Pass On Cisco Despite Its Attractive Valuation
 
It might seem odd that I recommend you pass on Cisco (CSCO) despite its attractive valuation. After all, I repeatedly state that investors should pay particularly close attention to valuation.
 
I last reviewed Cisco (CSCO) in my November 4, 2021 guest post at Dividend Power. At that time, Q4 2021 (July 31, 2021 FYE) was the most current financial information available.

In that post, I mention ‘it’s deja vu all over again’ because many investors are treating the equities market as a casino much like the days of the '.com bubble'.

I conclude that post stating I will not add to my CSCO position because:

  • If the US 10 Year Treasury yield continues to increase, a broad market pullback could occur soon;
  • I am increasing my exposure to other high-quality companies I think could generate superior long-term investment returns.

Fortunately, much has changed since that post and valuations have plunged! Just a few months ago it was a real struggle to identify high-quality companies that were attractively valued. Now, attractive opportunities abound (although not as attractive as in early May).

On May 18, 2022, CSCO released Q3 2022 results and revised FY2022 guidance. I consider this an opportune time to revisit CSCO.

Financial Results

Q3 and YTD2022 Results

You are encouraged to review CSCO’s Q3 2022 Earnings Release, Form 10-Q, and Earnings Presentation.

When CSCO released Q2 results in February 2022, management expressed optimism for the second half of FY2022 despite the supply and component challenges and other headwinds. Following that earnings release, CSCO continued to see strong demand thus resulting in a record backlog.

Two unanticipated events after that earnings call, however, impacted Q3 performance.

  1. The war in Ukraine resulted in CSCO ceasing operations in Russia and Belarus;
  2. The COVID-related lockdowns in China that began in late March resulted in an even more severe shortage of certain critical components. This prevented CSCO from shipping products to customers at the levels originally anticipated heading into Q3.

Given these events, CSCO's revised financial guidance (reflected below) errs on the side of caution.

On page 28 of 222 in the Q3 Form 10-Q, we see that CSCO has a $1B of term debt that matures within the next 12 months (June 15, 2022 and February 28, 2023). CSCO has ample liquidity to retire these obligations. Even after the repayment of these 2 notes, CSCO should still have over $20B of cash and cash equivalents and investments. This compares favourably with ~$24B of short-term liabilities of which ~$12B is short-term deferred revenue.

In a nutshell, CSCO has ample liquidity to provide investors with ‘peace of mind’.

FY2022 Outlook

When CSCO released Q2 results on February 16, 2022, management’s FY2022 outlook was:

Revenue: 5.5% - 6.5% YoY growth
Non-GAAP EPS: $3.41 - $3.46
GAAP EPS: $2.83 - $2.92

This has now been revised as follows:

Revenue: 2% - 3% YoY growth
Non-GAAP EPS: $3.29 - $3.37
GAAP EPS: $2.75 - $2.85

Reflected in this outlook is 52 weeks in FY2022 versus 53 weeks in FY2021.

Management believes revenue performance in the upcoming quarters is less dependent on demand and more dependent on supply availability. Several mitigation actions have been put in place to help alleviate many of the component issues CSCO has been facing and expectations are that CSCO will begin to see the benefits of these actions in the first half of FY2023.

Credit Ratings

CSCO’s long-term domestic unsecured debt credit ratings are unchanged from the time of my last review.

  • Moody’s: A1 (top tier upper-medium grade)
  • S&P Global: AA- (lowest tier high grade)

S&P Global’s rating is one notch higher than that assigned by Moody’s.

Moody’s rating defines CSCO as having a STRONG capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

S&P’s rating defines CSCO as having a VERY STRONG capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.

Both ratings are investment grade and should be satisfactory for investors with a low tolerance for risk.

Dividends and Share Repurchases

Dividend and Dividend Yield

CSCO has raised its dividend 12 years in a row; its dividend history is accessible here.

At the time of my last review, CSCO shares were trading at ~$54.60 and the $0.37 quarterly dividend yielded ~2.7%. I surmised that CSCO would likely declare one more $0.37 quarterly dividend payable in late January 2022 and that in February, the quarterly dividend would be increased ~2.7% to $0.38/share. As anticipated, CSCO's quarterly dividend was increased to $0.38 effective with the April 27, 2022 dividend.

Shares are currently trading at ~$45.60 and the new dividend yield is ~3.3%.

Although the dividend yield is attractive, investing based on various dividend metrics is an extremely poor way to invest. The focus should be on potential total return (capital gains and dividends).

To put things in perspective, the $0.01 increase in the quarterly dividend is a ~2.7% dividend increase. This is lower than the current rate of inflation!

Share Repurchases

In FY2016 and FY2017, CSCO repurchased $3.9B and $3.7B of issued and outstanding shares. It followed up these purchases with the repurchase of $17.661B and $20.577B in FY2018 and FY2019 and $2.7B and $2.9B in FY2020 and FY2021. In recent years, it has also repurchased $0.5B – $0.9B of shares for tax withholdings on the vesting of restricted stock units.

