If you hear a financial analyst say a company's valuation doesn't matter, just look at a stock chart for Cisco Systems (CSCO +13.38%). Adjusted for splits, Cisco's stock ran from under $2 per share to over $77 in the five years between 1995-2000. However, the stock was crushed with the pop of the Internet bubble. The last 13 years have treated investors to a stock in $20-$30 per share price range. Today, Cisco looks cheap by a few metrics, but even its relatively attractive yield isn't enough to offset three big concerns.
Yes, you can pay too much!
There might not be a more aggravating Wall Street-ism than the saying, "it's different this time." The truth is, there have been very few companies that, over the long-term, proved they were different. The good news for Cisco investors is it's unlikely that they are paying too much for the stock today.
Shares trade for just over 11 times analysts' projected EPS for this year and yield a healthy 3.5%. This puts Cisco in a similar class with companies like Microsoft (MSFT +1.03%) and Hewlett-Packard (HPQ 2.31%). HP carries a somewhat lower yield at under 2%, and a lower expected growth rate of 4%, but also has a cheaper forward P/E ratio. Microsoft is a former high-flyer that has come down to earth. Shares can now be had for under 14 times earnings, with an expected 8% growth rate and a nearly 3% dividend.
The first reason Cisco's 3.5% yield may not be enough is, the company has spent over $84 billion on share repurchases since the beginning of the current program. Unfortunately for investors, shares trade for less than a 6% premium to the company's average buy price of $20.54. In addition, diluted shares are down less than 1% in the last year. It's fair to say that Cisco could have done better using this $84 billion elsewhere.
The transition no one wants
Cisco's CEO, John Chambers, said in recent earnings, "I'm pleased with the progress we've made managing through the technology transitions of cloud, mobile, security, and video." Maybe what he should have said is, "We didn't anticipate how important these fields were going to be, but we are happy that we know now."
The second reason Cisco's 3.5% yield may be insufficient is, the company's gross margin has taken a serious hit. Last year, Cisco's gross margin was over 60%. In the last six months, this number dropped to just over 57%, and in the current quarter it fell further to 53%.
In comparison, HP still gets 50% of its business from personal computer and printer sales. With two major businesses slowly becoming obsolete, it's understandable that HP's gross margin sits at less than 30%.
Microsoft's gross margin was 70% two quarters ago, and today is 66%. With 68% growth in the company's devices and consumer hardware division, and just 9% gross margin, it makes sense that Microsoft's gross margin would decline.
However, Cisco is dealing with a different issue. There is massive competition, and routers and switches may be seen as commodities. With a significantly lower gross margin, it will be harder for Cisco to produce the same massive cash flow that it had in the past.
Speaking of that...
Cisco's cash flow is the third reason the company's 3.5% yield may not be enough for investors. In the last six months, Cisco's core operating cash flow (net income + depreciation) increased by just 1.5%.
HP and Microsoft are also managing through a transition phase in their businesses, yet both produced operating cash flow growth of at least 5% in just the last three months. It's hard to see how Cisco investors can feel good about this comparison.
Final thoughts
The bottom line is, Cisco isn't too expensive and shares carry a nice yield at more than 3%. However, questionable share repurchases, falling gross margin, and anemic cash flow growth should make investors question the real value of the shares.
Until Cisco can solve some of these issues, investors might want to wait for confirmation that Cisco will return to growth in the future. You might miss the first leg of a move upward in the stock, but waiting may save you from more lost years if the company can't find its way back.
