Cash-Rich Cisco Stock: Perpetually Misvalued

There are two types of non-beginner mistakes that I try to warn against. The first is that people shouldn’t generate a cash-generating asset simply because it has experienced a change in the business cycle that demanded a dividend cut, particularly if the business deals in commodities (see Conoco’s fall to $31 shortly after its dividend cut compared to the current price of $43 for an example). The other mistake involves ignoring companies with truly superior balance sheets–the Berkshire Hathaways, Googles, Microsofts, Johnson & Johnsons, and Ciscos of the investment world that are much stronger and have the capacity to quickly increase their earnings power in ways that a cursory P/E analysis do not make apparent.

If I had to create a buy-and-hold tech portfolio, the leading candidates would be Google/Alphabet, Amazon, Microsoft, and Cisco. I disqualify Amazon from consideration in almost all of my writing because there is no connection between the stock’s valuation and ongoing profits. For Amazon to build long-term wealth for the shareholders of today that pay $700 per share, Amazon will need to significantly bump up the costs of its delivery services. There is precedent in doing so–banks begged customers to use ATM/debit cards in the 1980s and 1990s only to start charging for the privilege in the 2000s once the customers had created a habit of relying on the convenient lifestyle–but I have to put the stock on the list of things I don’t understand because mega-cap companies trading at 100x earnings or more have never worked out well in the history of the American stock market.

Alphabet (GOOG) at $700 per share is most likely a fair deal, and something I hope to cover on the site soon. The same goes for Microsoft at $50.

But today, I want to talk about Cisco (CSCO), a pillar of “Old Tech” that is in the rare position of finding itself trading at fair value. For most of its history, Cisco fluctuated somewhere between ridiculous undervaluation and ridiculous overvaluation.

At the time of its 1990 IPO, Cisco was trading at a split-adjusted $0.04 per share. Earnings per share were only .0008 per share, for a P/E ratio of around 50, but the stock was like Starbucks at the time of its IPO–a total steal compared to the growth that was yet to come. For the next twenty years, Cisco would go on to grow its profits at almost 32% per year. It was, and is, the internet highway of the United States.

Imagine if, when President Eisenhower signed the Federal-Aid Highway Act of 1956, you could purchase stock shares in a company that would construct all the highways, own the cement producing facilities, own the cops that would patrol the highways, and then get to stick a toll on every highway and collect all the revenues from the tickets paid by people using the highway in a way that violated the rules of the land–no speeding here, you must stop there, etc.

That would be a pretty intriguing business because of its entrenched power over its self-created domain. For the past nearly thirty years, Cisco has been the internet version of that. They have their hand in every aspect of the internet highway–they create switches which launch networks, they create routers that connect these networks to each others, they create firewalls that permit outbound communication while blocking unauthorized intrusions into the network, they carry voice calls over an IP network with their VoIP tools, and they have the ability to directly innovate connection speed and security by creating new routing protocols that govern the pathways of how routers connect with each other.

All of this together has created a very lucrative first-mover advantage that has been hard to settle. By the mid-1990s, it became clear to many that almost all internet traffic would involve interacting with Cisco in some way, and investors got excited about the company’s stock. Scratch that. They got really, really, really excited about Cisco’s stock. When it was earning $0.30 per share heading into 2000, the stock hit a price of $79.38 per share in March 2000. That was a valuation of 264x earnings.

And at the time, there were 7.1 billion shares of Cisco stock outstanding. So the investors were valuing a company making $2.13 billion in annual profits at $565 billion. You can see how that’s a problem–today, Berkshire makes $24 billion in annual profits, and it’s only valued at $350 billion.

This wild fluctuation in Cisco’s valuation means that the long-term holders of Cisco have been punished severely for their patience while the long, long-term holders of Cisco got richer from Cisco stock than even their wildest dreams would have dared to envision. Bought $10,000 of Cisco in March 2000? You’d be down to $4,900 today, losing over half of your money for sixteen years of waiting. Bought it in March 1990? That same $10,000 would have turned into $3.7 million, for a compounding rate of 25.44% over the past twenty-six years (it was the best stock of the 1990s, delivering a beyond-staggering annual investment return of 88% that turned $10,000 into $6.3 million between 1990 and 2000).

When you look at Cisco today at $27, there’s not a whole lot you can extrapolate from its historical returns. The 1990s were anomalous because Cisco was engaging in the once-in-a-lifetime work of building the internet that simultaneously saw its valuation become insane, and the 2000 onward measuring stick doesn’t provide much guidance because the P/E ratio at the start was 264. It provides an instruction for why I wouldn’t touch Amazon today, as crazy disconnects between market cap and profits has no positive history of ending well, but it kind of hides the true long-term earnings power of a business like Cisco.

The medium-term results at Cisco suggest a very healthy business–high single digit revenue growth coupled with low double-digit earnings growth. The five-year revenue growth rate is 7%, and stretching out to ten years, the growth rate is 11%. The five and ten year earnings per share growth rate is 11.0% and 11.5%, respectively. If Cisco had been anywhere near fairly valued at the start of the millennium, it would be a staple of everyone’s long-term investment portfolio. Counting the dividend that got launched in 2011, you’d be looking at recent historical returns of roughly 13% if Cisco didn’t have such strong extreme valuation to burn off.

