Written by the FALCON Team
Just recently, we published our monthly ‘Tech Stocks On Sale’ series, exclusive for Seeking Alpha readers. After our prior article focusing on chip juggernaut Intel (INTC), we continue to extend our technology sector coverage with Cisco (CSCO), as the networking equipment giant also fared favorably in our quantitative screening process.
In light of Buffett’s teachings distilled from his 50+ years of shareholder letters, our analysis is based on the three dimensions that truly matter: operations, capital allocation, and valuation. Before we do that, however, let’s jump into what makes Cisco an interesting candidate today.
So what’s the story with Cisco?
Cisco is a global networking equipment behemoth, having its roots as an established Infrastructure Platforms provider (including switching, routing, data center, and wireless hardware and software offerings), with ~55% revenue contribution in FY2020, while the related support and maintenance service offerings also make up a significant ~27% chunk of the top line. Cisco’s Applications product category (~11% of revenue) consists primarily of software-related offerings, like the thriving online collaboration platform WebEx and application performance management service AppDynamics. Last but not least, Cisco’s Security product category (~6% of revenue) includes network security, identity and access management, and advanced threat protection solutions.
In light of the pandemic, Cisco’s FY2020 performance was heavily affected by the unfavorable economic environment, with Infrastructure Platforms taking the biggest hit, leading to a substantial, -10% YoY revenue decline, coupled with a neutral impact on Services. While the public sector and major enterprise clients fared fairly well in the current environment, smaller enterprise and commercial client spending have decreased meaningfully, with many delaying purchasing decisions until they have clarity on the timing of the global economic recovery.
Cisco’s Applications category also decreased by ~4% compared to the prior year, as the relative strength of WebEx and AppDynamics could not make up for the headwinds in other areas. The only exception to the rule has been Cisco’s Security category, posting an impressive, 10% year-over-year growth, driven by enhanced demand for network, identity and access, and cloud security.
Despite the recent headwinds, Cisco continues to execute well on the strategy pledged by its current CEO, Chuck Robbins who took the helm in 2015, namely to shift the focus on software and services to significantly increase recurring revenues. As a result, software and services make up over 50% of Cisco’s revenue by now, with SW alone projected to grow to 30% by 2022. The company’s efforts to push towards more recurring revenue are also bearing fruit, with subscriptions representing ~80% of SW revenue as of today.
Cisco’s leadership team also takes the currently sluggish demand in networking equipment as an opportunity to streamline operations, announcing a plan to remove over $1 billion in costs, and realign development resources into strategic areas. While the weakness in demand is expected to continue impacting Cisco in the near term, the ‘new normal’ work-at-home environment has shown companies the importance of state-of-the-art IT infrastructure. This may lead to an inevitable need to invest in modernizing their infrastructure, inducing an eventual rebound in Cisco’s top line after the dust settles, coupled with a boost from 5G infrastructure spending in the subsequent years.
As a general rule of thumb, a company has authentic earnings power when it has both defensive and enterprising profits. Thus, when assessing a firm’s operations, we care about two fundamental aspects: it has to pass the cash flow-based stability test, and it must be a consistent shareholder value creator measured in the EVA framework.
Stability: Assessing Cash Flow Consistency
As Hewitt Heiserman writes in his book, “It’s Earnings That Count”: The most ruinous mistake you can make as a buyer of common stocks is to own a company that goes bankrupt. For this reason, the defensive investor judges the quality of a firm’s accrual profit on the basis of its ability to self-fund. That is, whether it produces more cash from ongoing operations than it consumes, and not go deeper into debt or dilute current stockholders. When we look at the conventional financial statements, our primary concern, therefore, is the stability of the company’s cash generation.
Despite sluggish revenue growth, Cisco has generated a strong increase in net income over the past 10 years, while successfully converting it into cash, leading to a ~4.3% compound annual growth in operating cash flow since 2011. At first glance, the company seems fairly capital-light, with CapEx amounting to only ~7% of OCF on average over the past decade, trending downwards due to the pronounced focus on software and services. However, significant investments in R&D and acquisitions are also essential to ensure the company’s long-term survival (since it is operating in a rapidly changing, highly competitive environment), thus the related spending should also be treated as capital expenditure.
With that being said, Cisco easily passes our first criteria regarding stability, underpinned by its strong and steadily growing FCF generation capability. In the next step, we move on to the EVA framework, examining if the company can consistently create shareholder value, as EVA cuts through accounting distortions and charges for the use of capital.
