Saturday, May 14, 2011

Why CSCO is so cheap: John Chambers Risk

By any realistic measure, Cisco Systems stock is cheap.

Yes, the company reported a bad quarter and has announced plans to restructure, which will entail more asset write downs, separation costs, and other drains on the company while it seeks to right the ship.

But, at $17, the stock is trading at 12x trailing earnings and (while I put little faith in such a number) less than the average of analysts estimates for 10x forward earnings.  Such a set of metrics don't tell the actual story, though, because CSCO is sitting on a cash pile of $7 per share.  Net of debt, a $4.50 cash pile.  Subtract this from the price and the company is trading at 10x trailing earnings, and an even lower forward multiple.  (I suspect that analysts estimates will be wildly optimistic as CSCO is likely to take some very large restructuring charges going forward).

There are estimates that suggest that the pieces of CSCO are worth $24-28 share.  [Cannot find link at the moment - sorry].  I haven't done a detailed "sum of the parts" analysis on CSCO , but suffice it to say that a company with the demonstrated earnings power of CSCO should trade at a higher multiple, unless you have reason to question the quality of earnings going forward.

Turns out, there is a great reason to value CSCO at a discount to the value of its components: management sucks.  This is why, even though the stock is cheap, I will not purchase it.

Evaluating management is arguably the most important decision an equity investor makes.  Warren Buffett's first question for any business is about the quality of management.  Jack Welch argues that "people are the whole game" of business.  Why?  Because management all processes, policies, customer solutions - in short, everything that comprises a business, both internally as an institution, and externally as a competitor in the marketplace to solve customers' problems, springs from the human mind.  No business, no matter how good, is likely to continue to be successful if it is run by bad people, because bad people hire bad people, institute bad process and misuse or abuse the assets investors have entrusted to them.  This sounds alot like CSCO.

Henry Blodgett, has written an article describing his view on what has gone wrong at CSCO: he cites poor choices in management structure and lack of focus. I find his critique persuasive.  (Apparently, the company has 53 management committees, which sounds more like Congress than a corporation). 

In a CNBC interview, Chambers himself acknowledged that the company had become to unfocused, but notice how he continues to lobby for the copmany, talking always of what CSCO was "doing well" - and the revenue growth that various pieces of the business were experiencing.

Blodgett points out that revenue growth, a Chambers obession, is not really the measure of a business. It is the earnings power of that business into the future that counts.
I actually think Blodgett oversimplifies this, because the real measure of a business and of management is rather returns on capital employed (ROCE, RONA and ROIC). A CEO who is doing his job is earning high returns on the capital investors entrust to him, so that the stock can obtain a high multiple of book value.  This necessarily entails having strong earnings. CSCO actually does a decent job of earning high returns on capital employed - return on book is 17%, but adjusted for capital employed, returns are closer to 40%, which would justify a price to book significantly higher than the 2x at which the company presently trades. 

Blodgett's oversimplification is a problem, because it still focuses on growth in earnings, which is one way to raise a multiple, but using capital carefully is better - CL, hardly a fast growth stock, has a price 10x book value because of the efficiency of its balance sheet.

In contrast, CSCO management has not proven able to reinvest that money wisely, and has engaged in many shareholder unfriendly activities.  Chamber's relentless belief that CSCO can grow 15% per year has encouraged him to seek (and sadly to find) a host of business opportunities that promised to provide that top-line growth.  Unfortunately, these businesses may have had revenue, but did not have anything like CSCO's core economics and therefore actually undermined ROCE.  He would have been better off returning the money to shareholders. 

