Connecting with Cisco (CSCO)

Cisco Systems (CSCO) is the world’s leading manufacturer of data networking equipment, and its products include switches, routers, access equipment, and network-management software.  Switches connect computers to each other and routers connect them to the Internet.

Cisco Systems (CSCO) was the monthly Online Stock Study for March at the Better Investing website and was led by Suzi Artzberger, BI’s Director of Information Services.  Study materials include handouts from Cisco, the Value Line report, presentation slides, and the recording of the Online Study. 

 A Consensus SSG was completed, but has not been made available.  After the study, Suzi posted her SSG on BI’s First Cut page.  

Company Background 

– According to the S&P Stock Report, CSCO has four product segments: switches (41% of FY 2009 product sales), routers (22%), advanced technologies (32%), and other (5%).   

** The primary driver of future growth, S&P believes, will be advanced technologies which includes home networking, unified communications, security, storage area networking, wireless technology, application networking services, and video systems. 

– Morningstar considers that CSCO has a wide moat giving it a competitive advantage because customers are reluctant to switch vendors and due to Cisco’s reputation as the leading provider of networking equipment. 

** CSCO’s share of the $21B switch market has remained at about 70% for the last five years while its nearest competitor, Hewlett-Packard, is far behind at 5%. 

** CSCO’s routers, used by telecom and cable companies to move data, are also a market leader with Juniper Networks in second place. 

– One week after the Online Stock Study, the New York Times reported that CSCO had produced a new, high speed router with speeds 12 times faster than competitive equipment, its first major improvement in six years.  

– Acquisitions have been a major driver of CSCO’s growth and lists some 125 companies purchased in the past seventeen years, 27 in the last five [Cisco Corporate Overview, slide 24].   

** Its most recent acquisitions were Tandberg (video communications) and Starent Networks (mobile systems), each for $3 B cash announced in October 2009. 

– CSCO’s FY 2009 was dismal:  Sales were down 9%, product revenues were down 12% and EPS declined 20% [Cisco 2009 Annual Report, pages 2-3 and 7].

– In CSCO’s most recent quarter (Q2, FY 2010), Sales & EPS were up 8% & 23%.  Cisco’s recovery was so good that it announced plans to hire up to 6000 people in the next several months.  

SSG Discussion 

– I compared the Consensus SSG with Suzi’s and mine and with Take Stock.  After the table, I discuss several issues identified by the comparison and then examine the downtrends in CSCO’s Pre-Tax Profit Margin and Return on Equity, and its overall financial condition. 

Cisco Systems(CSCO)	Consensus        SSG	SuziA from       BI’s First Cut	Armin	Take Stock
Date	3-1-10 data        3-3-10 SSG	3-1-10 price       3-9-10 SSG	3-2-10	Same
Data	S&P	S&P	Same	Hemscott-Morningstar
Price	$24.33	$24.60	$29.60	Same
52 week High &        Low Price	N/A	$25.10 &               $13.61	Same	Not Used
Last Quarter          Reported Data	Q2 ending          1-31-10	Same	Same	Same
Software Used	Online SSG	Same	TK 6	TS Online
Project Growth  From End of	Last FY	Same	Last Q	Last FY
Sales Growth	10.00%	13.00%	10.00%	–08.00%
EPS Growth	10.00%                (PP= 10.70%)	13.00%               (PP = 13.60%)	10.00%	-15.10%
High PE	25.0                     (5 year ave)	24.0	25.0                    (5 year ave)	24.9
High EPS	$1.72	$2.02	$1.72	$0.47
High Price	$43.09	$48.48                 (21% > VL)	$43.00              (7.5% > VL)	$11.71
Value Line Estimated High Price = $30-40 as of 12-25-09
Low PE	16.35                   (default)	16.35                    (5 year ave)	17.3                    (09 Lo PE out)	16.2
Low EPS	$1.07                  (default)	Same	$1.07                 (ttm)	$0.97
Low Price	$17.02                 (ave low price last 5 years)	$17.40                 (low PE x          low EPS)	$18.50              (low PE x         low EPS)	$15.71               (low PE x         low EPS)
Upside/Down	2.57	3.22	3.0	Impossible to calculate
Total Return	12.11% or           13.02%	14.31%	11.80%	-13.80%
SSG Buy Under	Not Used	Not Used	$19.14	$5.86
RV/PRV	Not Used	Not Used	111.7/103.8 (2009 Low       PE out)	Not Used
RV/PRV                     (no outliers)	Not Used	Not Used	109.0/101.4	Not Used
Quality	N/A	N/A	B+	0.50 unacceptable
PTPM – 5 yr ave	26.87%               Trend down	26.87%                 Trend N/A	26.9%                 Trend down	Same                Same
ROE – Ending Yr Equity, 5 yr ave	21.44%                Trend NA	21.44%                Trend N/A	21.4%                Trend down	Not Used
ROE – Begin Yr Equity, 5 yr ave	Not Used	Same	24.0%                 Trend down	24.2%                 Same
Debt to Equity –    5 yr ave	15.12%         Trend N/A	Not Used	18.4%                Trend up	Not Used

