Love My Cisco

Last year was a year that everyone made money. It was a year for the history books, a year when all asset classes made money. As an investor it didn’t matter where you were invested, stocks, bonds, emerging market debt, junk bonds, real estate, commodities, art, collectibles all went up in value. The only losing investment was the U. S. dollar. This year making money has become a lot harder. As of today’s market close all three major indexes were in negative territory. This year gold and silver are up along with commodity prices. The dollar has rallied and bond yields have fallen. The 30-year bond yield has fallen from around 5.2 % at the beginning of the year to 4.8%. Nothing is working as it should be and asset classes are starting to diverge. To a rational investor it is clear that rising bond prices and falling interest rates can’t go hand in hand with rising gold, silver, and commodity prices. One of these trends is wrong and I feel this year we’ll know the real answer to which trend is the real primary trend of the markets.

Last year was the year to gamble, the riskier the investment the higher the returns. This was obvious by viewing which stocks out performed the major indexes. Companies that lost money, had deteriorating balance sheets, or were losing their competitive edge were bid up furiously by fund managers and momentum traders looking to make big bucks. Making a profit wasn’t high on investor’s priority lists. A rising stock price was all that mattered. Speculative or precarious financial situations attracted more money. Losing less money than expected was always good for a 10-20% pop.

This year the markets have become more troublesome. The economy has lost a bit of its steam, energy prices are soaring again, and terrorist attacks are becoming more frequent. The investment environment is once again becoming more dangerous. Investment professionals are feeling uneasy but are forced by competition to stay fully invested. On the other hand the investment public believes that the good ol’ days are back again. Investors can’t get rid of their cash fast enough.  With negative real interest rates and historically low yields cash has become trash. Hoping to make up for the absence of savings and rising debt levels, Herbie Homeowner, Larry Lawnmower, and Danny Day Trader are fleeing safe and liquid assets in pursuit of higher returns. Speculation and risk taking are back in vogue. The psychological impulse to invest in anything that is going up dominates the investment public. Nobody wants to miss out on a good thing. Right now real estate and speculative stocks seem like a win- win proposition.

Propping up the financial markets is a blind faith by both professional and individual investors that the Fed will continue to keep interest rates artificially low and pump plenty of money and credit into the financial markets to keep them elevated. There is also trust in history that in a presidential election year politicians will do all that is possible to keep stocks prices up. One positive that the markets have going for them this year is that central banks around the globe are inflating their economies supplying plenty of money at give away prices. The money supply in the U.S. after declining for several months is rising once again. M-3 has grown by nearly $200 billion since the beginning of the year.

Investors are now hooked on asset bubbles and have grown accustomed to them. Take the urge to speculate. Combine it with greed and blind faith in the Fed to create and support asset bubbles. You now have a market that is grossly unprepared for the unexpected. Yes, the economy may continue to grow and corporate profits, the main driver of the financial markets these last five years, may also rise much further. However, the financial markets have become more vulnerable to financial shocks or unexpected political events. If this happens or if these types of events occur more frequently this year speculative investments could implode the same way they did between 2000-2002. This is not the time to be speculating with your investments. Investors today have very little appreciation for risk and the markets aren’t compensating investors for taking them. Therefore, be forewarned and forearmed. Know what it is you are buying and what risks are involved. The mighty bear still lurks out there and is apt to catch you by surprise.

This market is not a return of the 1990s. We are not about to embark on a new tech revolution. Tech stocks remain grossly overvalued and over extended. If they go up from here they will be driven by momentum not sound business fundamentals. Last year investors made money in tech whether profits were rising or not. If a company lost money if they were a technology company their stock went up. Cisco was a good example. Their earnings have virtually gone nowhere in the last five years. Book value has nowhere since 2000. Cisco needs to use most of its profits to buy back stock in order to keep earnings from being diluted through excessive option grants.  Fundamental yardsticks such as return on equity, cash flow from operations, inventory turnover, accounts receivable turnover, and working capital have declined or worsened. Cisco’s earnings didn’t really begin to improve until the third and fourth quarter of last year. If the company actually had to account for stock option expense it is doubtful if they would actually look that profitable as a company.

Declining fundamentals hasn’t stopped Cisco’s stock from appreciating. From the bottom of the market in October of 2002 shares of Cisco have risen from a low of $8.60 to their high of $29.13 last January. Cisco’s earning per share rose from $.14 to $.18 including estimates for the present quarter. Cisco’s per share earnings peaked at $.18 a share in the final quarter of 2000 and the first quarter of 2001. That is exactly where they are again today. One has to ask if a 28% improvement in earnings justifies a 240% improvement in share price from the low of 2002. Certainly sales and profits haven’t been that robust nor have business fundamentals. Cisco stock also never became a value from an investment perspective. Benchmarks of investment value such as P/E multiples, P/Book & P/sales ratios remained high throughout the entire bear market. Cisco’s P/E multiple hit a high of 118 in September of 2000. It averaged around 46 throughout the bear market and remains at 36 today.