But even when the company does "return" money to shareholders, it does so in a shareholder unfriendly way.  Yes, the company has repurchased billions of shares of stock, and reduced shares outstanding by over 1.5bn.  But it has long resisted paying a dividend (it has finally relented on this point).  Worse yet, what it has taken away with one hand (shares from the marketplace), it has given away with the other (options to management), which has left the company with over 1bn shares in phantom equity awaiting conversion.
Companies that repurchase stock can easily overpay, as their intentions are public record and the volumes they seek to purchase are often a significant amount of the float.  They must therefore take care to ensure that they don't distort pricing and force the shareholders, through their ownership of the company, to earn poor returns on the cash used to repurchase.  As a result, companies usually make major repurchases over long periods to ensure that they don't compete with themselves for shares. Shareholder friendly management keeps annual share-based payments to 1% of outstanding shares or less to enable them to be net repurchasers while buying only 2-3% of the shares outstanding.  Under Chambers, CSCO has regularly made awards of 3% of the stock.

Moreover, companies that issue large amounts of stock often repurchase to offset dilution from option exercises.  This means, however, that the company is repurchasing at the moment option holders are exercising.  Since option holders have a choice of whent to exercise, they usually pick moments at which the stock is trading at high valuation, which means the company repurchases at exactly the wrong time.
Until CSCO gets more shareholder friendly, by focusing on generating high returns and funnelling that money to investors, I believe that the stock will struggle.  This cannot happen so long as John Chambers is CEO.  He has to go for shareholders in CSCO to regain investor's confidence.


  1. When is the time, if there is going to be one, to buy this stock.

  2. Thanks for the question, Thomas, for I believe that is exactly the question.

    For me, there are three criteria, one independent of the other two. The short answer is: I would need to see the board adopt more shareholder friendly policies with regards to equity compensation, Chambers should be replaced and/or the stock would have to trade at a discount to book (currently $9 per share).

    In depth, my reasoning is as follows:

    First, I need to see management and the directors make a clear statement that shareholders equity belongs to shareholders, not to employees. Yes, it is true that at some level, share-based payment is necessary to attract talent, but this should be used sparingly. Management needs to demonstrate that they get this, and clearly adapt a policy of awarding no more than a sliver (say 1% of shares outstanding) on an anuual basis. This would mean no more than 55 million shares, combining all forms of payment - options, restricted stock or stock appreciation rights.

    Second, Chambers has to go. Most of his outperformance as an executive came in his first few years when he corretly pushed the company to invest aggressively in networking at a moment when the dotcom bubble and its related telecom infrastructure bubble was not have been anticipated. He saw clearly, I think that the market was going to valuing those assets at a multiple of their cost - that is, when a customer bought Cisco products, the market priced those at a premium to their actual or replacement cost (this is why telecom companies could easily obtain financing for "optical networks" and all that other crap that they deployed in 1998-99, and which only now is starting to have end-user demand). Chambers, in short, understood as few did that if Cisco built it, customers would come. This gave the company a big advantage, until the game changed. Chambers has always believed that he can grow the company aggressively, and has made some very poor judgment calls in an effort to sustain revenue growth that simply wasn't there. Sometimes, you have to be happy with high single digit growth. He isn't so he wastes cash. 10 years on, he still hasn't gotten it, and an exec who cannot learn from his mistakes has to go. Period.

    Finally, even if the other two criteria were not fulfilled, were the stock to fall to or below book value, an unlikely event without a major market pullback, I would see it is as an in-the-money option on either or both of the first two conditions occurring, and would buy.

    I must say that these are very hard conditions, but there are simply too many other good things to do with my money than to buy and pray for CSCO to get itself straightened out.

  3. Most of his outperformance as an executive came in his first few years when he corretly pushed the company to invest aggressively in networking at a moment when the dotcom bubble and its related telecom infrastructure bubble was not have been anticipated. He saw clearly.

  4. All of his outperformance came from that period, now, whether he saw that as a bubble, or was always wildly optimistic - and had his optimism confirmed by a bubble - is hard for me to say.

    This much I can say for him, he was less willing than Lucent to extend sales to dotbomb firms on credit.

    Still, his thinking has never really seemd to recover from seeing the late 1990s as an anomaly rather than the rule.