Cisco: Out Of The Penalty Box
Back in November I wrote a piece in response to Cisco’s (CSCO) Q1 earnings, wondering whether or not this company is destined to be the next IBM (IBM) in terms of a consistently slumping top-line. I’ve been long CSCO for years and although many view this stock as a lumbering legacy tech company, it’s been one of my better performers. I’m up over 85% on the position that I began building in late 2013. My cost basis is $23.80 and my yield on cost is 4.87%. Even with such success in mind, CSCO was placed in the penalty box for me due to growth concerns. I’ve never considered selling my shares; I still view this as a strong dividend growth company, but I wasn’t willing to begin adding again until top-line growth returned after a streak of 8 consecutive quarters of negative growth. Well, that streak is over, Cisco is out of time out, and I’m hoping to add to my position on the next bit of weakness that CSCO shares experience.
For years now, Cisco has acted like many of the other large cap, “old tech” names. What I mean is, while experiencing a stagnating top-line, CSCO has used the massive cash flows from its high margin legacy businesses to return capital to shareholders (and consequently, financially engineer bottom line growth due to a vastly reduced share count). This is especially the case since 2014, as you will see in the graph below. What’s more, CSCO has increased its long-term debt load, which wasn’t exactly an irresponsible thing to do in a low rate environment with so much cash locked up overseas; however, it still weakens the balance sheet.
With that said, when you look at the chart below, while the sales and debt trajectories may be concerning, the shareholder return metrics are top notch. Honestly, it’s difficult to find a stock in the market that has performed better in this regard. CSCO is yielding ~3% at the moment and offers investors what appears to be sustainable prospects for strong dividend growth. I think the days of nearly 15-20% dividend increases will be over with after 2018, which I expect to be a banner year for shareholder returns due to benefits that CSCO will see from the recent tax reform. However, I wouldn’t be surprised to see high single digit/low double digit dividend growth moving forward and this should result in one of the higher Chowder Numbers coming form a name with a dividend yield in the 3% range.
Now, I don’t mean to sell CSCO short. Buybacks weren’t solely responsible for rising EPS in the face of falling sales; management has been able to slightly increase margins in recent years (once again, this trend is clear from 2014-present).
Other than the shareholder returns, none of the above figures are particularly impressive to me. However, when you’re looking at a stock operational performance aren’t the only variables to consider. CSCO has traded at a valuation far below the broader market’s premium for years now and slow and steady multiple expansion had to outsized returns.
Even after such strong performance over the last 5 years or so, CSCO still trades with a P/E ratio that is below the market’s multiple. Prior to the stock’s recent run up to ~18x ttm earnings, CSCO hadn’t traded above the 15x threshold since 2010. For years, analysts have been bearish on CSCO’s exposure to legacy hardware, which has led to the soft premium.
Source: F.A.S.T. Graphs
It’s only been recently that the company has been able to shrug off some of this hardware related bearishness as CSCO built out its services. In Q2, ~33% of CSCO’s sales came in the form of reoccurring revenues. The market loves the reoccurring model because it is more predictable and CSCO is being rewarded as investors show a willingness to pay a higher premium for shares.
As a CSCO shareholders I’m happy to see the company re-invent itself as a more services oriented company. I’m happy to see CSCO diversify itself away from the legacy switching and router business and into higher growth markets like data centers and security. I like the more predictable revenue model and the comfort that comes alongside it. Reoccurring revenues remove doubt and risk from future projections regarding the top/bottom lines, but until these sales make up a larger slice of the CSCO pie, I think it’s wrong to ignore the rest of the company. It’s important to remember that revenue was only up 3% in Q2, and this is coming off of a relatively easy comp since prior to the recent quarter, CSCO had been in a growth slump.
While CSCO is certainly a steady holding for income oriented investors, I don’t necessarily like the idea of paying a higher premium for shares. While the company has certainly improved itself in recent years, it’s still very far from being considered a growth company.
Furthermore, it is still likely to post slower growth than the market as a whole and its smaller peers who’re more focused on the high growth technology markets mentioned above. Right now, investors are performing a balancing act between higher growth prospects (albeit lesser ones than the market) and the income/income growth that CSCO offers as an up and coming dividend growth company (which are greater than the market’s). CSCO does have the M&A kicker with its huge incoming cash pile but the company’s market cap is over $215b so it’s going to be difficult to make a move that really moves the needle.
Some people have made connections between CSCO today and Microsoft's (MSFT) early days under CEO Satya Nadella when that company was transitioning from legacy cash flows towards their services based cloud growth engine. There was a time when MSFT was trading at a similar valuation that CSCO demands today; heck, from 2009-2014 MSFT shares were trading below 15x earnings. I think the comparison has some merits, but I also think it’s ridiculous to think that Nadella’s success at MSFT could be easily replicated by anyone. Sure, he’s laid out the blueprint for “old tech” to become attractive again in the market’s eyes, but this involves quite a bit of execution and CSCO simply doesn’t have the segments that can compete with MSFT’s cloud division in terms of growth (remember, CSCO is only guiding for 3-5% overall growth in the upcoming quarter; for the most part, this is growth that MSFT has significantly outpaced on a quarterly basis dating back years).
At the end of the day, I was pleased to see CSCO’s recent results but I am a bit concerned that the market is getting ahead of itself with regard to the bullish surge we’ve seen. CSCO is now out of the penalty box for me and I would love to add to my position, and consequently, bolster my income stream, but only at the right price. I think 15x is a fair price to pay for CSCO right now (remember, I said fair; I don’t think 15x is particularly cheap for a company that is still oriented around legacy hardware). Using forward looking, 2018 EPS estimates of $2.58, this means that I’m looking for pay ~$39 for shares. This is ~10% lower than CSCO’s current share price. I imagine that it will take another bout of broader market weakness to hit this price target and I’m not going to hold my breath while I wait for it, but I will be ready and willing to augment my CSCO position should I have the opportunity.
If not, I will happily sit back and watch the shares that I already own continue to grow. CSCO currently represents ~1.75% of my portfolio, which is a slightly overweight allocation. Because of the company’s strong shareholder returns, I’d feel comfortable pushing this allocation even further to the heavy side, but at the same time, I don’t feel compelled to chase the recent upward move.
Disclosure: I am long CSCO, IBM, & MSFT.