Saturday, July 08, 2006

Cisco Systems: Dangerous at any Credit Rating

One fundamental problem we corporate bond holders face is that company management doesn't work for us, they work for stock holders. Sure, they don't want to default on their loan, but sometimes what's best for shareholders is not what's best for creditors. Take the example of Cisco Systems.

Cisco's share price was $19.22 on July 2, 2001. Friday, the stock closed at $19.39. Needless to say that makes for a lot of disgruntled stock holders. Earnings growth has been pretty good, up from $1.9 billion in fiscal 2002 to $5.7 billion in fiscal 2005, but investors are less and less willing to pay growth-stock multiples for a company with 5% revenue growth over the last five years.

So what to do? Their recent $6.5 billion in new bond issues gives us a clue as to their plan. During the tech bubble, when Cisco needed funds for acquisitions, there was no cheaper currency than their own stock. Hence, until this most recent quarter, the company had no long-term debt. Today their cost of capital equation has changed. So when their announced the $6.9 billion acquisition of Scientific Atlanta (only $5.1 when you take out the cash on Scientific Atlanta's balance sheet), Cisco issued debt and paid cash. Note Cisco issued $6.5 billion in bonds to fund a $5 billion acquisition, despite the fact that they had $4 billion in cash on their balance sheet.

Bond holders should really think through the long-term implications of this story. Cisco Systems is currently rated A1/A+ (Moody's/S&P), but would their business be particularly harmed by a Baa or Ba rating? No. Cisco's balance sheet is too good. With Cisco's stock so cheap, management is clearly not be minimizing their cost of capital with the present equity/debt mix. Furthermore, if the company's growth rate is moderating, then Cisco will need to increase financial leverage to achieve an acceptable return on equity.

CSCO 5.5% 2016 issue (A1/A+) has recently been offered in the +88/10yr range. Compare that with Goldman Sachs -- GS 5.35 2016 (Aa3/A+) is offered at +97/10yr. Critics say that Goldman is just one big hedge fund and therefore fraught with risk. However, Goldman needs cheap access to credit in order to function as a business. While Cisco's management is intentionally increasing leverage and decreasing their credit quality, Goldman's management can't afford to do so. In other words, one company is incented against bond holders, and one company is incented with bond holders. And yet, for some reason, bond buyers accept less spread to own Cisco than Goldman.

Fair disclosure: my clients own bonds in one of these two companies. You can guess which.

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