Dueling Fools: Cisco Bear

I love Cisco Systems' (Nasdaq: CSCO  ) routers. I spent several years designing and building systems integrations, connecting applications running on Hewlett Packard (NYSE: HPQ  ) and Sun Microsystems (Nasdaq: SUNW  ) servers to one another, and using Cisco's hardware and Tibco's (Nasdaq: TIBX  ) software. While the rest of the infrastructure failed routinely, Cisco's routers were rock-solid.

Cisco has a well-deserved reputation for quality, and that reputation is one of the main reasons why it has a commanding lead over rivals like Juniper (Nasdaq: JNPR  ) . In technology circles, "You can't get fired for buying Cisco" is as prevalent today as "You can't get fired for buying IBM (NYSE: IBM  ) " was back when mainframes mattered. There is no question that Cisco is, and will likely continue to be, a leader in its industry.

Love the products, not the stock
That said, it doesn't matter how much I love and respect a company's products as a consumer. When I'm wearing my investor's hat and looking to buy a stake in a company, the way it treats its shareholders is key. While I'd give Cisco an A+ for technology, I'd have to give it a D- for shareholder friendliness.

When you own a share of stock, you're a part-owner of its business. You've put your capital at risk, with the expectation that the company's management will work on your behalf. They, of course, deserve to be paid for their efforts. In the end, however, management is supposed to work for its shareholders, not the other way around.

Cisco's generous stock-option grants and its reluctance to embrace option expensing signal that its executives view the company's shareholders more as their own personal piggy bank than as the true owners and ultimate beneficiaries of the company's success.

Even Cisco's aggressive share buybacks have done little for shareholders. The company's recent 10-Q filing boasts that it has spent some $24.7 billion buying back stock since Sept. 2001. Yet in that time, the number of basic shares outstanding only dropped by 872 million, from 7.31 billion to 6.44 billion. On average, therefore, Cisco paid about $28.33 per share for each net share bought back. Cisco's shares recently traded hands at $17.82 per stub. By my estimation [($28.33 - $17.82) * 872 million = $9,164.72 million], that's more than $9 billion of missing shareholders' equity.

Even for a company as large as Cisco, that's significant money. Some of that was spent buying back overpriced shares and has therefore vanished entirely. The rest of it, however, wafted straight into the company's executives' pockets, courtesy of the same aggressive stock options that caused the dilution that forced the buyback in the first place.

Under the financial covers
Cisco has done a tremendous job of turning its operations around since the post Y2K technology bust. Yet that bust itself highlighted two key facts that cannot be overlooked:

  • Companies can't grow to the sky forever.
  • Cisco is heavily dependent on corporate capital spending to sell its products.

These two facts, in conjunction with the tech bust, indicate that Cisco is a maturing, cyclical company. Its future operating profile looks to be more in line with traditional cyclicals like U.S. Steel (NYSE: X  ) than with its own aggressive-growth past. When looking at cyclicals, I like using two key pieces of data to help me project where the company is likely heading next -- revenue growth and accounts receivable growth. This chart shows those numbers for Cisco, since the technology cycle bottomed in 2002:

Fiscal
Year

Revenues
(Millions)

Revenues
Year/Year Change

Accounts Receivables
(Millions)

Accounts Receivables
Year/Year Change

2005 $24,801 12.5% $2,216 21.4%
2004 $22,045 16.8% $1,825 35.1%
2003 $18,878 - 0.2% $1,351 22.3%
2002 $18,915 N/A $1,105 N/A


Taken together, they say a lot about the company and its customers. Specifically, the recent slowdown in revenue growth indicates that the cycle may be peaking, and the fact that accounts receivables have grown at a faster rate than revenues the entire period indicates that Cisco has needed to provide ever more generous financing terms to its customers. The combination does not bode well for what will likely happen when the next cyclical trough occurs.

The Foolish bottom line
Cisco makes great products that provide the backbone of our modern, high-tech lives. Even the greatest products do not automatically justify an investment, however. In order to justify investing my money, I'd need to see a shift to more shareholder-friendly behavior (a dividend would be nice) and a valuation more in line with other economically sensitive, cyclical companies.

You're not done. This is just one part of a four-part Duel! Don't miss Rich Smith's bullish argument, Chuck's bearish rebuttal, or Rich's bullish rebuttal. When you're done, you're still not done. You can vote and let us know who you think won this Duel.

At the time of publication, Fool contributorChuck Salettahad no financial stake in any of the companies mentioned in this article. The Fool has adisclosure policy.


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