On March 21 networking giant Cisco Systems, Inc. (NASDAQ:CSCO) was downgraded by FBR Capital to underperform with a price target of $17 per share. The reasons given were the standard bear argument: a weak market for networking hardware due to software-based solutions. What the report doesn’t say, however, is where in the world this $17 price target came from. Is it based on actual fundamentals and analysis or, more likely, the fact that Cisco Systems, Inc. (NASDAQ:CSCO) is trading near its 52-week high?
In other Cisco news, the company announced a 21% dividend increase on March 29, raising the quarterly dividend from $0.14 per share to $0.17 per share. This puts the dividend yield at about 3.25%. This dividend increase, occurring less than a year after a previous 75% dividend hike, shows that the company is committed to returning profits to shareholders.
Why $17 is a ridiculous price
Sometimes I honestly think that Wall Street analysts don’t even look at the financial statements of the companies they cover at all. First, Cisco has a whopping $5.78 per share in net cash on the balance sheet. This means that FBR is valuing all of Cisco’s future profits at about $11.22 per share. Cisco Systems, Inc. (NASDAQ:CSCO) generates about $2 per share of free cash flow annually, so apparently FBR believes that Cisco’s profits are going to decay significantly.
A quote from the analyst press release states:
We encourage investors to take profits, and we move to the sidelines as we work to better understand the significant changes occurring across the networking landscape.
In other words, they don’t know. The downgrade seems to be more of a guess than anything. Cisco, with all of its cash and a strong profit stream, can simply acquire just about any company that poses a real threat.
Part of me thinks that Cisco’s stock history over the past decade, fluctuating between $15 and $25 per share from the most part, is the main driver of this downgrade. After backing out the cash Cisco Systems, Inc. (NASDAQ:CSCO) is trading at about 7.5 times the free cash flow, which for a dominant company like Cisco seems crazy.
Returning profits to shareholders
The new dividend will require Cisco to pay out about $3.6 billion per year in dividends. This is only about a third of the company’s free cash flow, so even if profits remain flat or shrink the dividend can be raised significantly. Cisco also buys back a lot of shares, with $4.7 billion spent doing this in fiscal 2012. Some of this offsets the dilution due to stock-based compensation, but the diluted float has been reduced by 25% since 2003.
Cisco could raise the dividend by 10% per year for the next 10 years and still be paying out less than the current free cash flow.