Friday, May 13, 2011

Cisco Reports Earnings: Opportunity or Trap?

Cisco (CSCO) reported earnings yesterday and the stock is down substantially in early trading:


One analyst at Cannacord Genuity said we are "stepping to the sidelines on what has been a challenged thesis..."


In contrast to that view, several money managers with good long-term track records managing actual money have been buyers of Cisco's stock in the 1st quarter. Some examples:

-Arnold Van Den Berg
-Whitney Tilson
-Donald Yacktman
-Tweedy Browne

There were also quite a few other money managers that, give or take, have a style that is some variation of Graham-Dodd or Buffett-Munger that were buyers of Cisco in 4Q 2010 at higher prices. Many of these have yet to report their 1Q 2011 holdings. It will be interesting to see if some of them have continued to add Cisco.

Obviously, all these managers could be on the wrong track but it's notable that managers who normally avoid tech stocks like the plague are buying. These managers would not have touched technology stocks a decade ago.

So who's more likely to be right, the professional money managers with long-term track records or the analysts?

In the long run I'd generally be inclined to go with the money over the mouth.

Tweedy, Browne's take on Cisco:

"Cisco is financially strong and we think statistically cheap. It has a dominant market position and has been growing within a category that we believe still has a lot of room for future growth. Perceived competitive threats and concerns about possible slower rates of growth have put pressure on Cisco's stock price, which has allowed us an entry point in the stock that we believe is at roughly a one third discount from a conservative estimate of the company's intrinsic value."

In 2003, Tweedy Brown wrote that they believed Cisco was overvalued:

"...it is a mystery to us why Cisco trades at a 68% premium to JNJ based on estimated earnings multiples."

Clearly Cisco has its share of real troubles. At the $ 16.80/share price as I write this and nearly 5 bucks ($ 4.81/share) of net cash on the balance sheet the company now has an enterprise value* that is roughly $ 12.00/share.

Even with its current difficulties, Cisco can earn nearly $ 1.50/share annually without breaking a sweat.

So you've got an 8x multiple right now** and a great opportunity for share buybacks. Cisco already has a $ 11.7 billion stock repurchase program in the works. At current prices that would erase ~13% of shares outstanding (at lower prices even more naturally).

Of course, as I've mentioned in previous posts, low multiples exist for many big cap tech names right now.

Remarkably, even Apple (AAPL) still seems not expensive.

Back to Cisco. I'm not the biggest fan of the company but eventually price matters. Let's assume the troubles get worse before they get better and earnings even go down a bit.

Charlie Munger has said that an equity investor should expect 50% drops in quoted price -- something that has happened to Berkshire multiple times -- from time to time:

"I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%." - Charlie Munger

So let's assume that a 50% drop from here happens to Cisco.

$16.80/share*.50 = $ 8.40/share

At that price they still have $ 4.81/share in cash so the enterprise value per share of the business would be:

$ 8.40/share - $4.81/share = $ 3.59/share

$ 3.59/share for an asset likely to earn something like $ 1.50/share?

At that price, the owners have a 42% earnings yield as long as management is competent enough to not throw the money earned into a furnace.

With that kind of earnings yield growth is hardly a necessity.

In fact, a simple, well-protected, mattress for the cash will do.

Now, if management actually can invest the cash intelligently that's a bonus (for starters, a buyback while the stock remains extremely low). So the simple arithmetic here provides no guarantees but at least some margin of safety unless earnings are on the verge of permanent catastrophic decline. Economic moat, destroyed. If that's the case all bets are off.

Otherwise, If bought at $16.80/share and the stock goes up the investor obviously makes money. No problem. If the stock drops by 50% but maintains anything close to that long-term earning power of $ 1.50/share it creates an enormous opportunity. Not only can the individual long-term investor accumulate more shares below intrinsic value, the company itself can buyback a larger percentage of the share count (for a given amount of dollars committed to buybacks).

Both actions, of course, will directly benefit long-term owners. So, if long-term earning power isn't impaired materially, long-term shareholders should hope for a declining stock price in the near to intermediate term. In the real world, I realize that loss aversion is potent enough that many investors have a tough time investing this way.

The key is to make sure the initial purchases made at or near the $ 16.80/share price are sized in a way that allows aggressive buying to occur at the lower prices.

That's often where the mistakes get made and opportunities are missed.

A true long-term investment time horizon is also needed.

No trades here.

