YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

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Cisco certainly isn’t a Wall Street darling. In fact, investors of Cisco since July of 1998 have had a loss in the stock. But Cisco isn’t completely to blame. Through no fault of its own, Cisco was at one time one of the tech stock kings, trading higher than 100 times earnings only to find its price falling back to earth with the rest of the tech bubble (gravity does that to objects high in the sky with no apparent force keeping them up…) Now, at a single digit P/E, nobody wants anything to do with Cisco.

They cite a rapidly changing industry, restructuring within the company, and poor decisions by management as reasons to avoid the stock like a plague. While these concerns are real, Cisco is still the 800-pound gorilla in the router and switch market, commanding a 70% market share in the Ethernet switch market, providing huge scale advantages. At its current price of $15.12, Cisco doesn’t have to do anything amazing, it simply has to show it has a pulse!

Our biggest difficulty in analyzing Cisco is figuring out how to properly value that massive lump sum of cash on Cisco’s balance sheet. If you were to aggressively assume that none of that cash was needed to operate the business and could be paid in a special dividend to shareholders (thus you could ignore debt and net cash numbers and instead subtract total cash per share from the stock price), you would still need to account for the fact that nearly 90% of that cash is held overseas and would be subject to repatriation tax. Thus, the seemingly $7.83/sh. in cash would really be worth $5.38/sh., assuming a 35% tax rate. But what if management is able to cleverly structure an offshore vehicle (similar to what IBM did in 2007), or perhaps a series of offshore vehicles, to repurchase shares while avoiding repatriation taxes? Then that $7.83/sh. might actually be worth $7.83/sh. or more since they would utilize it to purchase undervalued stock. Alternatively, what if they burn that cash by carelessly throwing it at high priced acquisitions (Ballmer, are you reading?) as they frantically search for growth? Or will they repeat history by making more poor investments with that cash such as the one for the flip video camera, which drew Cisco away from its core business? When it comes down to it, we believe the answers to these questions don’t mean much because they don’t help you determine if Cisco is cheap, but simply to what degree. If you value the cash conservatively at $5/sh, and estimate normalized earnings power of $1.40/sh, then Cisco is only trading at 7.2x earnings after stripping out the cash.

The current restructuring of the company is a positive sign that Cisco shouldn’t be off track for too long. They recognize consumer-related products were a drag on earnings and are re-sharpening their focus back into their core businesses, a move which should benefit as more and more business migrates to “the cloud.” Although Mr. Chambers sure has his work cut out for him in many aspects, we believe that at prevailing market prices Cisco is definitely an attractive long-term investment.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | June 10, 2011 | Permalink

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