Can Cisco Systems, Inc. Maintain These Massive Stock Buybacks?

Cisco is regularly accused of managing earnings per share through share buybacks, but should this keep investors from buying shares? When the demand doesn't hold up, the stock price has been supported by a rich dividend (for a tech company) and massive share buybacks. But can the buybacks grow too large for this to continue?

Cisco recently reported a very poor quarter where six of its eight product segments saw declines from the prior year.

 Q1'14Q2'14Seq Growth
Switching $3,754 $3,271-13%
NGN Routing 2,0431,741-15%
Service Provider Video987957-3%
Data Center6016051%
Other 8064-20%

Source: Cisco quarterly earnings spreadsheets and author's calculations. Figures in Billions

Negative revenue growth? The stock must have taken a bath. Think again. Despite that glaring problem, shares only traded off by 3%. Compare that with another hardware company: Rackspace .  When Rackspace reported slowing revenue growth, not even declines, the shares lost 19% of their market value in one day. In Rackspace's case though, the Street is modeling for $0.63 per share in earnings in 2014, and shares were trading at a nosebleed 68 times earnings before the release. Rackspace also doesn't have a dividend to attract income investors.  

Cisco's steady stream of earnings produced a low price/earnings multiple of 11.5 and a dividend that is now paying 3.5% in the coming year. In difficult quarters, Cisco has been known to buy back enough shares to keep the earnings multiple low while paying a good dividend.  However, this may not be sustainable. A close look at the numbers shows that Cisco is dramatically increasing the amount of capital it uses each quarter to buy back shares and may be reaching a crisis point. Each of the tables that follows is based on the company's quarterly filings or press releases.

In just the last 4 quarters, Cisco has increased the amount of capital it used for share repurchases by 370%.

$of Shares Repurchased0.851.171.994.02
$of Dividends Paid0.910.920.910.90
Total Capital Used1.762.082.904.92

Source: Cisco quarterly press releases and author's calculations.

Now the company is buying back almost 5 times the number of shares it did just 4 quarters ago. The share buyback in the most recent quarter accounted for 3.4% of the total shares outstanding!

Avg Price ($)20.8524.8023.6521.73
Shares bought back (millions)414784185
Capital expended ($, billions)0.851.171.994.02
Ending Sharecount (billions)
% Shares bought back0.8%0.9%1.5%3.4%

Source: Cisco quarterly press releases and authors calculations.

You may be thinking that Cisco must be getting a lot of bang for these bucks to justify such a large dollar volume of purchases. Unfortunately, that doesn't seem to be the case because the company is issuing shares as fast as it is buying them back. Over the four quarter period, outstanding shares did decline by 60 million shares but the company bought back 357 million shares.

(in dollars)Q3'13Q4'13Q1'14Q2'14
EPS Purchased0.0040.0040.0080.016
Non Buyback EPS0.5030.5190.5200.457
EPS Reported0.5060.5240.5280.473

Source: Cisco quarterly press releases and authors calculations.

So how would EPS look compared to consensus if we back out these buybacks? Not too bad until this quarter. This is the first quarter where earnings would have needed to be rounded up just to meet consensus, but in 3 of the last 4 quarters EPS would have appeared at least a penny lighter without the buybacks.

Net Income (Non-GAAP)2.7282.8472.8672.521
Capital for Div & Buyback2235
Dist % of Net Income65%73%101%195%

Source: Cisco quarterly press releases and authors calculations. Figures in Billions

The concern is what happens now. The capital used for dividends and buybacks has been increasing dramatically and in the January quarter, accounted for nearly 2 times net income. This isn't sustainable especially when revenues are continuing to decline. Cisco has already ratcheted back revenue expectations to a decline of 6% to 8% for the coming quarter so how will it meet earnings estimates going forward? If there is less revenue, there will also be lower margins and less capital to buy back stock.

Cisco has one of the best management teams in the business but these trends are very concerning. It seems like structural changes are going to be necessary because this level of buybacks cannot continue. 

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David Eller has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and Rackspace Hosting. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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