Andrii Yalanskyi/iStock via Getty Images

Andrii Yalanskyi/iStock via Getty Images

I’ve been long Cisco Systems, Inc. (NASDAQ:CSCO ) since 2014, with an average cost of $25.6 per share and a current yield on cost at 5.9%. The total return has been fairly good, coming in at 126%, on par with the S&P 500, which it outperformed for a long period, until the middle of 2020.

The downtrend in performance coincides with my increasing impatience with management as the financials have deteriorated slowly but surely in the last couple of years. This is something I’ve also laid out in previous articles covering Cisco. Cisco has been struggling with growing its revenue, free cash flow and consequently also dividend in the past years despite spending billions and billions on acquisitions, and as a shareholder it leaves me wondering what Cisco will look like in ten years, or perhaps even sooner. Cisco ending up in a situation similar to that IBM (IBM) used to be in is an unreasonable scenario; however, if Cisco continues to struggle in a similar manner, it is plausible that Cisco’s market cap will have to give way at some point in the future, as it appears the vast number of acquisitions remain unable to elevate Cisco’s future prospects.

With the ongoing pullback, now could be the moment when Cisco’s management went into the shed and dusted off the old elephant gun and pulled the trigger on a substantial acquisition in order to narrow some of the competitive gaps that have resulted in competition nibbling away at Cisco for many years.

Cisco still has deep pockets, and is also still in possession of a brand that means something. I hope management is able to make good use of both.

Cisco recently published its quarterly performance, where both the 2022-Q3 results and outlook were weaker than anticipated, causing the stock to plummet by 13%. The purpose of this section, however, is not to portray just the recent results, but also to zoom out and view Cisco from a broader perspective. The case surrounding Cisco is unfortunately not one as positive as it used to be. I’ll try to illustrate that.

If we observe Cisco’s revenue throughout the past decade, it has grown by 8% in total, with net income having grown by 31%. Cisco management has to claw more out of its revenue by improving margins. However, there comes a time where margins just can’t keep improving. The operating margin has improved by 22% over the past decade, but only 3.8% over the last five years, while it has actually declined 1.7% over the last three years. The trajectory is going the wrong direction, so Cisco will need to secure more revenue in an effort to grow the income, which has also been its largest headache for a number of years at this point.

Naturally, recent performance is of higher value in terms of indicating how the business is doing, and I’ve therefore included from 2015 up until today also because it coincides with Chuck Robbins having become CEO back then. As is evident above, Cisco is struggling with growing the top line, which is currently hovering around the $49 billion mark due to volatile product sales and slightly growing sales from services.

Until recently, services were following a trajectory of becoming a growing part of Cisco’s business, but some of that momentum has reversed during 2022. However, as with anything else, there can be the odd blip on the radar when observed over a longer term, as things rarely move in a straight line. Management has spent a lot of effort communicating the go-to market strategy of transitioning towards becoming a more software reliant business during this decade.

Numbers don’t lie, and while Cisco raised its dividend by 17% annually back in 2015-2017, the hike in 2021 was 2.8% and the recent one communicated earlier in 2022 was a 2.7% hike. Do you see where this is going? Cisco used to be a real compounding machine, but as you will see below, free cash flow growth is currently a thing of the past. This is naturally forcing management to hold back on what I would label real dividend hikes and not just token hikes.

Another very obvious indicator is the reduction in share buybacks. The situation is starting to resemble what is also visible for Coca-Cola (KO), with the buybacks more or less having come to a complete stop. In a few years, maybe we start seeing the share count grow once more?

The core of it lies in the illustration above, the development, or should we say lack of, within free cash flow. This is not to conclude that Cisco will never again experience growing free cash flow, but it is entering territory where it is difficult to excuse the situation by being the rare occurrence and that everything is much better just as we pass the next corner. With a weakened outlook beyond Q3-2022, odds are Cisco will have a tough start to FY2023, when we might be on the cusp of a worsening macro environment globally. In other words, the development we are seeing above doesn’t appear to be reversing. This effectively means that Cisco’s financial muscle will deteriorate if it doesn’t.

If we dive into Cisco’s cash allocation in the observation period, a total of $19.7 billion was utilized for acquisitions. Beyond the development concerning free cash flow growth, this is by far the most interesting topic.

Since 2015, Cisco has grown its revenue by $2.5 billion, but has in the same period spend $19.7 billion on acquisitions. Now, there can be a bit of periodization, but as you will see in a short while, spending billions on acquisitions is a core part of Cisco’s strategy. Organic growth aside, one way to put it would be, that for every $1 dollar spend on acquisitions, Cisco has managed to retain 13 cents. With $38 billion of goodwill on the balance sheet, it begs the question to what extent Cisco is able to create and sustain value creation from its acquisition strategy. Either the existing business is falling off a cliff and acquisitions are the only way revenue stays afloat, or the acquisitions completed might not add the value expected?

Another interesting observation is the massive volatility within share buyback programs, which has come to a complete stop, but which was a massive capital priority only a few years ago. Personally, I’m glad to see that management has limited this focus, as they are in dire need of a proper strategy for the cash flow, they are creating in order to secure future value. Upon having resolved the growth issues, I’d of course be perfectly content with seeing Cisco begin focusing on this area once more.

