Can Cisco Systems, Inc. Maintain These Massive Stock Buybacks?

Cisco (NASDAQ: CSCO  ) is regularly accused of managing earnings per share through share buybacks, but should this keep investors from buying shares? When the demand doesn't hold up, the stock price has been supported by a rich dividend (for a tech company) and massive share buybacks. But can the buybacks grow too large for this to continue?

Cisco recently reported a very poor quarter where six of its eight product segments saw declines from the prior year.

  Q1'14 Q2'14 Seq Growth
Switching  $3,754  $3,271 -13%
NGN Routing  2,043 1,741 -15%
Service Provider Video 987 957 -3%
Collaboration 1,027 881 -14%
Data Center 601 605 1%
Wireless 540 511 -5%
Security 365 393 8%
Other  80 64 -20%

Source: Cisco quarterly earnings spreadsheets and author's calculations. Figures in Billions

Negative revenue growth? The stock must have taken a bath. Think again. Despite that glaring problem, shares only traded off by 3%. Compare that with another hardware company: Rackspace (NYSE: RAX  ) .  When Rackspace reported slowing revenue growth, not even declines, the shares lost 19% of their market value in one day. In Rackspace's case though, the Street is modeling for $0.63 per share in earnings in 2014, and shares were trading at a nosebleed 68 times earnings before the release. Rackspace also doesn't have a dividend to attract income investors.  

Cisco's steady stream of earnings produced a low price/earnings multiple of 11.5 and a dividend that is now paying 3.5% in the coming year. In difficult quarters, Cisco has been known to buy back enough shares to keep the earnings multiple low while paying a good dividend.  However, this may not be sustainable. A close look at the numbers shows that Cisco is dramatically increasing the amount of capital it uses each quarter to buy back shares and may be reaching a crisis point. Each of the tables that follows is based on the company's quarterly filings or press releases.

In just the last 4 quarters, Cisco has increased the amount of capital it used for share repurchases by 370%.

 (billions) Q3'13 Q4'13 Q1'14 Q2'14
$of Shares Repurchased 0.85 1.17 1.99 4.02
$of Dividends Paid 0.91 0.92 0.91 0.90
Total Capital Used 1.76 2.08 2.90 4.92

Source: Cisco quarterly press releases and author's calculations.

Now the company is buying back almost 5 times the number of shares it did just 4 quarters ago. The share buyback in the most recent quarter accounted for 3.4% of the total shares outstanding!

  Q3'13 Q4'13 Q1'14 Q2'14
Avg Price ($) 20.85 24.80 23.65 21.73
Shares bought back (millions) 41 47 84 185
Capital expended ($, billions) 0.85 1.17 1.99 4.02
Ending Sharecount (billions) 5.4 5.4 5.4 5.3
% Shares bought back 0.8% 0.9% 1.5% 3.4%

Source: Cisco quarterly press releases and authors calculations.

You may be thinking that Cisco must be getting a lot of bang for these bucks to justify such a large dollar volume of purchases. Unfortunately, that doesn't seem to be the case because the company is issuing shares as fast as it is buying them back. Over the four quarter period, outstanding shares did decline by 60 million shares but the company bought back 357 million shares.

(in dollars) Q3'13 Q4'13 Q1'14 Q2'14
EPS Purchased 0.004 0.004 0.008 0.016
Non Buyback EPS 0.503 0.519 0.520 0.457
EPS Reported 0.506 0.524 0.528 0.473
Consensus 0.490 0.510 0.510 0.460

Source: Cisco quarterly press releases and authors calculations.

So how would EPS look compared to consensus if we back out these buybacks? Not too bad until this quarter. This is the first quarter where earnings would have needed to be rounded up just to meet consensus, but in 3 of the last 4 quarters EPS would have appeared at least a penny lighter without the buybacks.

