Cisco Systems (CSCO)

[chmcnfunds]

Buy Citi's Sell Cisco Call

Dec 12 2013, 09:08 | about: CSCO
Disclosure: I am long CSCO, MSFT.

Yesterday Cisco (CSCO) fell to $20.88 on volume well over its 10 day average volume on a sell call issued by Citi (C). You can read about Citi's downgrade here.

Why would anyone raise a sell call on a stock trading at a PE (trailing twelve month) of 11.38? The PE for the year ended July 2014 is expected to be 10.54, while the PE for the year ended July 2015 is expected to come in at 9.95. Cisco also offers an attractive dividend yield of 3.26% with a payout ratio of 35.5%. Everything points at the stock being well valued. So why would anyone issue a sell call? I would not be averse to reducing long positions on Cisco if the stock was expensive, but it's not.

Then I noticed the price target of $18. And I thought maybe Citi is talking price while I am thinking value. And since one has little to do with the other, never the twain shall meet. It's a bit like if I were jabbering on at you in Hindi, while you jabbered back in Greek, with neither one of us understanding the other!

Why Cisco

Cisco is in the business of the design and manufacture of internet protocol and other products related to the communications industry forming part of the information technology sector. You can learn more about Cisco by reading the excellent introduction on Reuters.

I think it is fair to say that the world grows more inter-connected by the day. And with rising inter-connectivity, communications are becoming more important. Not only is it here to stay, it is a huge growth area. Networks are powerful, and devices already number in the tens of billions. With exponential growth in the number of devices, networks shall grow in both size and power. Look at service delivery too: with the Internet and apps becoming popular service delivery mechanisms in 2014 we can expect to see 77 billion downloads. And when I look at that number, it looks suspiciously low. As far as innovation is concerned, Cisco remains formidable both in house and through acquisitions. Cisco is a market leader in routing, switching, voice, wireless LAN, tele-presence, conferencing and cloud. And they are number two in blade servers and storage area networks. I don't expect them to lose in stature anytime soon.

From time to time there will be surprises. That is all but natural in a cyclical business. Today Cisco faces challenges in US markets because of a slowdown in government spending. In addition, corporations have also held off on big spending for a long time. And the company faces pressure because the NSA has caused Cisco to be viewed with suspicion in several non US markets. To add to their headaches, they lost their challenge to Microsoft's (MSFT) acquisition of Skype. As I said, innovation is alive at Cisco; their Cloud Fusion project could well be a major growth driver, and thwart NSA to boot. And as long as innovation remains alive, in a circular world, today's headwinds are tomorrow's tailwinds!

Cisco has been in a firm downtrend since mid-August. And with Citi's downgrade encourages a continuance of the down trend. Does this create an opportunity to buy?

From data at Reuters we know that Cisco trades at a PE of 11.38 times trailing twelve months earnings. Over the past five years, the PE ratio has fallen as low as 10.54 and risen as high as 20.89. As it happens, the expected PE for the year ended July 2014 is expected to be 10.54. We may be close to a bottom.

It has a dividend yield of 3.26%, compared with 0.58% for the industry and 0.88% for the sector and a payout ratio of 35.20% compared with 4.16% for the industry and 18.80% for the sector. The dividend yield provides nice downside protection because it adds some defensive characteristics to an otherwise cyclical stock. The payout suggests that the dividend is well sustainable. But it also signals that Cisco will not grow as fast as younger participants in its industry; no surprises here: once a company reaches a large size, growth inevitably slows.

Operating margins over twelve months is 22.53%, far higher than comparable for the industry (16.51%) and sector (14.52%), and operating margins over the past five years have averaged 21.22% compared with 9.86% for the industry and 12.83% for the sector. Interestingly, operating margins have strengthened compared with five year averages. And they also outperform the industry and sector.

Return on equity over the past twelve months is 17.72% compared with 20.38% for the industry and 19.04% for the sector, and return on equity over the past five years has been 16.84% compared with 14.58% for the industry and 15.74% for the sector. Cisco has outperformed industry over a five year average, but the present headwinds have forced return on equity below that of competitors, even while it has risen over Cisco's five year average.

