Cisco (CSCO) – Driving Profitable Growth Strategy

I initiated a position in Cisco Systems, Inc. (CSCO) in mid-November 2010 and aggressively added to my position on two occasions at the end of June 2012; I hold these shares in a ‘Core’ account within the FFJ Portfolio.

In mid-August 2019, I acquired additional shares and hold these in a ‘Side’ account within the FFJ Portfolio.

CSCO’s valuation at the time of these purchases was attractive. The same, however, can not be said for some of my co-workers who aggressively invested in many high-tech companies during the dot-com bubble.

I distinctly remember when the one-day appreciation in the value of their investments (CSCO was one such investment) often exceeded their daily employment income.

Many of these co-workers, however, failed to exit their positions before the precipitous drop in the share price of these companies! Some had even employed the aggressive use of leverage; a few years later they were still repaying the debt they had incurred for what ultimately became worthless investments (ie. several companies went bankrupt).

CSCO did not go ‘bust’ but if we look at its stock chart dating back to January 1, 1996, we see what happens when emotions influence investment decisions. An investor who acquired CSCO shares between late January – September 2000 and never exited their position would still be ‘underwater’….more than 2 decades later.

Fast forward to the present and I have this ‘it’s deja vu all over again’ feeling as Yogi Berra so eloquently stated. Many investors are once again treating the equities market as a casino. Now, however, we have a low-interest-rate environment which has led to historical levels of margin debt. At the time of the dot-com bubble, interest rates were much higher than current interest rates. Investors essentially had other investment alternatives. In the current low-interest-rate environment, however, money has flooded into equities because the rates of return elsewhere are dismal. This has led to many wonderful (and not so wonderful) companies being grossly overvalued!

Cisco – Driving Profitable Growth Strategy – Overview

CSCO designs and sells a broad range of technologies that power the Internet. It integrates its platforms across networking, security, collaboration, applications and the cloud with these platforms designed to help customers manage more users, devices and things connecting to their networks.

Business is managed through three geographic segments:

• Americas;
• Europe, Middle East, and Africa (EMEA); and
• Asia Pacific, Japan, and China (APJC)

Products and technologies are grouped into the following categories:

• Infrastructure Platforms;
• Applications; and
• Security and Other Products.

In addition to CSCO’s product offerings, it provides a broad range of service offerings, including technical support services and advanced services which are increasingly being delivered through software.

The company’s customers include businesses of all sizes, public institutions, governments, and service providers, including large webscale providers. These customers often look to CSCO as a strategic partner to help them use information technology to differentiate themselves and drive positive business outcomes.

A comprehensive overview of the company including information about the competition and risk factors is found in Part 1 of the FY2021 10-K.

CSCO also held its Investor Day on September 15. Multiple presentations presented at this Investor Day are readily accessible here.

Cisco – Driving Profitable Growth Strategy – Financial Results

Supporting information that accompanies CSCO’s August 18 Q4 and FY2021 earnings release is accessible at FY2021’s archived events. The accompanying Earnings Release presentation is accessible here.

On page 83 of 122 in the FY2021 10-K, we see that CSCO has a $2B fixed rate note with an effective rate of 1.9% maturing September 20, 2021, and a $0.5B fixed rate note with an effective rate of 1.13% maturing June 15, 2022; these two amounts make up the bulk of CSCO’s $2.508B short-term debt as at July 31, 2021.

CSCO has ample liquidity and the repayment of the $2B note would have not been an issue; I expect to see this repayment reflected when the Q1 2022 results are released on November 17. Even after this repayment, CSCO should still have over $20B of cash and cash equivalents and investments. This compares favourably with ~$24B of short-term liabilities of which ~$12B is short-term deferred revenue.

In a nutshell, CSCO has ample liquidity to provide investors with ‘peace of mind’.

Subscription Revenue

A little over half a decade ago, CSCO began to aggressively transition its portfolio to more of a subscription and software-based model. This shift has led to a significant increase in deferred revenue; this is money CSCO receives before it is earned.

Deferred revenue can not yet be reported on an income statement because it has yet to be ‘earned’. Instead, this money is reported on the Balance Sheet as a liability. As CSCO delivers its products and services, the deferred revenue liability becomes earned and CSCO reflects this as revenue on the Income Statement.

Any deferred revenue CSCO expects to report as revenue within the next 12 months is a current liability. Any deferred revenue pertaining to products or services to be provided beyond 12 months falls under long-term deferred revenue.

If we look at CSCO’s FY2005 10-K, it reported only ~$3.6B of deferred service revenue and ~$1.5B of deferred product revenue for a total of ~$5.1B; ~$3.9B of this was current and ~$1.2B was non-current.

At the end of FY2021, CSCO reported ~$12.7B of deferred service revenue and ~$9.4B of deferred product revenue for a total of ~$22.1B; ~$12.1B of this was current and ~$10B was non-current.

This aggressive transition to a subscription and software-based model has had a remarkable impact on CSCO’s Balance Sheet. At the end of FY2005, it had cash and cash equivalents and short-term investments totalling ~$7B. At the end of FY2021, it had ~$24.5B!