Estimating Future Sales and EPS Growth for the Next 5 Years 

(A) Consensus SSG: 

– Suzi gave the group five choices to estimate future Sales growth: 8.00%, the most recent quarter; 10.00%, estimate for 2010 from S&P’s report; 11.40%, CSCO’s Sales growth last 5 year average; 12.00%, organic growth estimate for the next 5 years from Morningstar’s report; and 14.50%, mid-range of CSCO’s guidance according to Morningstar. 

** The Consensus choice was 10.00%, S&P’s one-year estimate (37% of the votes). 

– Suzi offered five choices to forecast future EPS growth: 8.00%, CSCO’s EPS growth last 5 year average; 10.00%, S&P’s estimate from the BI data files; 10.70%, Suzi’s estimate using the BI/NAIC Preferred Procedure; 12.00%, CSCO’s guidance; and 23.1%, the most recent quarter. 

** The Consensus choice was 10.00%, S&P’s estimate (42% of the votes). 

(B) Suzi’s SSG: 

– Her SSG from BI’s First Cut estimated 13.00% Sales and 13% EPS growth based on CSCO’s 12-17% guidance for the next several years plus her optimism about the company’s market position.

(C) Armin’s SSG: 

– When I did my SSG, the seven analysts I always check were estimating long-term EPS at an average of 10.58% with CNNMoney via FactSet CallStreet high at 12.00% and Value Line low at 7.50%. 

** The 12 analysts at CNNMoney ranged from 20.00% high to 10.00% low while the 11 analysts at Reuters.com ranged from 16.00% high to 2.00% low.   

** I used 10.00%, the lowest estimate by CNNMoney’s 12 analysts. 

### For how I estimate EPS for all my SSGs and the names of the seven different estimates I review, see Estimating EPS; click here 

(D) Take Stock: 

– Take Stock estimated -8.00% Sales and -15.1% EPS growth (both are negative forecasts) for the next 5 years and both seem foolish as well as unreasonable to me. 

Estimating the High and Low PEs for the next 5 years 

Consensus SSG: 

– Participants were given five options to choose the Forecast High PE: 25.0, five year average High PE; 24.0, an intermediate value (unexplained); 23.6, most recent year average High PE; 23.0, current PE; and 28.7, average PE for the last 5 years. 

** The Consensus chose 25.0, the five year average High PE (22% of the votes), but 24.0, an unexplained, intermediate value was close behind in second place (21%). 

– Participants were not asked to select a Forecast Low PE and Suzi chose 16.35, the Online SSG’s default value. 

Forecasting the Low Price 

Consensus SSG: 

– Suzi gave the group 5 options to choose the Forecast Low Price: $19.68, 80% of the current price; $17.49, Low PE x the Low EPS; $17.02, average Low Price in the last 5 years; $15.00, an intermediate value (unexplained); and $13.61, the recent severe low price. 

** The Consensus chose $17.02, the average Low Price (35% of the votes). 

Final Results 

– None of the four studies found that CSCO was a SSG Buy which requires a 3.0 Upside/Downside Ratio AND a 15.00% Total Return: 

• The Consensus SSG got a 2.59 U/D and a 12.11% TR
• My SSG got a 3.00 U/D and a 11.80% TR
• Suzi’s SSG came close with a 3.22 U/D and a 14.31% TR
• Take Stock doesn’t use the U/D concept and got a –13.80% TR

– Note that the Consesus SSG and mine used the same EPS estimate and High PEs, but my Forecast High Price was higher than the Consensus ($43.00 vs $38.50) solely because I chose to project growth from the end of the last quarter whereas the Online SSG is limited to projecting from end of the last FY. 

