Cisco Systems: Big margins, but lack of growth (NASDAQ: CSCO)

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Cisco Systems (NASDAQ: CSCO) consistently generates excellent cash flow and posts good profit margins. But the lack of revenue growth is a challenge for the company. The business can be fully valued, given the lack of revenue growth coupled with the potential global recession. Cisco is currently trading at 10x EBITDA. The company offers a safe dividend with a yield of 3.5%, but the 10-year US Treasury note offers a similar yield. Given the lack of growth and a slightly lower dividend yield than the US Treasury, it may be better to wait for a further decline in the stock before buying it. The stock trades based on market volatility; therefore, if there is more selling pressure on the S&P 500, Cisco Systems could sell more.

Cisco lacks revenue growth but offers strong margins and cash flow

The company is suffering from a lack of revenue growth. In the fourth quarter of 2022, the company recorded 0% year-over-year revenue growth [Exhibit 1]. Cisco’s end-to-end security product portfolio saw impressive revenue growth of 20%, while the Optimized Application Experiences category saw revenue growth of 8%. But the company’s Secure, Agile Networks product category continued its losing streak with a 1% revenue drop. This Networking product category accounted for 46% of Cisco’s total revenue.

Exhibit 1: Cisco Systems Fiscal 2022 Fourth Quarter Investor Presentation

Cisco Systems Fiscal 2022 Fourth Quarter Investor Presentation (August 17, 2022)

Cisco Systems Fourth Quarter Fiscal 2022 Revenue by Product Category (Cisco Systems Fourth Quarter Fiscal 2022 Investor Presentation (August 17, 2022))

Other performance obligations [RPO] can generate revenue for Cisco. The company had $31 billion in RPO at the end of 2022. Nearly 30% or $17 billion of the company’s annual revenue for 2023 is already in the bank. The lack of overall revenue growth is a persistent challenge for Cisco Systems. But, the company has consistent and impressive profit margins. Its gross margin for 2022 was an impressive 62.55% and its net profit margin is over 22% [Exhibit 2].

Exhibit 2: Cisco’s excellent and consistent profit margins [2013 – 2022]

Cisco's excellent and consistent profit margins [2013 - 2022]

Cisco’s excellent and consistent profit margins [2013 – 2022] (Seeking Alpha, Sec.gov, authors compilation)

Dividends, share buybacks and financial performance

Since fiscal 2013, Cisco Systems has spent $75.59 billion on stock buybacks. With these buybacks, the company reduced its diluted share count from 5.38 billion to 4.19 billion, a reduction of 22%. Share buybacks must overcome headwinds of dilution of outstanding shares caused by shares issued for executive compensation [Exhibit 3]. The company has spent $15.26 billion on stock-based compensation since 2013. Essentially, $15.2 billion of stock buybacks were used to counter the dilutive effects of the company’s stock-based compensation program. the society.

Exhibit 3: Cisco stock buybacks, stock compensation

Cisco stock buybacks, stock-based compensation

Cisco stock buybacks, stock-based compensation (SEC.GOV, author’s compilation)

Even if the company makes buybacks, this dilution of outstanding shares increases the effective price paid for each share. Cisco Systems paid an effective average cost of approximately $64 per share [$75.593 billion / 1.188 billion shares reduction in share count] since fiscal 2013. Shares are currently trading at $43.30, approximately 32% below the effective price paid for each share. Management presents share buybacks as a “return of money to shareholders”, but in most cases it prevents further stock dilution and helps support earnings per share. It also helps to increase the company’s return on equity [See next section]. The company returns a huge sum of money in the form of dividends. In 2022, the dividend paid by the company was $6.22 billion, while share buybacks totaled $7.68 billion. The company reported operating cash flow of $13.22 billion in 2022. In essence, Cisco Systems’ dividend and stock buybacks were greater than its operating cash flow.

How Cisco Systems increased its return on equity by 1,000 basis points in a decade?

