This is revisiting an old write-up, which I fixed up a bit.
The write-up is on CSCO LEAPs expiration January 2013 (strike price $30 not the common stock:
Cisco (CSCO) faces an ever-increasing range of competition and will see decreased revenue in the near term due to government spending cuts. It has also been reporting disappointing recent financial results almost every quarter, with the exception of Q3:11. Importantly, Cisco has 80% of its cash load overseas, which will be taxed if it is brought back to the US. There is fear that Cisco might use the cash for an overvalued acquisition, as Microsoft did with Skype, since it cannot use this cash to pay out dividends or buyback shares (without a tax burden).
I want to focus on the extreme mispricing in CSCO LEAPs expiring January 2013 (strike price $30). While there is a very good chance that these options might expire worthless, any bump up in the price of the stock can result in a huge profit from the LEAPs. Although the thesis is the mispricing of the LEAPs, I will first discuss the business of Cisco briefly.
Cisco is a dominant player in the IT industry. They design, develop, and sell infrastructure products that enhance Internet Protocol (IP) based network connectivity and improve high tech communication modes. It was founded in 1984 and since then has managed to establish an enterprise worth around $94 billion (exclusive of net cash). Despite the declining popularity of the company among investors, the performance of Cisco is not disappointing. Moreover, the financial strength and consequent liquidity of the company can be demonstrated through the net cash on Cisco’s balance sheet which is more than $28 billion. The company has also announced a dividend payout of 1% to 2% in 2011.
Due to the decrease in federal, state and local government spending however, Cisco’s government business in North America has faced slowing business. The Flip camera, a consumer product, failed to acquire retail presence due to Cisco’s distribution management. Despite problems in the North American marketplace, Cisco has realized growth opportunities in countries like India and China. It is here they will focus their growth efforts to enhance profitability. China is still a developing country with plans of mass urbanization. Those plans provide Cisco with extensive opportunity to extend their IT products and services in order to facilitate building of urban infrastructure. Their key areas would be education, health-care, and transportation. Cisco believes some of the strongest competition in the future would emerge from countries like China and India. Even though the potential exists for competition to emerge in these potential markets and reduce Cisco’s market share, history tells a different story. Cisco historically has been able to compete internationally by realizing their economies of scale and effectively adjusting to different market variations. They have been successful while two of their biggest competitors, Nortel and Newbridge have not.
Cisco intends to improve its business model to exploit the available opportunities in China, particularly the automobile manufacturing industry of the country. Cisco has long been expanding through mergers, acquisitions and partnerships; a great way to use that cash that they cannot bring back to the U.S. without heavy tax implications. Cisco is looking into the prospect of adopting a new business model, which would cater to the need of China’s automobile industry to establish joint ventures.
Cisco also has a large market in Canada, and this only helps further their international diversification and make them less susceptible to American economic volatility. To be able to survive, companies also need to be able to stay ahead of developments and set trends, especially in technology. Five years ago Cisco did just this by successfully anticipating the switch to cloud computing. They are continuing on that journey to be right again and heavily investing in video communication technologies. Between their opportunities, their ability and focus to stay ahead of the times, and their financial strength, Cisco is a great long term investment option.
Cisco’s strengths do not come without obvious threats to the business, though. A long term issue that Cisco faces is over $4 billion worth of senior unsecured floating rate debt. There is no guarantee that it won’t adversely affect the earnings of the company given that the fair value of this debt is subject to market interest rate volatility.
In the latest 10-K MD&A, the company notes that there can be no assurance that their incurrence of this debt will be a better means of providing liquidity to them than would their use of their existing cash resources, including cash currently held offshore. Further, they cannot be assured that their maintenance of this indebtedness will not adversely affect their operating results or financial condition. It seems this might be one of the bigger fears of the management, which is why it is holding on to a bundle of cash and not using it to indulge in acquisitions that would drive growth or pay back shareholders.
Presently, their total debt is $16B out of which long-term debt is $12B. This figure has doubled since 2008 when long term debt stood at $6B. With the Fed’s statement to maintain current low rate until at least mid-2013, and so much cash on hand, there is not much concern with CSCO’s current total debt level.
CEO John Chambers seems to realize the intense competition being faced, and is meeting the challenges that face a company competing in a difficult environment. With so much room for growth through M&A activity and a positive valuation, as will be presented below, Cisco deserves a shot at your portfolio.
Since CISCO does have this cash, and there is a good chance of tax repatriation before the election, I am looking at EV. Regardless of policy decision, CISCO can still deploy the cash for cheap acquisitions, or pay dividends and accept any tax penalties.