Due to the financial development within Cisco, I was looking very much forward to the 2021 investor day, especially as Cisco doesn’t host those on an annual basis and that we were anticipating their roadmap extending through 2025. Upon having seen the investor day and different presentations by management, I published an article here on Seeking Alpha where I concluded that significant execution risk was associated with what was a to be a significant improvement in Cisco’s underlying financials. It was this specific event I was awaiting, and as I note, it gave shareholders including myself something to be positive about after a number of meagre years. Quite frankly, if Cisco isn’t able to deliver on this roadmap, I have a hard time seeing the market cap hold up over the longer term.

Unfortunately, despite only being at the early innings of management’s updated expectations, it appears it may be difficult for management to execute accordingly. This means shareholders are at risk of experiencing more of the same. In the past three months, there haves been twenty downwards revisions by analysts when it comes to the revenue outlook, with zero upwards revisions. Similarly, the EPS outlook has also received pure downward revisions. As of today, the analyst consensus in terms of revenue over the coming years looks like the following.

The market might be forgiven for now, as we are still relying on the long-term roadmap provided by management, but should there be a need for an additional profit warning in the coming years, I doubt the long-term expectations can be allowed to stand, which would be detrimental for the market cap. As a shareholder, I therefore hope CEO Chuck Robbins was on point when he made the remark that Cisco is still seeing healthy demand for its offerings in connection to the 13% stock drawback. The dam build upon long-term expectations can only hold so much pressure.

Cisco has spent a tremendous amount of money on acquisitions. Since 1993 a total of 239 acquisitions has been completed, with 56 taking place in the observation period between 2015 and today. It is evidently a cornerstone of Cisco’s capital, product and growth strategy, and I’ve highlighted some select acquisitions below from 2015 until today.

Just to provide a sense of the activity, Cisco conducted nine acquisitions in 2020, six in 2021, and has conducted one YTD in 2022. During the years prior going back to 2017, Cisco closed between six-nine acquisitions each given year.

One parameter speaking in favor of this strategy is Cisco’s balance sheet, which is very strong. Total debt stands at $12.6 billion having come down significantly in recent years, but unfortunately cash and especially short-term investments have also experienced drastic reductions simultaneously. As such, Cisco is only able to withdraw roughly $20 billion from its coffers, in comparison to almost $50 billion back in 2018, but here total debt also made up $25.6 billion, more than double today. With a current EBITDA of $15.5 billion, Cisco’s debt/EBITDA comes in at a very healthy 0.8.

If Cisco pulled the trigger big time and leveraged all the way up to debt/EBITDA ratio 3.5 – 4.0, which would still be acceptable especially given the strong FCF generation, albeit decreasing slightly in these years, Cisco could strap on an additional $41 to $49 billion in debt. This doesn’t take into consideration that Cisco could throw existing cash into the mix or offer shares as part of a potential deal, but the example stands that Cisco could be able to expand its business substantially.

I’ve included a number of companies above that cater to different areas of operations related to Cisco. I originally included this list in a previous article a bit more than a year ago, so I’ve simply expanded it to include data as of today including how the market cap has fared since, with all companies showing growing revenue YoY. A potential acquisition could be either of these companies, also others I haven’t mentioned. For instance, hybrid cloud company Nutanix (NTNX), which has seen its valuation come down more than 30% YoY. Similarly, VMware (VMW) a current potential target of Broadcom (AVGO), could be interesting within this space. Given Nutanix’s current valuation, such a target would just blend in with Cisco’s other acquisitions and be considered a small to mid-sized one, while VMware would require real financial muscle. Interestingly, VMware as an example, despite its recent jump due to potential acquisition rumors, is still down substantially YoY in terms of market cap despite having increased its TTM revenue by $1.1 billion in a bit more than a year. It underlines that this is an environment where the "for sale" sign is more visible than a year ago, and where Cisco very well could utilize its financial muscle to go big.

Eventually, deciding factors could include a variety of purposes such as

As I view the situation, Cisco is challenged on enterprise, not necessarily having the best offering all-around – perhaps the focus on operational efficiency has made it difficult for Cisco to keep up with innovation. Therefore, seen from my chair, it makes sense to branch or strengthen, for instance, cloud and security in a large-enough scale to drive innovation and challenge for industry leadership in terms of development. However, those decisions are, of course, best left with in-house industry experts.

Given how the pandemic has reshaped work and taken the need for connectivity to the next level, I believe there should be plenty of long-term trends where Cisco can leverage its financial muscle and brand to attract the right match.

With Cisco having to play catch-up in relation to the roadmap covering through 2025, this might also be the last hurrah for the existing executive team should they have to abandon the roadmap. At least, that could be the consequence if an activity investor turned up, as Cisco at the end of the day remains a business with a large free cash flow that could be used for value creation.

As an investor, I’ve been frustrated to see how the underlying financials have developed, but I also believe we now are in an environment where management will have the chance to lock in the deal of this decade on behalf of Cisco in order to strengthen the company going forward. This would prevent the company from ending up withering away while competition steals their lunch. I do hope that Cisco, once and for all, will manage to elevate itself.

At the end of the day however, it also comes down to acquisition discipline. Cisco only has one loaded chamber in that elephant gun, as there is not enough additional dry powder to load it again once fired.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of CSCO, AVGO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.