cash flows over the last 4 years). The resulting yield, using the last four years’ average adjusted free cash flows and the current market capitalization net of excess cash and investments, is 22.3%. Significantly higher than originally the case, and reflective of the company’s undervaluation.
Speaking of valuation, we should get to that. All of the above is wonderful, but if the company’s shares are expensive, then what good does this do us? So far, everything has been historical, so we now have the task of projecting forward and considering whether the company’s price is sufficiently low relative to intrinsic value as to create a margin of safety. In estimating intrinsic value, I look calculate three different scenarios (Base, Bull and Bear), using both an Earnings Power Valuation and a Residual Income Valuation. I am not going to get into all of the assumptions, but I can only justify the current (6/24) price of $15.47 by using aggressively pessimistic assumptions, and even then – little to no downside. If the future turns out any better than those assumptions, I see fairly significant upside (especially when considering the growth rate of the industry), so I feel comfortable with the expected value of this investment, given my believe in the likelihood of the different scenarios. As always, you’ll have to make an assessment for yourself.
Why does this opportunity exist?
Before I am done here, I want to go back to the beginning of this article, to consider why, if CSCO is subjected to such scrutiny, an opportunity like this exists. There are a number of possible answers, and it is impossible to know for sure, but I expect the reason has to do with the composition of the market. Unfortunately (or fortunately, depending on how you look at it), the market is not comprised solely of long term value investors, carefully weighing the fundamental characteristics of each investment opportunity. These investors share the market with (at least) two other groups that, through their participation in the markets, create opportunities like this one.
The first group are those portfolio managers whose performance is subject to comparison on a regular basis with their peers. The pressure to outperform their peers by a few basis points leads them to cut their losses quickly, regardless of conviction about the long term direction of the company. The second group includes the mystics – those technical traders who, by virtue of the patterns they derive from chicken entrails and other nonsense, believe they can consistently predict the short term movements of the market. Predicted short term road bumps lead a member or two of the first group to sell, which causes ripple effects throughout the remainder of the first group and the second group, creating a negative feedback loop until the only thing remaining is a value opportunity.
This feedback loop is counterbalanced by longer-term investors who fear not the short term rhythms of the marketplace. These investors are able to purchase good companies for large discounts from short-term focused market participants, reaping the rewards as the market forces prices back to reality in the longer term. This is called time-arbitrage, and it is the main benefit of value investing. Is it any wonder that Warren Buffett, whose ideal investment horizon is “forever,” has been so successful?
I have a long-term investment horizon and I am happy to buy a company like CSCO, with strong return characteristics, stable margins, a conservative capital structure and colossal free cash flows, on the cheap from my time-challenged peers in the market. Are you?
Author Disclosure: Long CSCO
Talk to Frank about Cisco Systems
Fortunately, expectations aren’t always reality. While we may expect the company to be properly priced, we would be wrong in this case.
First, as always, I’ll start with the company’s historical returns. While I do not blindly extrapolate past returns, I believe our expectations of the future should at least be informed by our observance of the past. A company capable of generating strong return characteristics through good times and bad, should be given the benefit of the doubt going forward. For these companies, I start with a rebuttable presumption that the company will be able to earn returns in the range of what they have been historically able to earn. The following graph shows CSCO’s return characteristics.
Cisco Systems Returns, 1994 - 3Q 2011What we see from this graph, is that during the early years (pre-2000), there was a great deal of volatility, specifically in terms of ROIC. The dot com bubble burst around 2000, and the company took a massive $1.17B restructuring charge shortly thereafter. For the remainder of the decade up until the recession, the company’s ROE and ROCE continued to grow, and remain largely stable.
You might be looking at the chart and wondering why ROIC is so much higher than ROE and ROCE. I’ll get to that in a bit. Suffice it to say that I believe this is the more accurate representation of the company’s operating performance.
We now know the company has generated strong returns historically, with double digit ROCE, ROE and ROIC for the last eight years (the averages for these figures over that time period are 16.2%, 20.3% and 52.4%. Quite impressive), but it is important to also look at whether the company has been able to grow the top line, and whether or not margins have been contracting.
Cisco Systems Margins, 1994 - 3Q 2011This chart shows how CSCO has been able to grow revenues consistently over the period, and (impressively) maintain its margins in a fairly tight range. CSCO groups its revenues into two different categories: products and services. The following graph shows the company’s growth in each category since 2000, as well as the COGS for each.
Cisco Systems COGS, 2000 - 3Q 2011From this we can tell that the company’s services revenues have been growing steadily every year with the added benefit of gross margin expansion. Product revenues have been more volatile and present a degree of seasonality, but that margins have been holding up pretty well throughout the recession.
One of the primary concerns expressed by media and analysts is that the company’s margins will erode due to increased competitive pressure. This is clearly not the cast for services, but we see that over the last few quarters the company’s COGS for product revenue has increased, signalling some discounting may be occurring. Make note of this because it is definitely something to take into account when building a valuation model. We’ll get to valuation shortly, but first let’s take a quick look at the company’s cash conversion cycle for negative trends (for those who have read Financial Shenanigans, you’ll know not to skip this step!).
Cisco Cash Conversion Cycle, 1994 - 3Q 2011Here we see that, on an annual basis, the company has maintained its ability to take raw inputs and convert them into cash in between 54 and 68 days (excluding the outlier in 2002). Though this isn’t as attractive as Dell, I take solace in the fact that three of the company’s best years have been the last three years, and that this has been achieved not by punishing vendors (on the contrary, days’ payables has declined to its lowest point in history), but rather through improved inventory management, as Days of Inventory has declined significantly.