The company’s shareholders’ equity was $59.128 billion in 2013. By the end of fiscal 2022, shareholders’ equity was reduced to $39.77 billion. Most of this reduction in equity is attributable to share buybacks. The company’s bottom line has not grown fast enough to offset the negative equity effects of buyouts. Because equity is much lower in 2022 compared to 2013, the company’s return on equity has increased from 16.8% in 2013 to 29.7% in 2022 – more than a 1000% increase yield basis points [Exhibit 4]. This increase in the return on equity would not be possible without the decrease in equity since this equity constitutes the denominator of the ROE calculation.

Exhibit 4: Net Income, Equity, and Return on Equity of Cisco

Cisco Net Income, Equity, and Return on Equity

Cisco Net Income, Equity, and Return on Equity (SEC.GOV, author’s compilation)

The company’s net income fell from $9.98 billion in 2013 to $11.81 billion in 2022 – a CAGR of 1.89%, while shareholders’ equity declined -4.3% annually . Even the market darling and the world’s most valuable company, Apple (AAPL), has been carrying out massive share buybacks, depleting its shareholder’s equity. Apple also saw its net profit rise while Cisco’s barely budged.

Cisco’s return on investment [ROIC] is a very healthy 23% [Source: Seeking Alpha/YCharts]. Apple’s return on equity is a whopping 153%, while its return on invested capital is a more “mundane” 53% [Source: Seeking Alpha/YCharts]. Investors should be interested in the quality of the company’s financial returns rather than the key numbers.

Comparing Cisco’s Price Volatility and Monthly Return to the S&P 500 Index

From June 2019 to August 2022, Cisco Systems experienced an average monthly return of less than 0.07%, and 75% of the time [third quartile]the company’s monthly return fell below 4.83% [Exhibit 5]. The company has posted a negative return of 23% over the past year, compared to a negative return of 11.4% for the Vanguard S&P 500 Index ETF (VOO). Although Cisco has significantly underperformed the market, its monthly returns have a strong positive correlation of 0.62 with the S&P 500 index. close to market volatility, given that it has a beta of 0.94. A linear regression of monthly returns [June 2019 – August 2022] of Cisco and the Vanguard S&P 500 index gave a beta of 0.91.

Exhibit 5: Cisco Systems Monthly Returns – Average Monthly Returns, Standard Deviation, First and Third Quartiles [June 2019 – August 2022]

Cisco Systems Monthly Returns - Average Monthly Returns, Standard Deviation, First and Third Quartile

Cisco Systems Monthly Returns – Average Monthly Returns, Standard Deviation, First and Third Quartile [June 2019 – August 2022] (iexcloud.io, author’s compilation)

The market can fully assess the company at this time. It may be better for existing investors to continue to hold the shares. New investors should jump at the chance to hoard stocks near $40 in the event of short-term market turbulence. But if the Fed’s interest rate hikes come to an end, the US economy may not suffer further slowdown and the global economy may avoid a deep recession. If that happens, Cisco might be better off under those circumstances. There are signs that inflation may soon start to decline. It trades at a forward GAAP PE of 14.6x and an EV/EBITDA multiple of 10.6x.

The company’s remaining performance obligations [RPO] could provide some protection for its revenue and earnings in 2023. Wall Street analysts forecast $3.53 per share in 2023. The majority of its EPS revisions have been downward over the past three months.

Conclusion

The stock can’t shield a portfolio from the volatility of the S&P 500, given its beta of nearly 1. It doesn’t offer much growth in earnings or profitability, and a recession could have a impact on the business. Cisco customers are likely to prioritize digital investments even in a recession, it could be the last line item that could get the axe. Digitization and cybersecurity are essential for any business to achieve better financial returns and protect valuable digital assets. It’s also difficult for a business to completely halt any digitization efforts and relaunch when the economy recovers. Companies can slow down specific projects, but be reluctant to stop projects altogether. But even a modest slowdown in spending could put further pressure on Cisco Systems. It may be better to wait before buying Cisco Systems.

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