MorningWord 7/1/14: When the Music Stops

by Dan July 1, 2014 9:36 am • Commentary

Yesterday, I initiated a bullish trade in Cisco (CSCO) that had less to do with fundamentals but more to do with the technical and sentiment setup in the stock (read here).  Here is the thesis:

despite what amounts to anemic expected sales and earnings growth, the stock is attractive because it has a massive cash balance, a commitment to cash return (stated policy for capital allocation “return a minimum of 50% of our free cash flow annually through dividends and share repurchases” currently 3% dividend yield and $4 billion worth of stock bought back in fiscal Q2 and $2 billion in fiscal Q3), geographic reach and rock bottom valuation (trades 11.5x next years expected earnings, VS INTC and MSFT  at 14.5x.)  Since I first made the argument (in March), CSCO has rallied about 10%, which represents much of its year to date gains. But the stock still lags many of its old tech peers like INTC and MSFT which have both made new 14 year highs, while CSCO is till 27% below its 2007 high.

There is nothing earth shattering about CSCO’s laggard status, the stock’s recent consolidation at the 2014 highs, and the low levels of options prices that make long premium directional plays attractive for a defined risk breakout trade. There are other stocks in the same boat.

There is one point, however, that has the potential to be a double edged sword in a period longer than the duration of my trade and is a reason to be careful about making longer term investments in names like CSCO. Cash return.  As mentioned above, CSCO management is very committed to it which is great for shareholders, especially as earnings and sales are expected to grow at a fairly anemic pace for the next couple of years.

But as Enis pointed out this morning in his Macro Wrap (related to the S&P 500),  How Important Are Stock Buybacks?:

Profit margins have been relatively flat over the past 3 years, increasing about 0.5% in that period.  That 0.5% increase in margins would lead to a 5% incremental increase in earnings based on sales per share in the S&P 500 around 1120 at the moment.  The other 5-6% increase in EPS over the past 3 years is due to buybacks and other factors (like lower taxes).

buybacks have likely contributed about 5% of the 25% growth in Earnings Per Share in the S&P 500 index over the past 5 years, or about 20% of the total growth in EPS.

In CSCO’s last two earnings reports (fiscal 2014, 3 qtrs) the company has bought almost $8 billion worth of stock, or about 7% of their shares. If you do the EPS math, the company has single handily avoided a year-over-year earnings decline through the $8 billion debt issuance in February that funded their buyback (most of their $50 billion in cash is offshore).

CSCO’s cash return has kept earnings growth (or severe lack there of at 1% in fiscal 2014) in the green. But without a material uptick in demand it is hard to see how long they can keep this game up.

In the near term, this situation does little to change my thesis on my defined risk technical/sentiment trade, but this is the exact sort of corporate behavior that serves to hide the underlying difficulties in the business itself.  CSCO is having a tough time growing as numerous networking competitors take share and enterprise and government demand remain relatively subdued.  CSCO’s long-term business prospects are likely to remain under pressure, which makes it a better trading vehicle with defined risk using options than a consideration for a long-term investment.