Party Like it's 1999
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In a recent article on The Motley Fool, Sean Williams made a strong statement for adding Cisco Systems (NASDAQ: CSCO) to your watchlist. He of course mentioned that it may be a few quarters before Cisco's cost-cutting affects the company's bottom line, but he also pointed out that “it's really hard to ignore the fact that Cisco has generated between $8.8 billion and $10.8 billion annually in free cash flow over the past 5 years.” In one of the more emphatic statements I've seen Sean make he said, “if you don't have Cisco on your radar at $15 you need to stop everything you're doing and add it to your watchlist, period.” Rather than just putting the stock on my watchlist, I decided to do a little research to see if there really is opportunity in this seemingly forgotten multibillion-dollar company.
Back in 1999, Cisco, along with companies such as Juniper Networks (NYSE: JNPR) and Lucent technologies, which is now Alcatel-Lucent (NYSE: ALU), seemingly ruled the networking field and could do no wrong. To get an idea of the mood prior to the year 2000 dot-com crash, I found an article from CNET that said of Lucent, “the company repeatedly has beaten Wall Street's quarterly earnings estimates, posting a string of 7 record-breaking quarters.” This article was written in 1998, and the author was clearly impressed with Lucent's performance. The same article mentioned that the stock hit another 52-week high at over $116 per share. Fast forward to today, and those same shares sell for just over $1. Similar stories can be found about both Cisco and Juniper Networks, as both companies were bid up to ridiculous heights on the assumption that the convergence of data and voice networks would provide unlimited growth for the foreseeable future.
Of course, everyone knows what happened since then. The market took a massive hit once investors realized that unlimited growth was not going to occur. All three companies have fallen tremendously from their all-time highs, but sometimes there's opportunity in nearly forgotten dominant companies. Looking at Cisco's reported earnings, there are at least two steps that the company can take to not only improve the company's financials, but also to make the stock more attractive.
Investors already know that the networking field is not a huge growth field like it was over 10 years ago. That being said, most of the company's multiples have compressed along with their growth expectations. For instance, Juniper Networks currently trades at a forward P/E ratio of about 23, and is expected to grow at about 14% over the next five years. Alcatel-Lucent is still struggling and is expected to grow at just 6% over the same time frame. Cisco which is arguably still the leader in the field, currently sells for a P/E ratio of just 8.73, with expected growth of about 8%. To determine which is the strongest company, one measure we can use to compare the three is the operating margin.
The company with the highest operating margin either makes products that are superior and worth a premium price or is more efficient in utilizing its sales to generate income. In either case, there is a clear hierarchy of operating margins among Cisco, Juniper, and Alcatel-Lucent. At the bottom is currently Alcatel-Lucent, which actually has run a negative operating margin for the last several years. Juniper Networks, on the other hand, has improved its margins from just over 9% in 2009, to almost 14% as of 2011. Cisco Systems has actually seen its operating margin drop from over 20% in 2009 to under 18% last year. Though competitive pressures have forced Cisco to compete more on price, the company's cash flow generation is truly impressive. There are two ways that Cisco can more effectively use its cash in my opinion.
The company currently maintains over $50 billion in cash and investments and yet carries over $16 billion in long-term debt. While it's possible that the company is looking at strategic acquisitions, in the meantime, there is virtually no way that this huge pile of cash is earning enough to offset the cost of $16 billion in debt. Looking at the long-term debt breakdown, the majority of the company's debt shows effective rates between 4.5% and 6.11%. Of the $41 billion in investments, almost $31 billion is in Treasury debt. It seems that the first thing the company could do to improve its financials, would be to use some of its lower rate investments to retire its higher interest rate long-term debt. While this is a simple move and would help the company in a small way, the second step that Cisco should consider would have a significant effect on the stock.
Cisco's management is willing to return cash to shareholders, but their primary method has been through share repurchases. In the last three years, the company retired between $3 billion and $5 billion worth of shares. However, the company is paying out roughly $430 million a quarter in common stock dividends. In the most recent quarter, the company generated about $7.5 billion in free cash flow. From this cash flow, the company repurchased $2.868 billion in shares. To avoid stock option dilution, the company would need to repurchase around $1 billion per quarter in shares. However, in just the last quarter the company spent $1.753 billion to repurchase shares above this dilutive offset. My suggestion is, instead of repurchasing an additional $1.753 billion worth of shares, the company instead should consider redirecting these funds toward common stock dividends. With about 5.36 billion outstanding shares, this additional amount would add about $.33 to the company's current $.08 quarterly dividend. This would drastically change the perception of the stock, as the annual payout would increase to a total of $1.64. With a current stock price of around $16, the effective yield would be north of 10%. While it's certainly true that by doing this, the company's earnings per share might not have beaten estimates each of the last four quarters, that would be a small price to pay for a dividend five times the current amount.
I know it doesn't take Cisco management a lot of imagination to execute these two suggestions. However, sometimes the simplest ideas are the ones that would be the most rewarding to shareholders, who ultimately own the company. While it's true that the company's free cash flow generation is impressive, the stock isn't a screaming buy unless management is going to do more to directly help shareholders returns. A 10% yield, and a better balance sheet would definitely get investors attention.
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