– The Consensus SSG’s Forecast High Price was close to VL’s estimated High Price as was mine while Suzi’s was 21% greater and Take Stock’s was way, way out-of-whack ($11.71 vs VL’s $30-45 when CSCO was selling at $24.60). 

Pre-Tax Profit Margin (PTPM) and Return on Equity (ROE) 

– CSCO’s PTPM and ROE both are trending down which typically indicate red-flag warning signs of deteriorating quality.  Some SSGers would go no further and stop their analysis because of the downtrends.  Suzi saw the PTPM downtrend, but thought it still looked robust compared to its competitors.  She did not comment on (or spot) the ROE downtrend

This slideshow could not be started. Try refreshing the page or viewing it in another browser.

. 

– The downtrends could be a worrisome sign of declining fundamentals or a signal that CSCO has unsustainably high fundamentals.  Here’s what I found: 

Industry Comparisons with Morningstar-Hemscott data:  

– CSCO’s 5 year average PTPM is way better than its industry average (26.9% vs 12.1% Networking & Communication Device Industry).  Moreover, Cisco ranks first out of 21 companies. 

– CSCO’s 5 year average ROE is also way better than its industry average (21.6% vs 12.5% Industry) and ranks second.  Moreover, after I remove Superclik (SPCK) as an outlier, the adjusted industry average drops to 8.3% and Cisco is way, way better. 

Industry Comparisons with S&P data: 

– CSCO’s 5 year average PTPM is better than its industry average (26.9% vs 20.5% Communication Equipment Industry).  

– CSCO’s 5 year average ROE is also better than its industry average (24.0/21.4% vs 20.5% Industry).  Although SPCK is not an outlier with S&P data, there is no company-by-company listing, a serious omission in my judgment, and I therefore cannot identify other possible outliers. 

###  To learn more about the investigating Industry Info, see: Investigating Industry Info; click here 

Financial Condition 

– Value Line gives CSCO an A++, its highest grade for Financial Strength, and reports $35.4 B in cash assets, $10.3 B in debt (all long term), and $350 M annual interest as of 10/24/09. 

** VL also reported that CSCO is spending 12.9% of its sales on Research & Development which I see as an excellent investment in its continued financial strength. 

– Morningstar says that CSCO’s balance sheet is “rock-solid” with much more cash than debt and with free cash flows that have averaged more than 20% of sales over the past several years.  

** Cisco also covers its interest payments more than 20 times over with EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). 

– S&P’s Stock Report says that CSCO’s financial profile is one of the best in its industry (Communications Equipment), with $40 B in cash and investments as of January 23, 2010.  Long-term debt stands at $15 B with total debt to capital at 46%. 

** Cash flow from operations totaled approximately $10 B during FY 2009, close to a whopping $1 B per month.  And, CSCO’s ROE is attractive, according to S&P standards, at close to 25% in FY 09 and above the industry average. 

– The Bob Adams one-click Annual Report spreadsheet gave CSCO 57 out of 100 with 10 bullish results (good things) and 9 bearish (not-so-goods): 

** The good things include: ROE (debt not included) is very good; Interest Coverage is very good and Pre-Tax Profit exceeds interest by 23.2x; the Quick Ratio and Current Ratio are both 3.2 and are very good; Accounts Receivable, Inventories, and Shares Outstanding are all decreasing. 

** The not-so-goods include: Sales are decreasing while related costs are increasing; Long Term Debt is increasing; and Debt to Equity is high (27%, a caution flag). 

Quality  

– S&P gave CSCO a B+ for quality, fourth out of its eight grades.  Take Stock, on the other hand, rates CSCO as almost totally unacceptable, a .50 out of 10, with a minimum of 3.4 required to pass muster and 6.7 desired.   

– Other measures of CSCO’s quality: 

• #16 out of 100 on Fortune Magazine’s 2010 list of the Best Companies to Work For;
• #20 out of 50 on Fortune’s 2010 list of the World’s Most Admired Companies (and #1 in the Networking and Other Communications Equipment segment);
• #32 out of 50 on Business Week’s 2009 top 50 Most Innovative Companies.

Armin  

[please rate this post on the star-ranking scale below and/or leave a comment as your feedback is important to me]