Sales growth has been 4.57% compared with 17% for the industry and 24% for the sector over the past twelve months, and 4.22% compared with 15.12% for the industry and 13.35% for the sector over the past five years. Earnings growth has been 18.31% over the past twelve months, and 7.27% over the past five years compared with 25.41% for the industry and 18.62% for the sector. This is a worrying trend. It signals that rapid growth in the industry is diluting Cisco's stature as a bell-weather. And with the five year averages being subdued, it has sufficient longevity to worry that it might be a new trend. But with growth drivers ahead, while I doubt Cisco will beat the industry average in a hurry due to its size, I remain hopeful that long term growth shall accelerate back to at least 8% to 8.5%.

Capital spending shrunk at 1.76% over five years compared with positive 13.42% for the industry and 9.85% for the sector. Why does this not surprise me? It does explain the slowing sales and earnings growth!

Forward expectations for the year ended July 2014 come in at an average of $2.01, with a high estimate of $2.03 and a low estimate of $1.86. The estimate for the year ended July 2014 came in at an average of $2.10 twelve months ago. For the year ended July 2015 the average estimate is $2.09, with a high estimate of $2.30 and a low estimate of $1.90. The estimate for the year ended July 2015 averaged $2.24 twelve months ago. Clearly expectations have been declining over the past twelve months. Have they bottomed? I think, outside of a change in the broader macro economic environment which would impact most companies, the answer is yes.

What is Cisco worth?

With beta at 1.25 we know that Cisco is a high beta company in the context of the industry which has a beta of 0.99 and the sector which has a beta of 0.96. Thus to price the risk, our expected return must be higher.

Ahead in this post, I refer to a target rate of return. I calculate the target rate of return as the risk free rate (Rf ) plus beta multiplied by the difference between the market return (Rm ) and Rf, assuming that the ten year treasury currently yielding about 2.88% represents the risk free rate, and a 9% represents the very long term return from the market [Rf + Beta * (Rm - Rf)]. If we assume that the ten year treasury currently yielding about 2.88% represents the risk free rate, and a 9% represents the very long term return from the market, a stock with beta of 1.25 ought to deliver a target rate of return of 10.5%.

If we accept 8% as a very long term growth rate for Cisco, we have to consider what part of profits the company must reinvest to drive that level of growth, assuming it can maintain a return on equity of 17%. We have earnings of $1.98 expected for the year ended July 2014. To grow these earnings by 8%, we would need to grow earnings by $0.16 to arrive at target earnings of $2.14 for 2015. If the company were to reinvest 47% of the $1.98 in earnings, it would retain and reinvest $0.93. With a return on equity of 17%, this $0.93 of retained and reinvested profit would generate the $0.16 growth for next year. The remaining $1.05 ($1.98 less $0.93) is available to shareholders and can be returned to shareholders through a mix of dividends, buybacks or growth higher than the 8% level. For the stock, the indicated return is 13% (that is the $1.05 available to shareholders, divided by the $20.88 price plus the 8% growth rate). This is well above the target return expectation of 10.5% which should be expected from a stock with a beta of 1.25.

As it happens I have long positions in Cisco. My model which evaluates prices in the context of value perceived at a variety of differing levels of risk aversion indicates that the stock would be attractive to buy and hold style investors at $19.75. This is a level at which I would add positions. My model also indicates despair values of $16.65 as a potential target during a severe bear market. I would add further positions at this level. Thus we have downside of 5% to 6%, rising to a decline of 21% should we enter a severe bear market.

On the upside is a target of $41.36, which represents 20.89 (5 year high earnings) time earnings of 1.98: this represents potential upside of 98%. In the unlikely event that it occurs, I would be reducing positions at this level. I would also possibly reduce positions at $28.63 if there were better value opportunities available at the time this target is achieved: this represents a more likely upside potential of 37%. When I say reduce, I mean reduce. It is highly unlikely that I would ever eliminate my Cisco long positions as long as capital appreciation together with dividends over the long term continues to deliver a return consistent with its beta priced (presently of 10.5%).
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