I have never seen myself as an early adopter of new technology or technology trends in my life, nor my investing. I just don’t like the risk.
I much prefer to wait until it is clear as to which new technology or trend will win out and then make my purchases. That’s why I never owned a Betamax even though it was clearly a superior format to the VHS. I waited until the battle was over and the outcome was clear before I placed my investment in video equipment for my home entertainment.
Today, it seems certain that the next big thing in consumer technology is going to be the Internet of Things. I saw a commercial last night for a doorbell that rings to your cell phone. Now, you can always be home in the mind of anyone who comes to your door. You just might not choose to open it before telling them you are not interested.
How long will it be before the average consumer is scanning bar code labels to create their grocery shopping list? How long will it be before those lists are sent via the Internet to your favorite store for you and automatically pulled and bagged by robots so it is waiting when you arrive?
At that point, the grocery supplier will be able to simply debit your bank account for the required payment and all you will have to do is hop into your car and go pick them up. Maybe your car will not even require you to drive it. We already have the GPS to provide turn by turn directions and cars that can park themselves.
All of these changes will be a part of the “Internet Of Things" as our soon to be fully “connected” lives is now known.
Where we are going is already clear. You might not have noticed yet, but no matter who the businesses are that ultimately provide the individual products and services we will use are, one of the ultimate beneficiaries is clear. No matter who the smaller players are that supply the individual components, Cisco Systems (CSCO, Financial) will be a major beneficiary.
Cisco Systems is more imbedded than most realize
Cisco Systems designs, manufactures, and sells switches and routers that allow data to arrive where it is supposed to in the fastest and most efficient manner possible. A lesser known aspect of their business relates to providing services to the communications and information technology industry worldwide.
Its switching products provide connectivity to end users, workstations, IP phones, wireless access points, and servers. Its next-generation network routing products interconnect public and private wireline and mobile networks for mobile, data, voice, and video applications.
The company also offers service provider video infrastructure, including set-top boxes, cable/telecommunications access products, and cable modems; and video software and solutions. In addition, it provides collaboration products comprising unified communications products, conferencing products, telepresence systems, and enterprise mobile messaging products.
Its business to business operations also provide data center products, such as blade, rack, and modular servers, fabric interconnects, software, and server access virtualization solutions; security products, including network and data center security, advanced threat protection, Web and email security, access and policy, unified threat management, and advisory, integration, and managed services; and other products, such as emerging technologies and other networking products.
Further, the company offers wireless products consisting of wireless access points; network managed services; and standalone, switch-converged, and cloud managed solutions. Additionally, it provides technical support services and advanced services.
The company serves businesses of various sizes, public institutions, governments, and communications service providers. Cisco Systems sells its products directly to end users, as well as through channel partners, such as systems integrators, service providers, other resellers, and distributors.
Given the wide range of products and services where Cisco Systems is already an entrenched supplier of products and services, it is almost inconceivable that they could be easily or efficiently displaced.
How is Cisco currently valued by the market?
Cisco is a really interesting study in valuation because it holds $59.107 billion, or $11.64 per share, in cash and short term investments on its balance sheet as of the end of October. This cash is equal to 43.37% of the current market capitalization of the business. This is simply astonishing for a business of this size. The most encouraging aspect of this fact is that management has been able to build up this cash hoard without squandering it on over-priced acquisitions of hopeful small businesses in what is currently a somewhat pricey market.
Based on the current earnings estimates from analysts covering the stock, Cisco is expected to earn $2.27 per share in the fiscal year ending in July 2016.
|No. of Analysts
|Year Ago EPS
Based on the Dec. 15 closing price of $26.85, Cisco is currently trading at only 11.83 times earnings. For a business with the balance sheet of Cisco, this is a very low valuation in a market trading for close to 21 times earnings right now.
If we use the market valuation net of cash and short-term investments to determine the current P/E multiple of Cisco Systems today, we arrive at a current valuation of only 6.7 times current year earnings.
I used to have a Director of Finance who, when asked what the current period financial performance would be, would always respond with: “What do you want it to be?” It was always a little worrisome to me that there were so many ways to “massage” reported earnings in a given reporting period. But, reported earnings can be massaged.
My exposure to Mark and his ability to “work the numbers” instilled in me a solid sense of skepticism regarding reported earnings by businesses. It helped me to learn to use free cash flow as a confirmation metric of reported earnings.
Free cash flow, in very simple terms, is the cash from operations less capital expenditures and any other expenses necessary to operate the business. For the fiscal year ended July 31, Cisco generated cash from operations of $12,552 million, while spending $1,227 million in capital expenditures. The remaining $11,552 million of free cash flow divided into the market capitalization of $136.29 billion produces a free cash flow/price valuation of 12. While this is not a dirt cheap valuation, it is far below the 18 times free cash flow than many value investors consider to be a fair price for businesses that are dominant players is very sustainable industries.