Cisco was once a stellar growth company. It isn’t one today. The 20-30% top line growth rates are a thing of the past. We are also no longer in a technology mania where the company can use its stock as currency to buy overpriced assets of companies that have no profits. Cisco like many other technology companies is in a cyclical business that has very little pricing power. It must spend all that it makes to keep building better mousetraps in the hopes of staying ahead of the competition. It is making only average profits, experiencing only average growth, with more returns on capital and investment. The point here is the company is no longer the growth company it once was in the 90’s. What Cisco has become is a speculative tool for fund managers and momentum traders. It is no different than investing in the QQQ’s. If an investor is expecting a cyclical recovery in the economy or wants to get more defensive given the shaky condition of our financial markets there are far better alternatives than to overpay for poor business fundamentals.

Listed below are few comparisons made between Cisco and some of its peers within the Dow. I chose several cyclical companies such as Caterpillar and United technologies, a drug and medical products company John & Johnson, an energy company Exxon Mobile, a consumer products company Procter & Gamble, and a retailer Wal-Mart.

In the first table which measures top line growth Cisco ceased to be a growth company in 2001. Its sales fell along with the economy that year. They are slowly making their way back but it wasn’t sales growth that drove Cisco’s earnings last year. Other cyclical companies such as Caterpillar and United Technology had far better top line growth. The real growth company in the group is Johnson & Johnson, a company that has consistently grown its sales and profits at the same time of maintaining high returns on shareholder equity.

The fact that Cisco no longer remains a top growth company justifying high earnings multiples becomes obvious when profits and earnings per share (EPS) are considered. A simple look reveals that Cisco’s profits went up during the last five years but not enough to generate substantial EPS growth. Of all of the companies listed in the tables below Cisco was clearly the underachiever. Its profits have been less than stellar and even worse when they were translated into earnings per share. Share dilution from option grants is clearly impacting Cisco’s bottom line. The earnings picture would be much worse if they treated stock options as an expense the way Microsoft does. I would venture a guess that the profit picture would be even more dismal than it is today. The poor earnings fundamentals may be one reason why the company continues to ignore present trends of coming clean on options. Management is making too much money to change the way options are accounted for it has always been a major form of compensation within the company.

In my book the best way to evaluate management is to look at return on equity. This financial ratio tells an investor how well management has done in handling shareholder money. If a company doesn’t pay a dividend and invests all of its capital then investors should expect a high return on the capital. If you aren’t getting your returns in cash you should be getting them from internal returns on invested capital. If present management wants to keep all of the profits inside the company investors should expect a high return on that capital. Once again Cisco disappoints. Their returns on capital are the worst out of the whole group. Caterpillar Tractor a cyclical company generated better and more consistent returns on capital employed.

Finally, if you look at what an investor has to pay today to own Cisco it is obvious that investors are overpaying for underachievement. Cisco consistently sells at higher earnings multiple for earnings that are overstated because of stock option grants. The company has consistently underperformed other growth companies commanding a premium to the S&P 500. It’s P/E multiple is higher than the S&P. Cisco commands a higher P/book, P/sales, and P/cf than other members of this table and most S&P 500 companies.

If Cisco has been successful in one thing it is that it manages to maintain the illusion that it remains a growth company. Company press releases and press conferences give the impression that the best is yet to come, it maybe that the best has already passed. In viewing operation metrics, sales and profit margins, returns on shareholder capital the stock has less to be desired. At some point in time, and I can’t say when that will be in the current speculative investment climate investors may eventually wake up to the fact that the emperor has no clothes. If the investment markets turn sour, if the economy softens again, if another terrorist attack occurs, or if the dreaded unexpected occurs in the derivative markets high priced stocks will fall the furthest and the fastest. When this eventually takes place investors would be better off owning something that is real, essential, and under priced. Until then as long as investors have the urge to own appreciating assets at any cost you got to love Cisco.

Today’s Markets

Stocks popped right out of the starting gate this morning and remained there all day. Tech stocks led today’s charge with positive comments coming out of several analysts concerning the tech sector. Qualcomm gained 6% on analysts upgrade. Semiconductor stocks also rose on a positive report in Germany’s Handelsblatt newspaper which featured positive comments coming out of STMicro’s CEO, that chip sales could grow 20% this year.

The Nasdaq jumped 1.7%, the Dow gained 1.1 %, while the S&P 500 advanced 1.3 %.

Art Hogan, chief market strategist for Jeffries & Co. feels stocks are benefiting from lower energy prices. Oh really. Oil prices are still above $35 a barrel and natural gas prices have remained firmly above $5.

Volume hit 1.4 billion on the Big Board and 1.7 billion on the Nasdaq. Market breath was positive by 23-8 on the NYSE and by 22-9 on the Nasdaq.

Jim Puplava

© 2004 Jim Puplava
March 29, 2004
chart courtesy: www.stockcharts.com and www.economagic.com