The more expensive shares initially purchased near $ 16.80/share, in this scenario obviously now deeply in the red, should produce more than solid though obviously less spectacular returns for the long-term investor (though what's quoted will certainly be ugly for an extended period of time).

At that higher price Cisco still provides a 12.5% earnings yield based upon enterprise value.

Again, none of this is true if earnings are on the verge of a catastrophic sustained decline. Nor is it true if Cisco ends up needing most of its earnings to be reinvested in the business to remain competitive (or uses its funds to make expensive acquisitions). All things being equal, businesses that require lots of incremental capital to remain competitive are less attractive. Cisco historically hasn't been a capital intensive business but lots of capital has been used for acquisitions.

Ultimately, the judgment of intrinsic value has to be approximately correct and a long enough time horizon or none of this works. Other than that, it comes down to temperament, discipline and patience. The fact is many cannot stomach to see the paper losses that are an inevitable part of this process.

Try the same approach on a high flying stock selling at a 50-70x multiple of earnings that gets into trouble.

The math doesn't work.

"...many shall fall that are now in honor." - Horace

With an extreme multiple, earnings are far too small relative to the price paid to provide a useful economic cushion.

Better to buy at a price where nothing great has to happen to produce a nice return.

That's why I never buy a high multiple stock no matter how much I like the business. Every business runs into unexpected difficulties from time to time. I accept that I will not be able to predict when.  Paying a price that provides a margin of safety is your only protection from those unknowables.

"If you have a 150 IQ, sell 30 points to someone else. You need to be smart, but not a genius. What's important is inner peace; you have to be able to think for yourself. It's not a complicated game." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

The reality is successful investing is mostly about making judgments on many hard to quantify intangibles and being approximately right. Elaborate financial models built with complex spreadsheets are often better at being precisely wrong.

"If you need to use a computer or calculator to make the calculation, you shouldn't buy it." - Warren Buffett at the 2009 Berkshire Hathaway Shareholder Meeting

Maybe some smart folks get bored by arithmetic. If so it helps to explain, in part, the kind of frequent misjudgments that result in the routine extreme mispricing of assets in the market (both on the high side and low side).

Those schooled in complex statistics, detailed spreadsheets, technical analysis, algorithms, and other sophisticated "higher" forms of analysis that have become prevalent in the trading/investing world just may consider the insights revealed by arithmetic to be beneath them.

Too simple.

"...the hedge fund known as 'Long-Term Capital Management' recently collapsed, through overconfidence in its highly leveraged methods, despite IQ's of its principals that must have averaged 160. Smart, hard-working people aren't exempted from professional disasters from overconfidence. Often, they just go aground in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods." - Charlie Munger in a speech to the Foundation Financial Officers Group

Judging the risk/reward profile in a situation like Cisco is never easy. There is always unknowables and uncertainties in the future for any business (especially technology businesses). Yet, eventually price gets low enough that the simple math involved wins out over all the worst case scenarios one can imagine.

At the most recent shareholder meeting, Buffett said that he and Munger keep financial projections in their heads and ignore bankers' spreadsheets.

At the meeting, Munger's advice for those in business school was this:

"At least until you're out of school you have to pretend to do it their way."

Let's hope the rapid-fire-can't-wait-a-couple-quarters-for-a-business-to-sort-itself-out culture continues to provide opportunities.

With that said, the fact is there's just no technology business that I'm comfortable with as a long-term investment. Occasionally, some have sold at enough of a discount to be worth the trouble, but they will always remain very small positions. Most are involved in exciting, dynamic, and highly competitive industries.

That's precisely what makes them unattractive long-term investments.

Adam

Long positions in Apple and Cisco

* Enterprise Value = market capitalization - net cash.
Market Capitalization: Cisco has 5.537 billion share outstanding. At $ 16.80/share the market capitalization = $ 16.80*5.537 billion = $ 93.022 billion
Net Cash: Cisco has $ 43.367 billion of cash, cash equivalents and investments. They also have $ 16.749 billion of debt. So net cash = $ 43.367 billion -$ 16.749 billion = $ 26.618 billion
Enterprise Value = $ 93.022 billion - $ 26.618 billion = $ 66.404 billion
Enterprise Value/Share = $ 66.404 billion/5.537 billion = $ 11.993/share
** This works because the earnings are of decent quality (backed up by free cash flow) and look reasonably durable even if Cisco's earnings power shrinks a bit in the near term. There are plenty of low price to earnings stocks out there that seem cheap but are lacking earnings quality, earnings durability or both.
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