Read This Before You Buy Cisco: There Are Better Deals in Tech

This article is part of our Rising Stars portfolio series.

If you've been reading the financial sites recently, surely you know that Cisco (Nasdaq: CSCO  ) is in value territory. Its trailing P/E is 12, and its forward P/E stands at just 9. It also continually throws off massive amounts of cash. In the past 12 months, Cisco produced nearly $10.5 billion in operating cash flow against a market cap of just $85 billion. Best of all, the company has a net cash hoard of $28.8 billion, more than a third of its market cap.

Or … does it?

Well, here's where we uncover Cisco's parlor trick. Investors love focusing in on the following lines of Cisco's balance sheet:

Line Item

Total (in Millions)

Cash and Short-Term Investments $43,367
Long-Term Investments $912
Total Debt $16,749
Total Net Cash $27,530

Source: Capital IQ, a division of Standard & Poor's.

Finance articles of all kinds love to report that after deducting debt from cash, Cisco has nearly one-third of its value in cash. On the surface, that does look like an amazing deal. After considering that Cisco generates free cash flow of $9.25 billion per year and subtracting out cash, it trades for just 6.1 times trailing free cash flow.

However, that cash balance isn't quite what it seems. Cisco holds about 90% of its cash outside the country, and it would be subject to heavy taxation if brought back stateside. During the most recent company conference call, CEO John Chambers said of the company's overseas cash holdings:

Now moving on to our balance sheet, we did close the quarter with a total of cash, cash equivalents, and investments of $43.4 billion. [Figure excludes long-term cash holdings.] That was up $3.1 billion from last quarter, which included net additional borrowings of $1.5 billion, as well as continued strong operating cash flow of $3 billion. Of this balance, $4.6 billion was held within the U.S. at the end of the quarter.

That might sound trivial until you realize that repatriating this cash can trigger the upper 35% U.S. tax rate on those funds. That means the company could face a tax bill of up to $14 billion on its current cash holdings.

Here's what Cisco's cash balance throughout time looks like netted out, after considering overseas tax implications.

Source: Capital IQ, a division of Standard & Poor's.

This is, I admit, an oversimplified overview, with all cash assumed to be subject to a 35% repatriation tax. Still, you can see that Cisco's total cash after considering taxes hasn't increased substantially over the past half-decade. And its use of increasing debt creates an operating leverage of sorts: The more debt it raises and the more cash comes from overseas, the more deceptive its total cash hoard is. Even if Cisco's total cash amount is soaring, the net cash available to stockholders after considering additional taxes is barely budging.

So much more to buy
In any event, the tech world is rife with crazy cheap values without considering Cisco as an investment. For the following options, I again oversimplified to assume that all cash would be subject to a 35% repatriation tax, and I also eliminated stock-based compensation from cash flows.

Company

Adjusted Net Cash

Adjusted Free Cash Flow

Adjusted EV/FCF

5-Year Compounded Growth Rate

Cisco $12,032 $7,620 9.6 5.2%
Apple (Nasdaq: AAPL  ) $42,748 $22,254 11.7 62.6%
Microsoft (Nasdaq: MSFT  ) $25,487 $22,081 8.3 10.1%
Google (Nasdaq: GOOG  ) $19,176 $7,106 19.1 37.7%
Intel (Nasdaq: INTC  ) $9,128 $8,665 12.2 9.2%
Hewlett-Packard (NYSE: HPQ  ) ($14,032) $8,454 10.3 20.6%

Source: Capital IQ, a division of Standard & Poor's. All cash figures in millions. Adjusted net cash taxes all cash at 35% tax rate. Adjusted free cash flows subtract stock-based compensation.

This comparison is actually generous to Cisco, since its rivals generally hold less cash held overseas. My "adjusted cash" measure is therefore overly harsh on them. For example, Apple holds only about 60% of its cash overseas.

You can see that Cisco is comparable in value to many of its peers, but it's hardly in "deep value" territory as many articles would lead you to believe. In fact, the most undervalued name in big technology from this analysis is Apple, once you factor in projected growth rates.

Another wrinkle in the analysis
One last point on Cisco's valuation is acquisitions. With the company refocusing on core areas such as switching and routing, you might expect acquisitions to decline in the coming years. But historically, this has been a very acquisitive company. Here's a look at Cisco's cash flows compared against cash acquisitions.

Source: Capital IQ, a division of Standard & Poor's.

Simply put, if a company needs to acquire to grow, its free cash flow is overstated if you don't factor in the cost of those acquisitions. When you consider that Apple has historically been a very unacquisitive company, Apple looks even cheaper in comparison to Cisco than the free cash flow in the table would indicate.

