Cisco's 4th Quarter: A Tiger Changes Stripes

I had to reread Cisco's release for the fourth quarter and fiscal year ended 7/28/12 a few times to be sure.  Cisco is defying the old aphorism about a tiger not being able to change its stripes.  It has done so. The board and management should be commended for laying out their approach to creating shareholder value clearly in the whole body of the release.

Credit Suisse writes, "Cisco's declaration that it plans to return at least 50 percent of FCF to shareholders represents a watershed event."  Absolutely.

During the quarter, the company repurchased 108 million shares for $1.8 billion, at an average price of $16.62 per share.  It also raised its dividend by 75 percent, to $0.14 per share, which gives an annualized dividend yield of 3.2%.  Finally, the company made the above statement about use of its free cash flows in the future. 

By taking these actions, the company has just significantly widened its universe of potential institutional owners for CSCO shares.  Having a large cash horde is problematic for equity holders, as their fear is about management squandering the cash overpaying for acquisitions, as tech companies are wont to do.  Now, it's easier for an analyst to isolate what an investor would be paying for future growth and what they can expect from dividends and buybacks. 

Management of growth companies always fear dividends as signaling the company has run out of ideas and is on the way to becoming a pedestrian performer. It's really nothing of the kind.  With the current outlook for lower, mean-reverting equity returns, giving an investor a 3.2% yield takes quite a bit of risk out of the investment decision, assuming that the dividend can be funded, which it easily can.

All in all, using the most simplistic assumptions, it suggests that earnings growth moves to a mid to high single digit trend rate.  In the New Normal (I'm getting tired of this term, but I don't have a better one), this is pretty good for a large, liquid industry leader's shares.

Management is also having to tweak its business portfolio management to achieve its new goals, and again, this is commendable.  According to Credit Suisse, the company is dealing with a very significant 250-300 bp year-over-year rate of price erosion in product gross margin. 

Supply chain efficiencies and manufacturing cost reductions are offsetting the margin decline by 100-150 bp, according to Credit Suisse. The rest, CS says is from unfavorable product mix, especially weak growth in the core switching and routing proucts, about 31 percent of revenue. 

The flip side of the product mix issue is what seems to be stellar performance on the services side.  Services represent 21.1 percent of fiscal 2012's $46.1 billion in revenue. Sequentially, services held flat at $2.5 billion against a difficult market for product.  Services help customers solve problems, implement solutions, and they cement relationships for company equipment.  According to CS, the services gross margin rate of 67.1 percent has held for the preceding seven quarters and is close to the historical peak gross margin.  This compares exceptionally well when viewed against HP's issues in the same kind of business. 

The company's continuing adjustment of headcount seems geared to, among other things, maintaining the corporate operating margin as much as possible.  Operating expenses as a percent of revenues were 34.5% in the fourth quarter, which CS notes is near "the all-time low post-telecom bubble levels." 

For the fourth quarter, the operating margin compressed by 100 basis points sequentially to the fourth quarter.  However, given the weak revenue growth in the core, higher margin businesses, continuing and growing weakness in Europe, and some firming in U.S. enterprise order patterns, this isn't bad performance at all. 

The company's OCF was $3.1 billion for the fiscal fourth quarter, roughly flat to the preceding two quarters.  Of $48.7 billion in gross cash at the end of the quarter and fiscal year, some 87% is held outside of the U.S.  A fair and simple mechanism to repatriate corporate profits held outside of the U.S. would be helpful to a large number of our leading global companies.  However, there is no question of Cisco's ability to fund its higher dividend payout, now or in the future, according to the company.

The clouds on the horizon in terms of geographical mix of business are well laid out, so there shouldn't be negative surprises in the next few quarters, unless Europe collapses. 

This quarterly report is quite a refreshing change for a technology bellwether like Cisco, and lots of other Standard and Poors 100 "growth" companies ought to re-examine their stated growth objectives and consider raising their dividends.