Why does this opportunity exist?
I rarely feel comfortable trying to assign any reasonable explanation to the behavior of the market. I have always thought that anyone who claims to understand the “mind of the market” will lie to me about other things as well.
I will not claim to know why Cisco is as undervalued as it appears to be. I do have a theory though. Over the past several years, Cisco has been making the difficult transition from growth stock to value stock. Earnings growth has slowed to high single digit rates and analysts were expressing concerns that cloud services would begin to erode the market demand for Cisco’s routers and switches.
That has not turned out to be the reality. Compared to five years ago, Cisco’s combined revenue from routers and switches has actually increased slightly from $21.9 billion to $22.4 billion for the past 12 months.
So we have a very profitable business, generating rivers of free cash flow every quarter and already swimming in an ocean of highly liquid assets. Best of all, it is priced at bargain basement levels.
The only explanation I was able to find was the expectation that the router and switch business would decline because of the development of cloud computing. That has not developed.
Kelly Kramer, Cisco’s CFO, says the company is the market share leader in 12 of its 18 product lines (and No. 2 or No. 3 in the remainder). Its share of the American router market is 85%. Its wireless market share is about 50%. If these numbers represent a business in decline, I imagine many other businesses wish they could decline like this!
How can we assess the current fair value of Cisco?
I will often use both free cash flow and earnings as separate metrics in estimating fair values for businesses. However, in the case of Cisco, they are both about 12x multiples, so it is probably just as effective to pick either one.
If we were to simply assign the current average P/E multiple of the S&P 500 of 21x to Cisco, we would end up with a target price of $47.67 per share, or 77.5% above its current $26.85 share price.
Now, I think Cisco is a far better business than the average stock in the S&P 500. But, I would never pay 21 times earnings for the average stock in the S&P 500. I tend to view the fair value of that index to be about 15 to 17 times earnings. Therefore, that is how I choose to value Cisco.
Based upon the estimated earnings of $2.27 per share for the year ending next July, this produces a range of fair value between $34.05 and $38.59 per share. These prices would represent increases of 26.8% and 43.7% from the current share price, assuming the current consensus estimates are valid.
The company’s performance against the past estimates indicates the analysts are able to predict earnings for Cisco with a reasonable degree of accuracy based on the table below from Fidelity Investments.
In each of the last eight reported quarters, Cisco has exceeded the analysts’ projections by a few cents per share each time. While there is no guarantee this trend will continue unabated forever, it should provide investors with some degree of confidence in the numbers we can see today.
What is the opportunity going forward?
For investors, finding a business trading at an attractive current valuation is always good news. However, profitable investing is about future growth as much as current valuation or past performance.
While Cisco Systems in not currently projected to grow earnings at a rapid pace going forward, the table below shows that it is projected to expand earnings at an annual pace of 9.4% for the next five years.
|Past 5 Years (per annum)
|Next 5 Years (per annum)
|Price/Earnings (avg. for comparison categories)
|PEG Ratio (avg. for comparison categories)
If Cisco’s stock simply maintains its current valuation multiples and achieves 9.4% annualized earnings growth over the next five years, the share price should rise at that level as well. The company also pays aÂ generous dividend that currently yields 3.21%. When the dividend income is added to the projected annual gain in share price, investors can expect to be rewarded with an annual return of 12.61% over the next five years.
Remember, this estimate assumes that the valuation will continue to remain at the currently depressed levels.
I also do not believe that these forward looking estimates fully account for the massive benefit the coming Internet Of Things will have on Cisco’s future growth. This is the wildcard that could explode Cisco’s share price higher and blow my previous, rather conservative, estimates out the window.
Final thoughts and actionable conclusions
Cisco is one of the most iconic brands of the entire Internet story. The Internet would not exist and function the way it does today if not for Cisco’s products.
I believe the predictions of Cisco’s demise have been grossly overstated and I could not be happier about it as it is creating an exceptional opportunity for us today. Even with iconic bell weather stock like Cisco Systems, the market can seriously overreact to less than optimistic assessments by analysts and create spectacular opportunities for those willing to perform a bit of quantitative analysis.
As more investors realize the inappropriate valuation currently assigned to this business, those who buy today will be rewarded with much richer valuations. Until that time, they can expect to earn a relatively safe 12.6% annualized return on their capital.
One last thing before I go. As the Internet Of Things becomes more of a reality, it will begin to become clear which small businesses will become major players and beneficiaries of that development. Wouldn’t it be nice to be sitting on a huge pile of cash when it came time to snap one of those future winners up during a depressed market?
Where do you think you could find an attractive business that is also sitting on a huge pile of cash today?