Cisco's Free Cash Flow Runneth Over

Cisco Systems (Nasdaq: CSCO  ) appears to be one of the few large-cap technology firms able to grow somewhat consistently on an organic basis. And like some other tech giants, it is able energize that growth with outside acquisitions. The market liked what it saw when the company released fourth-quarter and full-year earnings last week, sending the stock up nearly 10%.

The future looks equally bright for this networking and communications gear provider. Total revenue grew an impressive 21% for the fiscal fourth quarter, though the acquisition of set-top box maker Scientific-Atlanta accounted for about 42% of that growth. Overall revenue for the entire year advanced just a hair under 15%. Management expects growth for fiscal 2007 of 15%-20%, higher than its original projection of 15% revenue growth.

GAAP increased slightly for the quarter, since this year included stock-based compensation expenses, but if you include stock-option costs for last year's quarter, earnings grew about 25%. Earnings for the full year grew close to 25% as well, when including stock-option costs in both periods.

Overall, Cisco continues to throw off impressive amounts of cash, reporting net profit margins near 20%. For the year, operating cash flow grew only 4%, but exceeded reported net income by almost 42%. Free cash flow also exceeded net income by a wide margin, coming in at about $1.13 per share. The company used all of its excess cash to repurchase shares and also issued about $6.5 billion in debt to acquire Scientific-Atlanta. Even after all that, it was left with almost $18 billion in cold, hard cash on its balance sheet.

Cisco is also a powerhouse in terms of return on capital, which has been close to 20% lately and has increased every year for at least the past five years. Revenue has only grown about 5.6% per year over this time frame, but management has proven quite adept at leveraging this into 16.6% annual growth in net income.

Taking this year's numbers into account, I estimate that if the company grows free cash 20% for the next five years, then takes five years for its growth to slow to that of the economy (or 3%), then the shares could be as much as 20% undervalued from current levels. That type of growth won't be easy for a $121 billion market-cap company with almost $30 billion in sales, but I think my discount rate of 15% takes into account a bit of that uncertainty.

Finally, I estimate that Cisco's free cash flow yield (the reverse of price-to-free cash flow, essentially), stood at 5.7% for fiscal 2006. That number in itself is solid, but it rises to more than 20% if you also take into account expected growth in free cash flow. (This is also referred to as free cash flow total return, and it's an excellent way to frame what a company's growth prospects mean for potential stock upside.)

There's no guarantee that future results will mirror its stellar historical track record, but I like the company's projected organic growth profile, especially compared to the prospects of other technology behemoths such as Microsoft (Nasdaq: MSFT  ) , Oracle (Nasdaq: ORCL  ) , Intel (Nasdaq: INTC  ) , or Dell (Nasdaq: DELL  ) . These also throw off impressive amounts of cash flow, but are collectively struggling to return to their glorious, rapid-growth roots. However you cut it, Cisco is an impressive company.

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Fool contributor Ryan Fuhrmann is long shares of Cisco, but has no financial interest in any other company mentioned. The Fool has an ironclad disclosure policy. Feel free to email Ryan with feedback or to further discuss any companies mentioned.


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