Investment Activity Review - January 2016 Part 3

Opened position in Cisco Systems (CSCO)

This would mark my 3rd iteration of owning CISCO. The previous 2 cycles were positive experiences.

1)     What do they sell?

(Courtesy Reuters) Cisco System, Inc. (Cisco) designs and sells lines of products, provides services and delivers integrated solutions to develop and connect networks around the world, building the Internet. The Company is engaged in designing, manufacturing and selling Internet Protocol (IP)-based networking and other products related to the communications and information technology (IT) industry, and provides services associated with these products and their use. It groups its products and technologies into the various categories, such as Switching, Next-Generation Network (NGN) Routing, Collaboration, Service Provider Video, Data Center, Wireless, Security, and Other Products. In addition to its product offerings, it provides a range of service offerings, including technical support services and advanced services.

 Cisco in my eyes is the nuts and bolts of the Internet. They built the information highway. If you go to any data centre or IT systems department, chances are you will find a Cisco router or switch connecting a bunch of servers and systems enabling them to talk to each other as well as other computers around the world. Cisco in essence designs and builds today's copper pipes.  As a result, Cisco’s business lies behind the scenes of the Internet unlike the Facebook and Twitters of the world. It’s not that sexy company you think of when you hear Internet, but they a play huge role in its functioning.

2)     Who do they compete with?

Because they are so entrenched in the network hardware and services business (Hey they built the Internet after all), Cisco owns a dominant position in the network market. Its main competitors are Juniper Networks, and China’s Huwei. Huwei in particular has made huge inroads in the networking space and taken market share from Cisco outside North America, primarily via lower prices. It has yet to gain a foothold in North America as security issues cloud the company.

3)     Who buys their products and services?

Any company that has any semblance of a corporate Information Technology infrastructure would be interested in Cisco’s array of product and services.

4)     Will they buy it over and over again?

They may not buy the equipment on a daily basis but they will definitely buy the ongoing service and maintenance support that keeps the cash flow churning.

5)     Do they make any money?

Cisco in recent years doesn’t get the same chatter as it used to in the early 2000’s. Despite this, it continues to generate high levels of Return on Invested Capital that is greater than its cost of capital. Even in the slower periods in the business cycle, the company continued to generate strong rates of Economic Profit. The rate of operating profit has been falling in recent years as competitors make their mark on the sector. They may be even worse as the company has been aggressively buying back stock which gives a little juice to their profits.  Despite this they company continues to generate a ridiculous amount of cashflows. Their cashflow margin has averaged 23 percent over the past 3 year, which is incredibly impressive.  

6)     What do they own and who do they owe money to?

The company has a pretty decent balance sheet, with almost $60 billion cash which is about 3 times their debt level. So they are incredibly strong in financing their operations organically. Their goodwill and intangible assets levels are at about 25 percent, which is fairly high. One of the company’s core strategies is to grow by acquisition and their ability to integrate new products into their existing technologies are infamous within the industry. As a result, their intangible asset levels tend to be higher. I would normally be concerned about this, however given the strong cash position in their balance sheet, it gives them a bit more of a financial buffer.

7)     How risky is the business?

Hardware technology companies are always ripe for disruption as rapid change in engineering result in the potential for networking products to become a commodity. Cisco for a long period because of their entrenchment in the corporate networking space was almost indestructible, but new players like Huwei and Juniper have played hardball especially on price points. Cisco’s gravy train of maintenance and service support shields them from some of the forces.

That being said, the company faces clouds. Cisco has realized that this Internet backbone it is supporting is evolving. The emergence of the Cloud Computing is reducing its clients reliance on having its own full service IT shop, hence a lower requirement for servers and databases and routers needed to connect them all. Technology is not moving out of the office and into cars, phones, thermostats, speakers, the so called Internet of Things we hear more and more about. As a result, Cisco trying to pivot to ensure that the backbone it has been supporting can support the next generation of hardware.  Recently Cisco paid $1.4 billion of Jasper Technologies, a company that develops software that let these nouveau Internet oriented hardware talk to each other.

8)     Is the stock cheap?

The stock has been valued at between $30 and $40 per share. The stock had been trading in the high and $20’s for most of the past year, but with the recent market pullback the stock tracked down to the $22-23 range.  From this perspective the stock is cheap. On a relative basis, the stock is cheaper than its peers trading at about 12.5 times next years earnings versus a Juniper which is trading at about 15 times. The industry average is about 17.5 times future earnings.  There appears to be a fair bit of upside on the stock at least to the high $20’s in the medium term.  Based on this, I decided that the current price level provides a nice entry point, so I decided to open a small position and to periodically add to it especially if the stock tracks down and fundamentally nothing significant has occurred. Cisco is more of utility company so it doesn’t’  get the same buzz like it used to nor is it likely that it will return to those glory days. It’ s pretty dull company now. I’m fine with boring. I’m happy to wait.

Update:  Since I wrote this piece, the company has announced that it is increasing its stock buyback to $15 billion as well as its dividend payouts. The market liked it and sent the stock up 9 percent in one session.