Monday, August 20, 2012

Cisco Reports Earnings, Hikes Dividend

Cisco (CSCO) released it's fourth quarter and fiscal year 2012 earnings on Wednesday of last week.

The company earned $ 1.9 billion in the most recent quarter and $ 8 billion for the full fiscal year.

Cisco's free cash flow comfortably exceeded their earnings at $ 9.5 billion in the most recent fiscal year.*

So, at a minimum, it seems fair to say that the $ 8 billion that Cisco earned this past year is a conservative reflection of the company's current earning power.

Buyback activity during the past year reduced Cisco's shares outstanding from 5.496 to 5.354 billion shares. In fact, over the past five years Cisco has reduced their share count by nearly 1 billion shares.
(Since the beginning of their stock repurchase program, Cisco has bought back 3.7 billion shares at an average price of $ 20.36/share.)

Using Friday's close price, Cisco's market value is:

$ 19.06/shares*5.354 billion

= $ 102 billion

Net cash and investments on the balance sheet (cash and investments minus net debt):

= ~ 32 billion

Enterprise value (market value minus net cash and investments):

= $ 70 billion

So, as of last Friday, investors were willing to pay roughly $ 70 billion for a business that earned $ 8 billion or roughly 8.7x earnings. The multiple is more like 7.3x using the $ 9.5 billion free cash flow number.

Also, consider that the stock was selling at roughly $ 15/share as recently as July 25th, 2012. At that price investors were paying just 6x current earnings and 5x free cash flow.**

A multiple of 5-6x implies the expectation of real trouble for the business. At that kind of valuation, all long-term investors really need is for the company really has to prove is that the business is stabilizing -- show evidence that the moat is not collapsing -- while doing a reasonably good job allocating capital over time. No growth required.

Buffett said the following in the 2007 Berkshire Hathaway Shareholder Letter:

A truly great business must have an enduring "moat" that protects excellent returns on invested capital. 

Then later added...

A moat that must be continuously rebuilt will eventually be no moat at all.

Of course, the price action of any stock can be just about anything over the next few years. I'm simply saying that (at least at a 5x to 6x multiple) those with a true long-term investing time horizon simply need earnings to not fall off a cliff and management to not be wasteful of owner capital for the arithmetic to work.

With an earnings yield in the mid-to-high teens (the 5x to 6x multiple inverted) it would seem not much has to go right. At that valuation, the Cisco will naturally generate in cash every 5 to 6 years the company what investors paid up front. If the analysis were only as easy as that. The math is simple, of course, but the key is judging whether the excess cash is truly excess and that the earnings power is truly persistent. In other words, all or most of those earnings must not needed to continuously rebuild the moat.

How well long-term investors consistently judge this matters a bunch. Growth matters less but is a bonus if you can obtain it without paying too much.

Otherwise, buying cheap shares (those selling a plain discount to value) of businesses that have durable high returns on invested capital is the key driver of long-term returns.

A cheap multiple isn't enough.

An investor has to be confident the business can produce returns on invested capital that are both durable and attractive.

An investor has to be confident the excess capital will generally be put to good use.

Back to Cisco. The company's shares certainly don't appear expensive these days. The question that's tougher to answer is the long-term strength/durability of Cisco's moat and whether the company's excess capital will be put to good use going forward.

In a separate press release Cisco announced that it was hiking its quarterly dividend by 75%. As far as returning excess capital to shareholders goes, that would seem to be a meaningful step forward.

Cisco now has a nearly 3 percent annual dividend yield at the current price.

Adam

Established long position in CSCO just below the current price

* I do not include share-based compensation expense in my calculation of free cash flow. The dilutive effect of stock options is potentially very expensive in the long run for shareholders even if share-based compensation expense is also a rather imperfect estimate of what the real costs will be. Unfortunately, it's nearly impossible to gauge precisely what it will really cost so, as an investor, if a company is heavily reliant of stock options for its compensation, I prefer to assume something closer to the worst case. Nothing wrong with being pleasantly surprised if the actual costs to shareholders ends up being much lower. The non-GAAP results that Cisco reports back out share-based compensation expense so they're of little use to me.
** 5.354 shares multiplied by $ 15/share = $ 80 billion market value. Subtract the ~ $ 32 billion in net cash equals $ 48 billion in enterprise value. $ 48/$ 8 billion = 6x earnings. $ 48/$ 9.5 = ~ 5x free cash flow.
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