  Q3'13 Q4'13 Q1'14 Q2'14
Net Income (Non-GAAP) 2.728 2.847 2.867 2.521
Capital for Div & Buyback 2 2 3 5
Dist % of Net Income 65% 73% 101% 195%

Source: Cisco quarterly press releases and authors calculations. Figures in Billions

The concern is what happens now. The capital used for dividends and buybacks has been increasing dramatically and in the January quarter, accounted for nearly 2 times net income. This isn't sustainable especially when revenues are continuing to decline. Cisco has already ratcheted back revenue expectations to a decline of 6% to 8% for the coming quarter so how will it meet earnings estimates going forward? If there is less revenue, there will also be lower margins and less capital to buy back stock.

Cisco has one of the best management teams in the business but these trends are very concerning. It seems like structural changes are going to be necessary because this level of buybacks cannot continue. 

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  • Report this Comment On February 25, 2014, at 11:01 PM, BradReeseCom wrote:

    Hi David,

    It appears Cisco may have become extremely creative at "posturing itself in a favorable manner" with its financial results.

    For example, I confirmed (page 32) that Cisco may have violated the U.S. Foreign Corrupt Practices Act and is being investigated by both the U.S. Securities and Exchange Commission and the U.S. Department of Justice:

    "At the request of the U.S. Securities and Exchange Commission and the U.S. Department of Justice, we are conducting an investigation into allegations which we and those agencies received regarding possible violations of the U.S. Foreign Corrupt Practices Act involving business activities of Cisco's operations in Russia and certain of the Commonwealth of Independent States, and by certain resellers of our products in those countries. We take any such allegations very seriously and are fully cooperating with and sharing the results of our investigation with the Commission and the Department."

    This follows an earlier rumor that the SEC recently investigated cooked books at Cisco:

    "The SEC has been inquiring about potentially unscrupulous business practices that may have inflated Cisco's earnings by hundreds of millions of dollars over the years.

    "The scheme goes like this:

    "Have Enterprise Reps on the Largest Accounts in the country sign Strategic Letter Agreements with their clients that promise in return for certain volumes of purchases, Cisco will lock in discounts and set aside a percentage off of list to an Innovation Fund that can be used by the customer to purchase additional Cisco HW, SW or Services.

    "The catch, orders booked on these deals were not settting aside the 2,4, 6 and sometimes 8% of list price as deferred revenue.

    "They were booking it as current quarter revenue and keeping track of it manually on the back end.

    "Often times in order to let the customer use the money, it came out as Zero Dollar orders from new orders, so in essence they were keeping two sets of books and were violating Sarbanes Oxley.

    "In addition, if they did have the money set aside (which in some rare cases they did), when the money was used for purchases, the customer did not pay any taxes. So clearly there are tax implications as well.

    "Evidently the SEC's inquiry led to an internal audit to 'discover' these innovation funds and PWC recommended that their existence be banned as there was little to no oversight of the funds which could have caused mistated revenues."

    Where there's smoke, there's fire!


    Brad Reese

  • Report this Comment On May 20, 2014, at 1:59 PM, kspellman02 wrote:

    The mention of stock purchases and price manipulation brings to mind the simple fact that Cisco has a large stock "freebie" coming....and in fact has already been seeing some of the benefits of employee stocks that were promised as part of compensation packages to employees (stock options) that in a large amount of cases have or will expire long before they have any trade-able value. There are several thousand employees that have lost the rights to 10's of thousands of share because they are underwater at the time of the required purchase. Could Cisco actually be manipulating the stock price so that it never has to pay that money out? Could they be buying shares back with money they know they will never have to pay? Seems like this Ponzi scheme has some huge benefits to Cisco.

  • Report this Comment On May 29, 2014, at 9:04 PM, thidmark wrote:

    The Department of Justice itself is corrupt.

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David Eller

I started contributing to the Motley Fool in 2013. I have held research positions at two investment banks and two hedge funds before trying more entrepreneurial ventures. I'm passionate about helping people find freedom in financial independence. Feel free to add comments and start a discussion. I hope to use these articles as forums to learn from you as well as share my opinion.

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