Not only has CSCO’s financial position improved but management has better visibility and can now provide guidance which is something management did not previously provide.

Supply Challenges

CSCO is not immune from the supply challenges many companies are reporting. Its supply chain team is continuing to manage through the components shortage challenges and is working with global suppliers to meet customer demand as quickly as possible.

Management expects these supply challenges and cost impacts to continue through at least the first half of FY2022 and potentially into the second half.

Strategy and Growth Markets

The 3 pillars of CSCO’s growth strategy are:

• Build a cloud-first and app-centric portfolio that delivers end-to-end solutions to power customers’ digital transformations and to provide unparalleled connected experiences;
• Transition to software and subscriptions, delivering innovation faster with predictable revenues via SaaS/XaaS.
• Expand reach beyond IT, Networking and Security to Developers, Line of Business (LOB), Cloud and Digital teams

Cisco – Driving Profitable Growth Strategy – Financial Guidance

CSCO did not historically provide guidance for the upcoming fiscal year. Its successful transformation toward driving a higher proportion of revenue from subscriptions, recurring and deferred revenue, however, now affords management additional visibility into its outlook for future growth. Given this, investors can expect guidance going forward.

At its September 15, 2021 Investor Day, management included guidance as part of the Driving Profitable Growth segment of the presentation; management is assuming a non-GAAP effective tax rate of 19%.

Cisco – Driving Profitable Growth Strategy – Credit Ratings

The following are CSCO’s current long-term domestic unsecured debt credit ratings:

• Moody’s: A1 (top tier upper-medium grade)
• S&P Global: AA- (lowest tier high grade)

S&P Global’s rating is one notch higher than that assigned by Moody’s.

Moody’s rating defines CSCO as having a STRONG capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

S&P’s rating defines CSCO as having a VERY STRONG capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.

Both ratings are investment grade and should be satisfactory for investors with a low tolerance for risk.

Cisco – Driving Profitable Growth Strategy – Current Valuation

In FY2012 – FY2021, CSCO generated diluted EPS of $1.49, $1.86, $1.49, $1.75, $2.11, $1.90, $0.02, $2.61, $2.64, and $2.50. The weak FY2018 results are because of the enactment of the Tax Cut and Jobs Act (TCJA) on December 22, 2017. The TCJA significantly revised the U.S. corporate income tax by, among other things, lowering the statutory corporate income tax rate from 35% to 21% effective January 1, 2018, implementing a modified territorial tax system, and imposing a mandatory one-time transition tax on accumulated earnings of foreign subsidiaries.

Were it not for the enactment of the TCJA, CSCO’s FY2018 GAAP earnings would have been relatively consistent with that reported in recent years. However, because of the TCJA, CSCO’s PE based on GAAP earnings was 15.59, 12.68, 12.19, 18.92, 14.44, 14.46, 19.95, 139.77 (FY2018), 19.03, 18.12, and 22.2 (source: Morningstar).

Given the low-interest-rate environment for other forms of investments and the improvement in the quality, predictability and consistency of CSCO’s earnings, a PE in the upper teens based on GAAP earnings seems reasonable.

CSCO’s FY2022 adjusted diluted EPS guidance is $3.38 – $3.45 and shares currently trade at ~$54.60. Using the $3.415 mid-point, the forward adjusted diluted PE is ~16.

Guidance from the brokers which cover CSCO is as follows:

• FY2022 – guidance from 29 brokers is $3.37 – $3.50 with a mean of $3.43 thus resulting in a forward adjusted diluted PE of ~16 based on the mean value.
• FY2023 – guidance from 28 brokers is $3.55 – $4.02 with a mean of $3.67 thus resulting in a forward adjusted diluted PE of ~14.9 based on the mean value.
• FY2024 – guidance from 12 brokers is $3.70 – $4.10 with a mean of $3.87 thus resulting in a forward adjusted diluted PE of ~14.1 based on the mean value.

CSCO ceased being a high-growth business many years ago. In fact top-line revenue in FY2012 – FY2021 is 46, 49, 47, 49, 49, 48, 49, 52, 49, and 50 (billions of $).

In my opinion, CSCO does not warrant an adjusted diluted earnings multiple that is much different from the current level. I would, therefore, be very reluctant to pay much more than CSCO’s current share price.

Cisco – Driving Profitable Growth Strategy – Dividends and Share Repurchases

Dividends, Dividend Yield and Share Repurchases

CSCO’s capital allocation approach includes a commitment to return a minimum of 50% of Free Cash Flow (FCF) to shareholders annually.

The following image shows the extent to which CSCO has rewarded shareholders in recent years.

CSCO’s dividend history is accessible here.

With shares currently trading at ~$54.60, the dividend yield is ~2.7%.

CSCO will likely declare one more $0.37 quarterly dividend payable in late January 2022. In February, I expect the quarterly dividend to be increased ~2.7% to $0.38/share. Cisco is a Dividend Contender having raised the dividend for 11 years in a row.