Value Creation: What type of moat rating is warranted?
We tend to prefer companies whose businesses are protected by large and enduring economic moats, as buying those companies at the right price generally leads to outperformance, as outlined in our research article. In the EVA framework, the EVA Margin (EVA/Sales) will be our ratio to define a company’s moat. A 5% EVA Margin can be used as an indicator for a “good” company, whereas persistence of a 5%+ EVA Margin for 10 years makes a company great and thus “moaty.”
Let’s start by looking at the chart: Cisco’s EVA Margin has averaged ~12% over the past decade, showcasing the company’s exceptional shareholder value creation capability, resting heavily on its premium pricing and favorable brand recognition. It is also readily apparent by the positive underlying trend, that the shift towards less capital-intensive, higher-margin software and service offerings clearly benefited the company’s EVA Margin, reaching as high as ~18% in the last quarter. Considering the strategic rationale behind the transformation, the company’s EVA Margin has the potential to stabilize above the exceptional 15% mark going forward, allowing Cisco to easily pass the quantitative wide-moat threshold.
Assessing incremental EVA returns
EVA Momentum measures the growth rate in EVA, scaled to the size of the business (measured by its sales). It is the EVA framework’s equivalent for Return On Incremental Invested Capital or ROIIC. Any positive EVA Momentum is good because it means EVA has increased, and it is an indication that it is worthwhile to reinvest capital in the underlying business. Instead of pinpointing any single-year performance, we prefer to look at the long-term trailing averages in EVA Momentum.
Over the past decade, Cisco has generated an average EVA Momentum of 1.2%, which was primarily driven by a substantially improving EVA Margin, coupled with sluggish sales growth over the period. To put that into perspective, the long-run average for the 75th percentile of the U.S. stock market (represented by the Russell 3000) is 1.0-1.5% percent. While the clear driving force behind the outstanding historical EVA Momentum figures has been Cisco’s transformative margin improvement, the return to top-line growth will be a key factor to watch going forward, since profitable growth is an inevitable condition for a sustained positive EVA Momentum. With that being said, Cisco fares exceptionally well in terms of shareholder value creation, as every reinvested dollar leads to incremental EVA generation for the company’s shareholders.
Our take on the moat
The EVA framework enabled us so far to prove from a rearview-mirror perspective, whether the company has an economic moat based on its historical consistency of shareholder value creation. From a qualitative standpoint, Cisco derives moat sources from its reputable brand name as an intangible asset, as well as the switching costs its customers would face in case of changing network equipment vendors.
The company, relying on its reputation, prides itself as the premium choice on the market, and its pricing power is clearly reflected in the exceptional EVA Margin levels. Although it is rarely the cheapest solution, the different hardware and software offerings bundled with analytics and security not only offer great value for customers, these also make Cisco a “one-stop-shop” for most companies’ network needs, while the increasing portion of subscription-based offers further strengthens Cisco’s highly loyal client base.
Although Cisco’s existing enterprise and commercial customers are reluctant to switch networking products due to costs and risks associated with such a change (making it hard for competitors like Arista (ANET) to threaten Cisco’s dominant campus market position), the single biggest threat to the company’s infrastructure platforms is the exploding adoption rate of hyperscale cloud solutions (e.g. Amazon’s (AMZN) AWS and Microsoft’s (MSFT) Azure). With tremendous in-house networking design capabilities, these juggernauts depend inherently less on Cisco’s technology and expertise for their datacenter applications.
As this disruptive trend could weigh on Cisco’s uniquely strong market position in the long term (as the future success of its networking platform segment will highly depend on its ability to work alongside cloud providers facing strong white-box hardware competition), a narrow moat rating seems warranted for Cisco from a qualitative standpoint (in line with Morningstar’s assessment). That said, despite disruptive technologies and increasing competition, the company’s long track record in innovation and massive R&D spending gives us confidence in Cisco’s ability to adapt to changes in the market environment and remain an important player, thus outearn its WACC for an extended period.
Taking a brief snapshot at the company’s debt profile, Cisco has an S&P Credit Rating of AA- coupled with a long-term debt to capital ratio of 22%. The company’s ability to generate consistent cash flow, coupled with its substantial amount of cash reserves gives it ample room not only to navigate through today’s rapidly changing IT environment but also to make further strategic investments and acquisitions as well.
