Buying Cisco, CSCO, selling SPYs

The market has been on an absolute tear the last 4 months, up almost 20%. Consequently I have reduced exposure, and think that selling losers this week is a pretty good idea. Get the tax benefit, clear out any crummy names you own and be a little more cash rich to put some dough to work on solid, cheap names next year when it looks a lot uglier than now.

It is only human that we want to buy stocks when they are going up, and that inclination only gets stronger the more they've rallied. The downside of that is that most investors are most exposed at market peaks, and least exposed at the bottom. As for right now, I think the risk reward in equities in general is mediocre. We have perhaps 5% upside from here, and 10-15% downside. Can the market go higher? Absolutely, but you want to manage risk, that is how you preserve capital and get in and out of stocks at better times.

The sentiment index is also one I closely follow, and last week we hit a near annual high of 63% bullish. (that is, 63% of investors surveyed are bullish on the market). This is a contrarian indicator, and when it hit 65% last April, the market fell 13% over the nex 6 weeks. When everyone wants to be long, there is no more room to go up. For some perspective, at the market lows this year at the end of August, a mere 20% of those surveyed were bullish. That was the time to buy.

So, yea, here I am buying Cisco today. Yes, this may pull back, so I am shorting some SPY's against it dollar for dollar. (Ticker SPY if you've never traded this, just an S&P index ETF). But the math on Cisco is pretty compelling.

Generally I started peaking at this name a month ago when it got blasted 18% after reporting its October numbers. The stock fell from over $24/share to about $20, then drifted down to 19 and change. Reasons for the selloff: declining margins, concerns over the company losing market share, and generally a weak revenue outlook (lower spending in the public sector and Europe) were the culprits.

So, the bad news is priced in and here is why I think so. The company earned $1.36 per share on a TTM basis. This is after huge stock compensation expenses, and also excludes interest income and interest expense numbers (there were negligible anyway). In addition, net cash on Cisco's balance sheet is $25BB. Yes, thats $4.35 per Share in pure cash. 22% of the market cap of this company is in the form of cash.

So, that leaves you paying $15.80 a share for a business that did $1.36 in earnings on a trailing basis. That implies its trading at 11.6x earnings. (yes the $1.36 excludes interest income/expense). Next year, analysts are forecasting $1.61 in EPS. I ran some numbers myself, and generally the company guides to a long term revenue growth outlook of 12-17% per year. Lets use 12% next year, despite the fact that sales grew 19% year over year in the October quarter. Lets also assume margins compress to 18.5% from 19% TTM. (note that over the past 5 years, margins have averaged over 20% per year.)

Net net I get $1.52 in EPS for 2011. So on a business you are creating at 15.80/share (netting the cash against the stock price), you are paying a little over 10x (Worst Case EPS) for a company that will grow 12-17% annually (thru the cycle acc to management). Assuming this can get back to a 15x multiple company, that implies a $27 stock, for upside of 35% in the next year. For an unlevered, blue chip, growth company with massive piles of cash, that make this one a buy to me, even in a market that looks well overbought.

As far as the downside goes, I would suggest that they flat line at 1.35/share in another recession. Using 9x earnings, a very low PE, net of cash, still gets me 16.50 per share. That's downside of 18%. However, I think the probability of them beating the streets forecast of $1.61 per share is very real, and if they did say 1.75, then at 15x you could see a $30 stock for 50% upside. Good risk reward.

Now, I should mention that the stock is up today given a Barron's article touting the company over the weekend. I wont rehash it but the main points are:
- The company has actually gained market share in 12 of 15 of its major products in the past year.
- Its much more diverse than just a router/networking company, which today is only 16% of revenue.
- The street's EPS forecast next year of $1.61 is using low end of the company's guidance, and is likely to be exceeded.
- Its cheap at 12x earnings (altho I note that they exclude the cash here).

I would add that the company authorized a $10BB stock buyback just last month, and for a $114BB market cap company, that is almost 10% of the stock outstanding. In addition, the company has stated they intend to implement a dividend next year, one that will be at a "competitive yield" I think they said. Given that the company generated $1.93 in FCF/ share (Depreciation and amortization are far higher than Capex), there is a lot of room here to pay a meaningful dividend.

Did I mention that $1.93 in FCF equates to a 12% Free Cash Flow yield per share? Lots to like. Marketwise, not a lot to like, so hedge it appropriately.

If you want a copy of the barrons article, let me know.