It catches my attention every so often that there are these companies performing wonderfully and nevertheless get labelled “dead money” because they have valuation issues at the start of the comparison period. You saw this with Johnson & Johnson, which saw its stock price trade in the $60s during every year between 2005 and 2012 even as earnings grew from $3.50 to $5.10, or 45%. You saw this with Microsoft stock, which saw its stock price trade in the $20s every year from 2001 through 2013 as it grew profits from $0.90 to $2.65, or 194%.

Then, Microsoft zoomed to $50 and Johnson to over $110. There’s no guarantee of when business performance will translate into a stock price change reflective of business performance; but if the price is decent and your time horizon sufficiently long enough, you’ll eventually find the stock price act like a weighing machine.

That’s why I like Cisco at $27 per share. The price is right, and the cash flows being thrown off from the business are enormous. The profits are expected to be $2.30 per share this year, for a P/E ratio of 11.7. The company has $60 billion in cash compared to debt of $24 billion, for a net of $36 billion in cash and cash equivalents on the balance sheet. When you have revenue per share growth in the high single digit, earnings per share growth in the 8-12% range, a P/E ratio under 12, and over $7 in cash for each $27 share you buy, you’re stacking the deck in your favor.

But for whatever reason, Cisco seems to attract investors with an all-or-nothing attitude towards it. Among the people who buy large chunks of it, they end up putting something obscene like a quarter of their net worth into it. Others seem to swear off it altogether because it’s a tech company that has lost half its value over the past fifteen years. I view it much more as an ancillary stock investment than a core holding.

First, I’ve never cared much for the amount of compensation that the management receives. This isn’t just the usual grumble grumble about high executive pay that you see everywhere in the Fortune 500. Even in an age of capitalist excess, Cisco’s pay structure is noticeably extreme. Between 2007 and 2011, Cisco repurchased $38 billion worth of stock. If there were no dilutive equity grants to management, you would have expected the share count to decline by 28% over this time frame. Instead, the share count only declined from 6.1 billion to 5.4 billion, for 11.4% in retired shares.

There was some acquisition activity over this time that required some dilution, but almost $15 billion went as stock compensation for officers (John Chambers specifically). That’s about eighteen months profit wiped out as part of contractual debt issuances to officers that were only delivering performance that could be at best described as “above average.” It’s the kind of thing that makes you want to place a buy, buy, buy order for Berkshire Hathaway and leave the rest of the investment universe alone.

Even in spite of this, I do think Cisco belongs somewhere as part of a 10+ year investment plan. It may not be a generational holding, but it’s a nice middle-age to retirement holding. Even in spite of the king’s ransom executive compensation, the earnings per share growth was still in the low double digit range. The benefits outweigh the costs, but the compensation at Cisco is so high that it becomes almost a moral issue.

A lot of shareholders talk about suing Cisco for its executive compensation, but that’s not a practical response. In 2005, Michael Ovitz got to collect over $130 million after fourteen months of work at Disney. Shareholders launched a derivative suit, demanding that the corporation sue the Board for its negotiation of a contract that amounted to corporate waste, and the Delaware Supreme Court rejected it because it didn’t constitute “corporate waste” defined as the “total gifting away of corporate assets” (incidentally, Ovitz was represented by Charlie Munger’s firm, Munger, Tolles, and Olsen LLP). That’s the kind of threshold we’re dealing with–it’s very hard to challenge corporate pay as a shareholder, and you really should contemplate the status quo remaining in place unless you have the resources to make investments big enough to get Board representation.

The other reason why I would hesitate to make a substantial investment in Cisco is due to competition from Google. The reason Cisco is a valuable business is because it builds the best mousetrap, or at least, one of the best mousetraps. Google is getting involved with the creation of data center infrastructure, and its Google Cloud Platform may prove a serious threat to Cisco–Google has Home Depot and Disney committed to its platform, and this trend will weaken Cisco’s business model. Owning the only highway in town doesn’t mean as much when people start travelling to their destinations by helicopter.

Cisco does do things to offset the Google threat. It’s riding the trend towards HD Video streaming by launching a joint venture with Ericsson and Intel to build a 5G mobile router that will offer 1 Gigabit-per-second information transmittal. Extending the highway metaphor, when Cisco lets you drive down the highway at 80 MPH instead of 65 MPH, those regular helicopter rides from Google aren’t quite as tempting.

If someone declined to invest in Cisco as a moral matter, stopping the inquiry upon learning of the executive compensation, I wouldn’t blame them. But I do conclude that, even with all the drawbacks acknowledged, Cisco has a good chance of beating the S&P 500 over the next 5-10 years due to its favorable valuation, large cash position, dividend yield of 3.77%, and very strong core business that generates extremely lucrative profits compared to capital deployed (Cisco earns 13.5% returns on total capital). But the drawbacks are of the type that ought to deter Cisco from becoming a meaningful percentage of your net worth. There are intelligent ways to make big bets–if someone put 10% of their net worth into Nestle for 25 years, that is behavior that still falls in the realm of intelligent conduct with a very probability of creating substantial wealth. With Cisco, you buy a bit of it and let it play out for the next decade or so.