Partially offsetting all these share repurchases is the issuance of common stock as part of the company’s employee compensation.

Putting together all these purchases and issuances of common shares over the years, we see a gradual reduction in the number of outstanding shares except for FY2018 and FY2019 when significant share repurchases occurred; the average shares outstanding in FY2012 – FY2021 is 5,404, 5,380, 5,281, 5,146, 5,088, 5,049, 4,881, 4,453, 4,254, and 4,236 (millions of shares).

In Q3 200, CSCO repurchased ~5 million shares for a total of ~$0.252B at an average price of $54.20. This has reduced the average shares outstanding to 4,204 in Q3 2022.

At the end of Q3 2022, ~$17.6B remained under the authorized repurchase program.

Valuation

In FY2012 – FY2021, CSCO generated diluted EPS of $1.49, $1.86, $1.49, $1.75, $2.11, $1.90, $0.02, $2.61, $2.64, and $2.50. The weak FY2018 results are because of the enactment of the Tax Cut and Jobs Act (TCJA) on December 22, 2017. The TCJA significantly revised the U.S. corporate income tax by, among other things, lowering the statutory corporate income tax rate from 35% to 21% effective January 1, 2018, implementing a modified territorial tax system, and imposing a mandatory one-time transition tax on accumulated earnings of foreign subsidiaries.

Were it not for the enactment of the TCJA, CSCO’s FY2018 GAAP earnings would have been relatively consistent with that reported in recent years. However, because of the TCJA, CSCO’s PE based on GAAP earnings was 15.59, 12.68, 12.19, 18.92, 14.44, 14.46, 19.95, 139.77 (FY2018), 19.03, 18.12, and 22.2 (source: Morningstar).

When I wrote my November 4, 2021 guest post, shares were trading at ~$54.60. CSCO’s FY2022 adjusted diluted EPS guidance was $3.38 – $3.45. Using the $3.415 mid-point, the forward adjusted diluted PE was ~16.

In addition, we had the following adjusted diluted PE levels based on the forward adjusted diluted guidance from the brokers which cover CSCO:

  • FY2022 – guidance from 29 brokers was $3.37 – $3.50 with a mean of $3.43 thus resulting in a forward adjusted diluted PE of ~16 based on the mean value.
  • FY2023 – guidance from 28 brokers was $3.55 – $4.02 with a mean of $3.67 thus resulting in a forward adjusted diluted PE of ~14.9 based on the mean value.
  • FY2024 – guidance from 12 brokers was $3.70 – $4.10 with a mean of $3.87 thus resulting in a forward adjusted diluted PE of ~14.1 based on the mean value.

CSCO is now trading at ~$45.60. The following are the current adjusted diluted PE levels based on the forward adjusted diluted guidance from the brokers which cover CSCO:

  • FY2022 – guidance from 25 brokers is $3.32 – $3.39 with a mean of $3.35 thus resulting in a forward adjusted diluted PE of ~13.6 based on the mean value.
  • FY2023 – guidance from 25 brokers is $3.25 – $3.76 with a mean of $3.55 thus resulting in a forward adjusted diluted PE of ~12.8 based on the mean value.
  • FY2024 – guidance from 13 brokers is $3.52 – $4.05 with a mean of $3.81 thus resulting in a forward adjusted diluted PE of ~12 based on the mean value.

CSCO's valuation is likely this low because the broad investment community views it to be a very low-growth company. I think it would be unwise to anticipate a meteoric increase in CSCO's share price.

Final Thoughts

CSCO's valuation and dividend yield are attractive and the credit risk is low. However, I do not recommend it as a long-term investment. Many other great companies are now reasonably valued or undervalued. They offer greater potential to generate superior long-term total returns than what can reasonably be expected from CSCO; I cover some of these companies in recent posts.

As much as CSCO's capital allocation approach includes a commitment to return to shareholders a minimum of 50% of Free Cash Flow (FCF) annually, CSCO is not growing. CSCO's top-line revenue (billions of $) in FY2012 – FY2021 is 46, 49, 47, 49, 49, 48, 49, 52, 49, and 50. In the first 3 quarters of FY2022, the top line is ~$38.5 and management's FY2022 guidance is for a decline between 1% - 5.5%.

Despite my recommendation not to invest in CSCO, I do not intend to sell my shares. I have been a CSCO shareholder since 2010 and my book value is substantially below the current market price. If I sell, I will trigger a capital gain and this will interfere with our tax planning strategies.

A valid argument can be made that I should not automatically reinvest my quarterly dividends. I, however, only currently own 846 shares in one of the 'Core' accounts within the FFJ Portfolio. The dividend income is immaterial and so I will simply leave my CSCO shares alone.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long CSCO.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.