Summary of operations – the Quality Score
The EVA framework’s Quality Score is a comprehensive way to assess a company’s overall quality, by combining its EVA-based Performance (EVA Margin and Trend) and Risk (e.g. Volatility and Vulnerability) metrics into a single score, measured against the broader market. In the case of extraordinary companies, we would like to see a Quality Score consistently above 80 over a long period. As outlined in our research article, the upper quintile tends to outperform the market historically.
In the case of Cisco, the company’s Quality Score has been nothing but exceptional for the past decade (hovering well above the 80 mark), following a strong bounce-back from 2011 lows as the company’s subsequent turnaround plan started to bear fruit. The success of the current CEO’s software-focused strategic shift is yet again reflected on the chart, as the company’s EVA Margin expansion (coupled with a low Risk Score resting on Cisco’s fortress financials) translated to an exceptional Quality Score surpassing 90 after 2015.
As a final assessment, Cisco is a highly profitable business with stellar shareholder value creation consistency, although the underwhelming top-line performance is a key factor to watch since margin expansion is not an everlasting growth driver for EVA. The company passes our operational criteria with ease, and Cisco’s narrow-moat rating seems fully warranted both from a quantitative and a qualitative standpoint. (Nevertheless, from a purely quantitative standpoint, Cisco would be absolutely deserving of a wide-moat rating.)
After looking at the operations dimension, we continue investigating the company through the capital allocation lens. Remember, the incremental return on invested capital (measured by EVA Momentum) is a crucial element when it comes to the assessment of successful capital allocation by management. If the company can earn a positive EVA by reinvesting all the cash generated by the underlying business, shareholders are better off if the firm retains most of its earnings. In the table below, we have dissected all the possible uses of cash for Cisco for the past decade.
As outlined earlier, Cisco’s operations require a fairly low level of reinvestment, with CapEx amounting to ~7% of OCF on average over the past decade, while significant R&D expenses and acquisitions are also necessary for the company to be able to keep its competitive position. With Cisco’s EVA Momentum coming in at 1.2% from 2011 to 2020, the current level of reinvestment seems justified, since it translates to incremental shareholder value creation going forward. The company has been making considerable investments to support and grow its innovation pipeline both organically and through bolt-on acquisitions, while its strong cash flow position gives it considerable leeway to distribute excess cash to shareholders.
As part of our capital allocation strategy, we intend to return a minimum of 50% of our free cash flow annually to our shareholders through cash dividends and repurchases of common stock.”
Source: 2019 Annual Report
Between 2011 and 2020, the company generated an aggregate of $121.1 billion in free cash flow, while buybacks and dividend payments amounted to $109.2 billion, or 90% of FCF. It is important to note that the two major repurchase programs in 2018 and 2019 were financed with a significant portion of the $67 billion cash pile Cisco repatriated during 2018.
Cisco has been a regular repurchaser of its shares, amounting to $67.8 billion during the last 10 years, reducing the share count by ~23%. In terms of shareholder value creation, it is always crucial to assess whether share repurchases are executed in an opportunistic manner. While share buybacks can provide much value to shareholders, it is important to examine when these purchases are taking place, since if these happen at a premium to the intrinsic value of a business they are actually value-destructive, not value-enhancing.
Unfortunately, neither the elevated amount of buyback spending in 2014 nor the 2018-2019 ill-advised repurchase spree falls into the opportunistic category. During 2018-2019, share repurchases amounted to more than $38.5 billion and by looking at the chart above, it is clear that these did not take place at historically appealing levels. At the time of the purchases, Cisco was trading at well above 25% Future Growth Reliance levels, while the 10-year historical average comes in at only slightly above 10%. That said, it is always easy to look smart in hindsight, and management may also have had a different opinion about the valuation of the company at the time. The repatriated cash windfall has likely been a one-off event as well, making the probability of similar blunders significantly lower in the future.
Besides share buybacks, Cisco has been paying quarterly dividends since 2011, although the once stellar initial growth rates have tapered-off into the single-digit territory in recent years. Nevertheless, dividend payments remain an important cornerstone of the company’s capital allocation policy, even in light of today’s challenging economic situation:
Today, we announced a $0.01 increase to the quarterly dividend to $0.36 per share, up 3% year-over-year. […] This dividend increase reinforces our commitment to returning capital to our shareholders and our confidence in the strength and stability of our ongoing cash flows”
Source: Kelly Kramer, CFO, Q2 2020 Earnings Call
The current dividend yield of 3.76% is certainly enticing in historical terms as well since the stock provided a higher than 3.5% entry yield only 10% of the time since initiating a dividend in 2011. Although the current economic headwinds will likely lead to only low single-digit growth rates in the near term, we are confident that the dividend is safe, considering a healthy payout ratio (averaging ~40% of FCF in recent years), underscored by Cisco’s strong balance sheet and significant cash reserves.