The quarterly data paint a different picture, with the Cash Conversion Cycle trending upwards. There is a greater amount of volatility in quarterly figures, so a note should be made to watch future developments to see if this trend continues. If it does not, and the company is able to reduces the number of days it takes to generate cash (in this case, by continuing its long-term trend of reducing inventory and by collecting on its receivables), we can count on improvements in cash flows…. which brings me to my next point.
Free cash flow. This is what it’s all about. How much cash can the company generate in excess of the cash it needs for the continued operating of the business? If a good business is marked by the ability to generate a significant amount of free cash flow, then Cisco Systems is a damn fine business indeed.
Cisco Systems Free Cash Flows, 1994 - 3Q 2011Comparing this chart with the second chart presented above, we see that CSCO has been able to grow free cash flows roughly in line with revenues. This, combined with the company’s consistent returns (the first graph), is a good sign. It shows that management effectively grows the top line without compromising on the returns and quickly turns the growth into free cash flow (by not growing into capital intensive businesses) (here’s another business that has been successful in doing this). Also, if we look at the red line which indicates the ratio of Free Cash Flows to Net Income, we see that the line stays close to the 1.0 mark, meaning that free cash flows and net income track relatively closely, which readers of Financial Shenanigans will know is a good sign, since it indicates the company is not improperly capitalizing regular operating costs.
You might be looking at this chart thinking “Frank, this shows Free Cash Flows in the $8 Billion range. That’s hardly impressive for a company trading for $85 Billion (as of 6/24). That’s only a 9.4% free cash flow yield.”
You are right a 9.4% yield wouldn’t be very impressive. Thankfully, this is vastly understated. In order to get a better picture of the yield, we should look at the company’s capitalization.
Cisco Systems Capitalization, 1994 - 3Q 2011WOW. Look at the red line shoot upward. Looks like the company is taking on massive debt, right? Well, their debt is growing, but the more relevant consideration would be to compare the difference between the purple line (cash) and the blue line (debt), for the net cash figure. Just by eyeballing this, you can see that net cash has been growing since the company took on debt for the first time in 2006. This net cash figure represents cash and securities that the company carries. Why keep so much cash (currently nearly $45 Billion, or more than 1/2 of the company’s market cap) and add debt? Tax arbitrage. The company holds the bulk of this cash offshore, and it faces high tax rates if it repatriates that cash. So until the government eases business tax rates, or creates another repatriation holiday for corporations, that cash will stay offshore.
For our purposes, we will take an owner’s perspective of the business and subtract net cash from the current market capitalization. We do this not because we believe the cash will immediately come back to investors (Though, CEO John Chambers has been leading the charge in Washington for a repatriation holiday that would allow big businesses to bring cash back into the United States and put it to work, so there is reason to believe the cash may come back in the short term), but because we want to get an idea of what free cash flows the company’s assets are generating relative to the market cost of buying those assets (net of excess cash). When we do this, it is important to remove from Free Cash Flow those cash flows that are the result of the excess cash (interest and gains/losses, which averaged just ~3% of free cash flows over the last 4 years). The resulting yield, using the last four years’ average adjusted free cash flows and the current market capitalization net of excess cash and investments, is 22.3%. Significantly higher than originally the case, and reflective of the company’s undervaluation.
Speaking of valuation, we should get to that. All of the above is wonderful, but if the company’s shares are expensive, then what good does this do us? So far, everything has been historical, so we now have the task of projecting forward and considering whether the company’s price is sufficiently low relative to intrinsic value as to create a margin of safety. In estimating intrinsic value, I look calculate three different scenarios (Base, Bull and Bear), using both an Earnings Power Valuation and a Residual Income Valuation. I am not going to get into all of the assumptions, but I can only justify the current (6/24) price of $15.47 by using aggressively pessimistic assumptions, and even then – little to no downside. If the future turns out any better than those assumptions, I see fairly significant upside (especially when considering the growth rate of the industry), so I feel comfortable with the expected value of this investment, given my believe in the likelihood of the different scenarios. As always, you’ll have to make an assessment for yourself.
Why does this opportunity exist?
Before I am done here, I want to go back to the beginning of this article, to consider why, if CSCO is subjected to such scrutiny, an opportunity like this exists. There are a number of possible answers, and it is impossible to know for sure, but I expect the reason has to do with the composition of the market. Unfortunately (or fortunately, depending on how you look at it), the market is not comprised solely of long term value investors, carefully weighing the fundamental characteristics of each investment opportunity. These investors share the market with (at least) two other groups that, through their participation in the markets, create opportunities like this one.
The first group are those portfolio managers whose performance is subject to comparison on a regular basis with their peers. The pressure to outperform their peers by a few basis points leads them to cut their losses quickly, regardless of conviction about the long term direction of the company. The second group includes the mystics – those technical traders who, by virtue of the patterns they derive from chicken entrails and other nonsense, believe they can consistently predict the short term movements of the market. Predicted short term road bumps lead a member or two of the first group to sell, which causes ripple effects throughout the remainder of the first group and the second group, creating a negative feedback loop until the only thing remaining is a value opportunity.
This feedback loop is counterbalanced by longer-term investors who fear not the short term rhythms of the marketplace. These investors are able to purchase good companies for large discounts from short-term focused market participants, reaping the rewards as the market forces prices back to reality in the longer term. This is called time-arbitrage, and it is the main benefit of value investing. Is it any wonder that Warren Buffett, whose ideal investment horizon is “forever,” has been so successful?
I have a long-term investment horizon and I am happy to buy a company like CSCO, with strong return characteristics, stable margins, a conservative capital structure and colossal free cash flows, on the cheap from my time-challenged peers in the market. Are you?
Author Disclosure: Long CSCO
Talk to Frank about Cisco Systems
