Cisco Is Too Cheap Given Its Massive Free Cash Flow

Cisco Systems (NASDAQ:CSCO) has had a rough three months. Since Aug. 10, right before its earnings release last quarter, Cisco stock tumbled more than 21.7% to $37.67 on Oct. 26. But it’s too cheap now. If it takes another hit after earnings come out on Nov 12, investors should dive in.

Slim Margins Are a Real and Continuing Problem for CSCO Stock
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Cisco has got to be one of the largest tech stocks (it has a $162 billion market capitalization) that is down for the year. Year-to-date it is off 19% and down about 17.5% in the past year. That is nothing to write home about for such a large-cap stock.

It’s Too Cheap

It is not like Cisco is losing money or is deep in debt or not producing cash flow. Right now, Cisco stock trades for about 12.2 times this fiscal year’s expected earnings (year ending July 2021).

Moreover, it is trading at only about 3.3 times sales. This is very cheap by any kind of tech company standard.

But even more importantly, Cisco is gushing out free cash flow (FCF). As I pointed out in my last article, Cisco is a FCF powerhouse.

For example, its FCF is 136% the size of its net income, which is its FCF “conversion” ratio. Last quarter, it converted $2.64 billion in net income into $3.59 billion in FCF. That is extremely impressive, especially since many tech and software companies do not make anywhere near as much FCF as their net income.

Its FCF is so high that Cisco not only pays a generous dividend, which costs $1.5 billion each quarter, but it also is reducing debt by the same amount. I estimate that its $13 billion in debt will be paid down within two years or so.

What Cisco Stock Is Worth

In addition, the company has been buying back stock. I suspect that once its debt is more fully paid down the buyback program will shoot up.

Lastly, it is highly likely the dividend will rise next quarter. It has been at 36 cents for the past four quarters and the company tends to hike the dividend each year.

Assuming the dividend rises to 38 cents per share, the prospective yield is 4% (i.e., $1.52 divided by $37.67 per share). Seeking Alpha says that Cisco stock has had an average yield of 3.10% over the past 4 years.

Therefore, that implies the stock is worth $49.03 per share, or 30% more than today. This is found by dividing $1.52 in the next year forecast annual dividend by 3.10%, or $49.03.

Moreover, as I pointed out in my last article, the stock should have an FCF yield of at least 4% to 5%, not its present 8.6% FCF yield.

I found this yield by taking its quarterly FCF (about $3.5 billion each quarter), annualizing it, and dividing it by the market cap. In other words, $14 billion ($3.5 billion times 4 quarters) divided by $163 billion is 8.6%.

Therefore, if Cisco stock should have a 4.5% FCF yield, the market cap needs to be $311 billion (i.e., $14 billion divided by 4.5%). This implies a gain in Cisco stock of 90.8%. The stock should be at $71.90.

What to Do With CSCO Shares

Based on these two value points, Cisco stock is worth between $49.03 and $71.90. That averages $60.47, or 60.5% above today’s price.

Even if it takes two years for the stock to move toward that price, its average cumulative annual return is 25.7% per year over the two years.

In addition, the stock has a dividend yield of at least 4% or so. That makes the total return close to 30% per annum for the next two years (i.e. 25.7% plus 4%).

That represents a very high return, much higher than average in the market.

And, it is possible that Cisco stock might even get cheaper after its upcoming earnings. It seems to be out of favor, despite its powerful financial stature.

Analysts expect the company will make 70 cents per share on $11.85 billion. Depending on whether the company beats these estimates it may fall more.

And it’s not just that. Analysts seem to be really down now on the stock. For example, Citi just downgraded Cisco stock since they think the move to working at home will permanently increase the market share of lower grade equipment. That will take away Cisco’s market share.

No worries. There is always a reason a stock is cheap. As long as it is super profitable and gushing FCF, it’s worth buying. Investors will likely get a bargain purchase by using an average-cost buy-in method over time.

On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.

Mark Hake runs the Total Yield Value Guide which you can review here.

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