The True Value Ceators of the DJIA Part VI
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In a previous five article series (this link to article 5 contains links to the first four), we took a close look at four DJIA firms for their higher-than-average residual earnings generating ability. As the series explained, McDonald's (NYSE: MCD), Wal-Mart (NYSE: WMT), IBM (NYSE: IBM), and Intel (NASDAQ: INTC) were not only able to create value through the growth in residual earnings over the past five years, but they also presented investors with considerably higher investment returns over the same time period:
- Wal-Mart: Residual earnings growth 14.2%, Return 6.7%
- IBM: Residual earnings growth 18.3%, Return 15.4%
- McDonald's: Residual earnings growth 27.3%, Return 21.7%
- Intel: Residual earnings growth 49%, Return 7.5%
These figures, calculated on a five-year CAGR, compare with the average DJIA (all 30 firms collectively) residual earnings growth of only 3.4% and investment returns of -0.2%. The article series showed that a very obvious requirement of continual residual earnings growth, and hence shareholder value creation, is a sustainable competitive advantage.
This final installment (an epilogue, of sorts) in the series examines one of the opposing "value destroyers" with hopes of finding a link between shrinking residual earnings and business strategy. Over the five-year study, Cisco Systems' (NASDAQ: CSCO) residual earnings decreased by an average of 19.5% per year, and an investment made and held in the corporation over the same time period would have yielded a -7.2% annual investment return.
As in the first five articles, the examination of CSCO's excess earnings ability follows the value creation framework illustrated below.
Five Year History
In looking at the value creation breakdown, the drivers behind CSCO's relatively poor performance stick out quite noticeably. The corporation's net asset base (shareholders' equity balance) grew an average of 10.7% per year, but the returns on those net assets (ROCE) fell by 14.4% per year. Remember that Residual Earnings = (ROCE - Cost of Capital) * Average Equity.
ROCE Decline
Because the average net asset base increased, a closer analysis of the declining return on those assets is in order. CSCO's return on common equity of 14.2% in 2011 is well below the decade average of 18.4% and the decade high of 26.5% in 2007. Throughout the five year period, increasing use of financial leverage actually, on the surface anyway, acted to boost the corporation's return on common equity because its average borrowing cost was well below its return on core assets. Using the illustration above, ROCE = RNOA + (Financial Leverage * Spread).
This superficial boost from financial leverage was more than outweighed by the reduced return on core assets (RNOA). Defined as post-tax operating income divided by net operating assets (operating assets - operating liabilities), CSCO's RNOA of 32.5% in 2010 was well below the five year average of 42.7%. As asset turnover metrics remained relatively stable and sales levels increased over the five year period, the primary influence to the reduced return on core assets was margin contraction.
Gross margins, experiencing their high of more than 70% in 2003, have since dropped to 61.4%. Operating margins, due to a decrease in gross as well as a large restructuring charge in 2011, are more than 550 basis points off the decade average. With sales increasing a respectable (considering CSCO's size) 5.5% CAGR over the past five years and overall profitability declining, the corporation's problem seems to be much more ingrained in its actual business strategy.
A Loss of Focus
It would be a mistake to think that the past five year decline in performance will be the corporation's downfall. CSCO is still very profitable despite the unfavorable economic climate, and it still controls the majority market share in its key router and switch markets. However, it would also be a mistake to ignore the relative loss in profitability due to changes in the corporation's core business.
As similar to all highly-profitable and growing markets, CSCO's core switch and router segments have always been prone to attack by new entrants. Although it still controls around 68% of the switch market and 54% of the router market (as of mid-2011), both Juniper Networks and Hewlett-Packard have made significant inroads on the corporation's share over the past several years. This goes without mentioning the multitudes of other players that have been allowed to continuously chip away at the corporation's core businesses.
Many would agree that CSCO lost its edge with attempts of breaking into and improving new markets -- i.e. consumer space, video, telepresence. This does not mean that attempting to improve a business through new product/service offerings is always value-destroying, but it does show that the loss of focus on one's core competency in exchange for a less-than-perfectly executed entry into new markets is usually detrimental to long term profitability.
Router and switch revenue, which once accounted for nearly 72% of the corporation's revenues in the early 2000s, now comprises slightly less than 50% of the revenue stream. Other revenue sources have grown considerably to fill the router/switch shortfall -- allowing total revenues to grow nearly 7% per year over the past ten years. This is well and good, but does the company have a sustainable competitive advantage in these spaces? The declining growth rate in revenue from these alternate sources may hint that CSCO in fact may not -- revenue growth rate of 10% over the past five years is 94% less than the average annual growth rate the corporation experienced in these segments between the preceding five years. Whether the growth at a decreasing rate is due simply to the current unfavorable business climate or a poor product/service mix decision can be debated, but the overall outcome is nonetheless weakened performance.
Straying From Core Competencies
A suitable parallel can be drawn to pre-Michael Eisner Walt Disney Co. Following Walt Disney's death, DIS gradually overextended itself through the acquisition of assorted media companies and even sports teams -- ABC, ESPN, Anaheim Ducks -- and drifted away from and lost market share in its core animation business. Eisner released a statement after the purchase of Pixar in 2006 stating:
"Animation is the foundation upon which the company was built and for years was a core competency. However, in recent years Disney placed less emphasis on animation and, as such, the company was not at the forefront of the digital revolution and did not produce many animation movie hits."
The company's more intense focus on its core business, through increased budget and headcount, has led to the subsequent creation and release of many animated blockbusters, including 2010's Toy Story 3 ($1.06 billion in worldwide box office revenues).
As the most important player in the networking industry, the relatively unimpressive performance generated by CSCO is hardly going to be the corporation's downfall, but it does present an interesting case in point for this series' theme. In terms of long term value creation, the continual growth of excess earnings above and beyond an entity's cost of capital requirements is not as simple as just having a competitive advantage. Competitive advantages, like long-lived assets, tend to erode in time due to natural competitive forces.
Without continually investing in these advantages and without continually widening the protective moat that surrounds them, lost market share, sales, and earnings will eventually result. CSCO's declining performance over the past several years is a perfect illustration, as the company has lost focus (even if ever so slightly) on its core strengths. The company will undoubtedly begin to improve its performance once again as the overall economic landscape becomes more favorable, but any market share lost to competitors like HPQ and JNPR over the past several years is simply market share that CSCO will have to fight hard to have a chance of regaining -- possibly through continued margin contraction over the mid-term.
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