Cisco has made over 200 acquisitions during its 36-year history, matching the company’s strategy of keeping a leading position in switching technology, security, and software-defined networking. In recent years, Cisco’s M&A activities have revolved around improving its competitive position in four key areas: 5G wireless, data center/hyper-converged infrastructure, artificial intelligence, and security.
In a crowd of Cisco’s countless bolt-on moves, the 2017 $3.7 billion AppDynamics deal stands out in terms of magnitude and strategic importance. Although the lofty price tag seemed hard to justify at the time, it has quickly become the world’s #1 application performance management solution to power complex multi-cloud environments of leading enterprises.
Acquisitions also contributed to the rapid growth of Cisco’s Security portfolio, with the product category evolving into one of the most important growth engines and unique selling points of the company. A notable deal in the space was Cisco’s 2018, $2.35 billion Duo Security takeover. Significant investments in this segment also helped Webex to become the most trusted, secure platform for remote collaboration among enterprises, giving it an edge over popular rival Zoom (ZM).
Future Growth Reliance
Our prime historical valuation indicator in the EVA world is the Future Growth Reliance (FGR), which is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA. As outlined in our research article, it is the best-of-breed sentiment indicator that addresses accounting distortions, thus gives us a true picture of which companies seem attractively valued in historical terms.
Looking at the chart of Cisco, today’s share price implies an FGR that is close to the lower end of its historical valuation range. Numerically, it stands at -8% as of today, indicating a highly favorable valuation compared to the 5-year average FGR value of 19%. Current levels indicate an EVA destructive scenario going ahead, which seems like an overly pessimistic scenario since it completely disregards the company’s high EVA Margin and still positive historical average EVA Momentum (despite lackluster sales growth). In our view, a 0% FGR scenario would already represent an overly conservative base case, translating to a share price of ~$42, which would imply zero growth in EVA.
As a second step, we use Morningstar’s valuation system, where analysts create industry and company-specific assumptions, and then all the inputs are used in a discounted cash flow model. In order to reflect all moving parts within the business, the analyst firm also evaluates the level of uncertainty with all the stocks they cover. Morningstar assigns Cisco a medium uncertainty rating with a $48 fair value. The thresholds between the different star ratings are illustrated below:
With the stock currently trading at $38.4 as of October 5, a 4-star rating is warranted, implying that Cisco’s shares are slightly undervalued based on Morningstar’s estimate, in line with our previous analysis relying on EVA fundamentals. It is worth noting, that our ~$42 fair value estimate (assuming 0% FGR scenario with 0 baked-in growth in EVA) falls roughly in line with Morningstar’s 4-star threshold. No matter from which angle we look at it, the value proposition of Cisco’s shares seems compelling at current levels, with an ample margin of safety to fair value.
Summary of the investment thesis
PRVit score – heat map vs. market
After all our due diligence, we turn to the PRVit model for a final judgment of the overall attractiveness of a stock. The PRVit is a multifactor quantitative stock selection model based on EVA-centric measures of Performance, Risk, and Valuation. Combining a company’s Quality Score with its actual Valuation Score can be visualized on a heat map like the one below, where the gradient diagonal line signals fair value. We want to see a stock in the upper-right hand corner of this heat map, but we are more concerned with the Quality Score, as we believe that over the long-run, we are better off with a truly exceptional business bought at a fair price, rather than a fair company bought at an exceptionally attractive price.
As visible on the above heat map, Cisco remains an attractive investment candidate within the EVA framework, as an opportunity where such a premium quality name trades at these depressed valuation levels is hard to come by. While we acknowledge that Cisco is likely to struggle to achieve top-line growth in the short term, the level of EVA deterioration implied by the current valuation seems highly unlikely.
Since both the DCF and the EVA-based valuation are pointing to a compelling risk/reward ratio, we believe Cisco offers an attractive buying opportunity at current levels for enterprising investors with a pronounced focus on quality. More conservative value investors might stay on the sidelines though, until shares reach truly bargain-basement territory below $36 (translating to an entry yield of 4.00%), from where it is almost impossible to come up with a single-digit annualized total return scenario.
One more thing
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.