Investors who want to be successful must do two things. First, you need to buy the right companies. As the undisputed market leader in the computer-networking industry, Cisco Systems (Nasdaq: CSCO ) certainly could be a great company to own. After all, its market leadership has given it the scale it needs to invest in new innovation and profitably keep its prices competitive. That's quite an accomplishment, and it's a tremendous testament to Cisco's market dominance.
On that first critical criterion, Cisco passes with flying colors. Unfortunately, simply buying the right companies isn't enough -- because the second thing an investor needs to do to excel is to buy the right companies at the right prices. And on that front, Cisco isn't quite the shining star that it may appear to be.
A tarnished edge
Sure, on the surface, Cisco's trailing price-to-earnings ratio of around 23 looks respectable -- even downright affordable when compared to its frothier heyday. If you check back to last month, though, you can see the source of this apparent cheapness. Weakness in the U.S. market forced a revenue drop in Cisco's core switching business -- a business that makes up about a third of its overall sales.
Cisco, after all, is both mortal and cyclical. It depends very heavily on its sales to other companies, but it's rare that a faster computer network is an absolute necessity. If a company is feeling the pinch from a tightening economy, anything that isn't in a must-have category becomes a candidate for scaling back, postponing, or cancelling entirely.
As a general rule, cyclical companies are at their most dangerous state when they look the cheapest. For instance, all of these classical cyclical companies currently sport trailing P/E ratios of less than 10.
|
Cyclical Company
|
P/E Ratio
|
|
AMR (NYSE: AMR )
|
7.8
|
|
International Paper (NYSE: IP )
|
5.2
|
|
JPMorgan Chase (NYSE: JPM )
|
9.4
|
|
Royal Dutch Shell (NYSE: RDS-B )
|
9.0
|
Are they dirt cheap? Probably not. Quite often, low P/E ratios among cyclicals are signs that earnings -- the "E" part of the ratio, remember -- have peaked. As those earnings fall, what had looked like a bargain turns into a value trap as the earnings no longer exist to support the previous price. With Cisco showing its cyclicality amidst the beginning signs of a potential recession, you can't just look at its historically low (for Cisco) P/E ratio and declare it a bargain.
The ugly cost of ownership
In addition to showing that it's not immune to economic realities, there's the way Cisco treats its shareholders. Sure, its frequent buyback announcements make the headlines. Left largely unsaid, however, is that Cisco needs to perform those buybacks just to keep its share count anywhere near static. Just take a look at how generous Cisco has been -- and continues to be -- in handing out shareholders' capital in the form of stock options, even when compared with other high-tech giants:
|
Company
|
Options
Outstanding
(Millions)
|
Shares
Outstanding
(Millions)
|
Potential
Dilution
|
Retained
Earnings
(Millions)
|
|
Cisco Systems
|
1,327
|
6,082
|
21.8%
|
$121
|
|
Intel (Nasdaq: INTC )
|
705
|
5,847
|
12.1%
|
$29,975
|
|
Apple (Nasdaq: AAPL )
|
68
|
876
|
7.8%
|
$9,101
|
With a worse than 20% potential options overhang, Cisco is off the charts in terms of options-related dilution. And this is not a new phenomenon for the company, either. Even though Cisco has earned billions in its lifetime and has never paid a single cash dividend, its retained earnings are a meager $121 million. All told, that table shows pretty clearly that Cisco is, and has been, forced to spend pretty much everything it makes simply mopping up its options-related dilution.
What do you get for your money?
With so much of Cisco's cash production spoken for just to keep the share count relatively stable, very little remains for directly rewarding the company's owners. With no dividend -- and none likely anytime soon -- where's the compelling reason to own shares? Sure, the lack of a dividend, in and of itself, is only a minor annoyance. When added to the options overhang and the cyclical nature of its business, however, the total picture looks less than compelling.
You're not done with this duel yet! Read the other three arguments, sound off at Motley Fool CAPS, and vote for a winner.
RSS Headlines
Fool UK