Bottom line
Cisco does have some factors going for it. Even if it is losing share to competitors such as Hewlett-Packard and Juniper (NYSE: JNPR  ) , it still has immense advantages in the routing and switching space. And it pays a dividend, while Apple doesn't. However, if you're looking for a dividend-paying stock in the space, Microsoft looks cheaper and pays a larger dividend than Cisco.

The threats to Microsoft are fairly obvious, such as mobile sales that reduce PC growth and an alternative operating system from Google. But Cisco faces threats, too -- they're just a bit more opaque. In its core market of switching, for example, rivals such as HP have become more competitive. Then there's the cloud. Like Microsoft, Cisco sees opportunity there, but projects such as Open Flow threaten to increasingly commoditize networking in cloud computing and further threaten Cisco's margins.

Despite my concerns, I still own Cisco. Given a proper refocus, I think it can turn the corner -- but I also think the company's "deep value" pedigree is overblown. If you're looking for the best deals in tech, definitely look elsewhere.

Meanwhile, to stay updated on Cisco or any of the other companies in this article, make sure to add them to our free My Watchlist service. My Watchlist collects articles on all of the companies you select to keep you a step ahead on all of their changing dynamics. Add the companies we've discussed here to your watchlist today!

Eric Bleeker owns shares of Cisco. The Motley Fool owns shares of Microsoft, Google, Intel, and Apple, has created a bull call spread on Cisco Systems, and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Cisco Systems, Google, Microsoft, Apple, and Intel, shorting Juniper Networks, and creating a bull call spread position in Apple and a diagonal call position in Microsoft and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 25, 2011, at 1:48 PM, dallaspatent wrote:

    There's a lot of things that CSCO can do with its cash without triggering taxation. It can pay any legitimate business expense or buy any company without paying a dime of tax. The only thing that triggers any tax is paying the cash to shareholders or repatriating it into a US company. CSCO has little need nor intent to do either. I don't see this as any reason to adjust their cash balance in analyzing the stock. It seems like a non-issue to me.

  • Report this Comment On June 25, 2011, at 2:36 PM, andresmitchell wrote:

    Great point, dallaspatent about CSCO not needing to give the cash to shareholders. I mean, its only THEIR money. Another thing that would not trigger any taxation would be to fire John Chambers. That would be free.

  • Report this Comment On June 25, 2011, at 3:13 PM, jhf678 wrote:

    CSCO is way too cheap in comparision to HPQ and JNPR. Therefore, I think the author of this article is so wrong about his analysis.

  • Report this Comment On June 25, 2011, at 3:32 PM, TMFRhino wrote:

    Hey Dallas,

    Those are very good points- and that's what drove me to add the cash from acquisitions section - to show that if they use the money to acquire, investors should factor that into their cash flows. I would disagree Cisco has little intent to bring cash back home, however... Their growing debt load is a function of 1.) Cheap borrowing but also 2.) Not wanting to repatriate funds while also having a desire to keep re-buying shares and paying dividends.

    To Cisco's credit, there's experts at utilizing capital, but I also think investors give the company to much credit by

    1.) Netting out cash with no potential tax consequences

    2.) Ignoring its large (relative to opearting cash flow) stock-based compensation.

    3.) Not factoring its consistent acquisitions into cash flow.

    jhf678,

    The direct comparison from Cisco was that Apple (and you could even say Microsoft) appear to be equal or greater values. How would you arrive at Cisco being too cheap compared to HP? They seem to be similarly valued.

    Thanks for commenting,

    Eric

  • Report this Comment On June 25, 2011, at 4:26 PM, jhf678 wrote:

    Eric,

    you did not mention Juniper, which you highlighted in your article. Their share is $30. Cisco is only half of their price. How do you explain that?

    Thanks for responding.

    jhf678

  • Report this Comment On June 25, 2011, at 4:39 PM, TMFRhino wrote:

    Hi jh,

    For the record, I don't feel like Juniper is some stunning value. I included them as an illustrative competitor that's managed to steal share in some core segments. I included Google, HP, Apple, and Microsoft as more direct mega-cap peers, to look at how their valuation compared to Cisco after makings some adjustments.

    However, what's the significant of share price? Berkshire Hathaway is worth more than $100,000 per share, but is only worth a couple times more than Cisco in market capitalization. Just remember that price per share doesn't mean anything, you need to look at company value.

    Cisco is worth $80 bilion.