Investors who focus on dividend yield and dividend growth could be disappointed with CSCO’s dividend growth rate. This is because the annual inflation rate for the United States is 5.3% for the 12 months ended August 2021.

Inflation is likely to remain at elevated levels over the next few quarters. Unless CSCO increases its quarterly dividend to at least $0.39/share, the value of CSCO’s dividend will be eroded on an inflation-adjusted basis.

In FY2016 and FY2017, CSCO repurchased $3.9B and $3.7B of issued and outstanding shares. It followed up these purchases with the repurchase of $17.661B and $20.577B in FY2018 and FY2019 and $2.7B and $2.9B in FY2020 and FY2021. In recent years, it has also repurchased $0.5B – $0.9B of shares for tax withholdings on vesting of restricted stock units.

Partially offsetting all these share repurchases is the issuance of common stock as part of the company’s employee compensation.

Putting together all these purchases and issuances of common shares over the years, we see a gradual reduction in the number of outstanding shares except for FY2018 and FY2019 when significant share repurchases occurred; the average shares outstanding in FY2012 – FY2021 is 5,404, 5,380, 5,281, 5,146, 5,088, 5,049, 4,881, 4,453, 4,254, and 4,236 (millions of shares).

With only $0.5B and $1.25B of debt maturing in FY2022 and FY2023, it is not beyond the realm of possibility that CSCO will use a significant percentage of its annual FCF to make sizable share repurchases in both fiscal years.

Cisco – Driving Profitable Growth Strategy – Return on Invested Capital (ROIC %)

The ROIC % metric measures how well a company generates cash flow relative to the capital it has invested in its business.

According to conventional wisdom, an annual ROIC of ~7% or greater is considered good for an equity investment. This is also about the average annual return of the S&P 500 when accounting for inflation.

While I like to compare a company’s ROIC % relative to its competitors and other investment opportunities, I appreciate that it has its limitations because it does not account for risk or time horizon and it requires an exact measure of all costs. As a result, investment decisions must be evaluated based on multiple metrics and not just ROIC%.

CSCO’s annualized ROIC % for the quarter that ended in July 2021 was 14.49%.

As of September 29, 2021, CSCO’s weighted average cost of capital is 6.94% and its ROIC % is 14.22% using trailing 12-month income statement data; CSCO generates higher returns on investment than it costs to raise the capital needed for that investment.

In comparison, the competitors reflected in Part 1 of CSCO’s FY2021 10-K have the following ROIC % (figures in brackets denote negative ROIC):

• Arista Networks, Inc. as of June 2021 – 48.46%
• Broadcom Inc. as of July 2021 – 14.30%
• CommScope Holding Company, Inc. as of June 2021 – 1.83%
• Check Point Software Technologies Ltd. as of June 2021 – 15.83%
• CrowdStrike Holdings, Inc. as of July 2021 – (11.5%)
• Dell Technologies Inc. as of July 2021 – 4.57%
• Dynatrace Inc. as of June 2021 – 2.71%
• F5 Networks,Inc. as of June 2021 – 8.61%
• FireEye, Inc. as of June 2021 – (13.32%)
• Fortinet, Inc. as of June 2021 – 18.05%
• Hewlett-Packard Enterprise Company as of July 2021 – 4.85%
• Juniper Networks, Inc. as of June 2021 – 4.92%
• Lenovo Group Limited as of March 2021 – 5.94%
• Microsoft Corporation as of June 2021 – 30.8%
• New Relic, Inc. as of June 2021 – (38.71%)
• Nokia Corporation as of June 2021 – 7.05%
• Nutanix, Inc. as of July 2021 – (40.51%)
• Palo Alto Networks, Inc. as of July 2021 – (3.06%)
• RingCentral, Inc. as of June 2021 – (18.9%)
• Ubiquiti Inc. as of June 2021 – 144.64%
• VMware Inc. as of July 2021- 6.88%
• Zoom Video Communications, Inc. as of July 2021 – 59.75%
• Zscaler, Inc. as of July 2021 – (27.53%)

CSCO’s ROIC % is neither the strongest nor the weakest amongst the list of companies reflected above. It is, however, inferior to that of other high-quality companies in which I want to increase exposure.

Cisco – Driving Profitable Growth Strategy – Final Thoughts

CSCO’s financial strength is appealing. It generates significant annual FCF and is committed to returning a minimum of 50% of FCF to shareholders annually. CSCO may increase its share repurchases given that little debt matures in the next 2 fiscal years; I think this is more likely to occur than a significant increase in the quarterly dividend.

Despite this, I am not prepared to add to my CSCO position because:

• If the US 10 Year Treasury yield continues to increase, a broad market pullback could occur soon; this rate has risen from 1.31% on September 1 to 1.55% on September 29.
• I am increasing my exposure in other high-quality companies I think could generate long-term investment returns exceeding those of CSCO.

Stay safe. Stay focused.

I wish you much success on your journey to financial freedom.

Disclosure: I am long CSCO and MSFT.

Author Disclosure: I disclose holdings held in the FFJ Portfolio and the dividend income generated from these holdings. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author Disclaimer: I do not know your individual circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.

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