Cisco has ~$45B in cash (including short term investments). Debt is ~$16B, making net cash a total of $29B. Market cap, as of November 1st is ~$95B. I am assuming earnings for FY12 of $1.71, and a forward P/E of 5.8x. I also assume that long term debt will hover around $16B, unchanged from today, and short term debt will be ~$600M, down from $3.1B today due to the paying down of debt from free cash flow. Cash should be ~$46B, giving the company net cash of ~$29B (virtually unchanged from today). Assuming Cisco’s share price increases from $15 to $30, in 12 months from now, market cap will be $137B. No change in shares outstanding will give the company a new equity value of $24.90. This equates to a P/E of 14.6x, hardly expensive for a company like Cisco.
A quick look at a few valuation metrics for Cisco and its competitors:
CSCO – 6.51x
AAPL – 9.84x
RIMM – 1.93x
This conservative valuation shows that Cisco is quantitatively cheap.
There is further value in the oprtions in the CSCO LEAPs, strike price $30, expiration Jan, 2013, where there seems to be extreme mispricing.
A Deeper look into the Option Pricing
Even though there is so much room for growth with Cisco, volatility in the global economy, and the ever-constant need to stay on top of customer demands has led to low demand and high uncertainty on Cisco’s outlook. It is not acting in favor of the longer term options either. The Jan 2013 LEAPs currently stand at $0.11 for strike of $30 or 0.33%.
On August 10th CSCO released earnings for the 3 months ended June, which were higher than analysts estimated. Revenue increased 3% taking the EPS to $0.40 cents per share as compared to analyst estimates of $0.38 per share. It propelled a one day 12% increase in stock price and option value for the $30 strike price, which increased to $0.13.
The following are costs of options for the competitors for a ~2x strike of current stock price; expiration Jan 2013. (Note option prices are very volatile and have a wide spread. There may be a slight discrepancy between stated prices below and current market prices.) Price as of close October 31st.
ALU (current price of $2.74) strike at $7 stands at $0.2 or 2.85%
JNPR (current price of $24.74) strike at $40 stands at $0.93 or 2.33%
AAPL (current price of $404.78) strike at $600 stands at a cost of $1.79% (there were no 2x call options for Apple).
RIMM (current price of $20.20) strike at $45 costs $.57 or 1.27%
CSCO (current price of $18.53) strike of $30 currently costs $0.14 or 0.47%.
All technology companies face the risk of obsolescence of their products, but because Cisco is a market leader, it has staying power and can weather a product failure or two. Cisco currently controls over 50% market share for both routers and switches. The current low stock price might just be compensating for the risks taken. Another fact that has affected option prices is the company’s move during recent years to reduce its reliance on stock options as a means of compensation. They have drastically reduced option compensation over the last three odd years.
Looking at other tech sector companies, each has its own main and unique products. Their signature products are protected by extensive copyrights and the fact that they were the first to market. This allows them to continue to improve the products while other companies have to break into the market so they will be considerably behind the curve. Apple is well-established and experienced sales growth with the iPhone and iPad lines as well as a massive increase in Mac products. They were able to do this while maintaining what might be the lowest overhead in the industry. Cisco has one of the highest overheads in the industry however; they are more specialized in regards to product lines. This gives them lower price ratios but increases their stock volatility. This also contributes to an increased options price compared to APPL. RIMM has only the Blackberry and is quickly losing market share to the iPhone and Android products. They face a risk of becoming obsolete and should not have options priced 4x Cisco’s.
Scenario and Return Analysis
Below are scenarios for returns on options bought today at the $30 strike using the Black-Scholes model with 28% implied volatility, sold 12 months from now.
If the underlying price reaches $23.50, the options can then be sold for $0.197, equating to a 1.8x return.
If the underlying price reaches $25.70, the options can then be sold for $0.54, equating to a 3.7x return.
If the underlying price reaches $28.92, the options can then be sold for $1.60, equating to a 15x return.
If the underlying price reaches strike of $30, the options can then be sold for $2.20, equating to a 20x return.
Black-Scholes assumes constant implied volatility over time and actual option price might be significantly different if volatility is not close to the current 28 percent 12 months from now.
Although we would like to see some positivity for CSCO resulting from core operations as opposed organizational restructuring, it might be able to maintain enough liquidity to keep its avenues open for expansion. They could also restructure their organization further to cut down SG&A costs.
While there is a very good chance these options will expire worthless, the mispricing of the options offers an excellent opportunity at a 20x return, while the stock still remains cheap, with a healthy valuation.
Like all options, these LEAPs can expire worthless
Competition in the tech field
Bad acquisitions due to tax laws
Most analysts see CISCO as a buggy-whip company. While this could be true, as stated above the Company still possesses an impressive moat. If an investor is uncertain the LEAPS seem to be a cheap way to invest in CISCO, with a much high possible return than the stock