    Juniper is worth $16 billion, or about a fifth Cisco's value.

    Of the two, I'd rather own Cisco (and do hold it in my personal portfolio).

    Foolish best,

    Eric

  • Report this Comment On June 26, 2011, at 1:41 PM, PEStudent wrote:

    It seems that some commenters are confused about what it means for a stock to be "cheap." It's NOT the share price. It's how the share price compares to the company's growth and dividends, and there are several formulas that provide and initial valuation. One somewhat standard initial way to screen for value ("cheapness") is the sum of the projected avg. annual 5-yr % earnings growth rate plus the % annual dividend divided by the P/E. Any "Value Index" over 1 is a candidate for being a great value stock.

    So, the share price of HPQ is $34.40, JNPR is $30.02 and CSCO is "only" $14.93 share. But (using Yahoo's often wrong data, just to illustrate the exercise):

    HPQ's value index is: (9.2+1.4)/8.6 = 1.23

    JNPR's is: (18.6+0)/27.5 = 0.68

    CSCO's is: (10.0+1.6)/11.7 = 0.99

    This would indicate HPQ and CSCO (close enough to 1) are both reasonably cheap stocks, but that JNPR is not cheap. There are, of course, other formulas that treat growth rates with more respect and put more value in JNPR, like the Value = Earnings + 8.5 + 2 x Growth Rate from Graham's "Intelligent Investor" and "Security Analysis."

    Even though this quick-and-dirty evaluation pretty much matches what Eric concluded in the article, note that such a value index should be only the beginning of stock evaluation.

    Competition, leadership or innovation (rule maker, rule breaker), low long-term debt, long-term steady growth in revenues, earnings, and dividends, and more -including the points mentioned in this good article- should be considered.

  • Report this Comment On June 26, 2011, at 9:02 PM, mercator79 wrote:

    It would have been a fairer comparison had overseas funds been considered in those 'better deals.' Way to do half of the work...

  • Report this Comment On June 26, 2011, at 10:16 PM, TMFRhino wrote:

    Overseas funds were considered for every firm, Apple holds $66 billion and was netted down to $43. If you're saying that I didn't specifically breakdown their actual overseas holdings, that's not always disclosed (as far as I could find). I'm not sure how this is "unfair" since as stated, those measures are actually *more generous* to Cisco.

    Using specific numbers for say... Apple (the comparable) only changes its adjusted multiple a couple decimal points. But to not get to far from the forest from the trees on this.

    Best,

    Eric

  • Report this Comment On June 26, 2011, at 10:30 PM, TheDumbMoney wrote:

    While I agree CSCO is likely not as undervalued as Microsoft or Apple, it's my understanding these firms can use their overseas cash.

    For example, unless I'm much mistaken, Microsoft used all overseas cash in its $8 billion Skype purchase.

    http://blogs.wsj.com/deals/2011/05/11/dealpolitik-lesson-fro...

    Skype is/was a Luxembourg corporation, even though it has a large U.S. user base.

    Can't assume these companies are going to have to repatriate all of this cash. (Though arguably Microsoft should have repatriated that cash or kept holding it instead of buying Skype.)

    That said, your point is a good one.

  • Report this Comment On June 26, 2011, at 11:14 PM, TMFRhino wrote:

    dumberthanafool,

    Yeah, before the article was published I'd asked the editor working with it whether we should drop a portion in about legitimate uses of cash such as acquisitions or overseas investments (within the existing business). But, it was already running long as is and wanted to get the broader point across that netting out the cash can be dangerous without incorporating tax potential tax consequences since it can't be directly returned to shareholders.

    Of course, that could change via legal means.

    On the acquisition front- I don't know what foreign companies Cisco could really buy to put it to use. You could even argue that they might make some poor decisions on buying international companies because of tax consequences (Backward looking - Tandberg maybe an example of this?).

    There are precedents for using overseas cash to buy domestically. Eli Lilly used foreign cash to buy ImClone domestically, but there was a convoluted mess in between. I'll do a bit more research in the coming week on that.

    Anyway... Completely understand the desire to see more text on what they *could* do with the cash and as I said, I'll try following up on the article next week, but glad you appreciated the broader point.

    -Eric

  • Report this Comment On July 01, 2011, at 11:43 AM, dba74 wrote:

    Just as a reminder to everyone, today's the last day to buy (or hold) for the dividend. I could really use a special dividend to ease some of my suffering as a patient long, as Ralph Nader is proposing in his letter to John Chambers. So far Mr. Chambers hasn't responded. Have a great weekend.

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