Lessons from Cisco’s Past for Today’s Tech Titans

In 1999, it was easy to see how transformational the internet could become. It had firmly made its way into everyday life, and everyone knew that some aspects of life had changed forever. Stock investors, always looking for the next big opportunity, started partying like it was… 1999. One company at the heart of the Internet revolution was Cisco Systems. In 1999, they built the routers that were critical in connecting the Internet together, and still do today. Cisco dominated the market back then. The opportunities appeared endless, and Cisco reaped the benefits.

 

 

Looking back, quarterly revenues for Cisco grew exponentially from $1.6 billion in January 1997, to $6.7 billion in January 2001 (more than 3x in three years). Wall Street was convinced that earnings would follow and aggressively purchased the stock. In January of 1997, you only had to pay $7 for a share of Cisco, and by early 2000 it had reached $82 per share. A look at Cisco’s market capitalization shows just how popular the company had become. In 2000, Cisco reached a market valuation of $550 billion during a time when US GDP (the economy) was $10 trillion annualized. At the time, that represented 5% of the entire US economy, but remember Cisco had only reached $15 billion of annual revenue ($15 billion is a long way from $550 billion). They did possess mouthwatering gross profit margins of 65%, so investors were betting Cisco had the capability of becoming a cash-generating machine. The fascinating thing is that Cisco did continue to grow. Revenue is now $57 billion on a trailing 12-month basis, and net income is $13 billion. Since 1997 annual revenue has grown by 850%. By almost any measure that is a win. You probably can guess where this is going, how has the stock performed?

 

 

In 2000 the stock reached a high of $82, however, it now can be bought for $49. Fortunately, Cisco started paying a dividend in 2011 and now has a yield of 3.3%, which helps offset what became a poor investment if you bought it in 2000. The lessons here are numerous. The first and probably most important lesson is that you can pay too much for a great company. Microsoft was in a similar scenario in 2000 and it too reached a total market capitalization of $590 billion. However, there is one interesting difference between the two. Cisco was and still is a transactional company; they sell equipment. Even if you are good at what you do, others will inevitably attempt to copy your product, or worse, create a better product to earn some of your pie. Microsoft was also a transactional company selling software but largely transitioned to a service or subscription model. This is one key factor that contributed to their meteoric rise. Microsoft became a successful investment even if you paid too much in 2000, (although it took about 15 years to get back to even), while Cisco struggled. Transactional business models are almost always worth less than relationship or service-based models. If you are perceptive, you may realize there is another hot company that is also transactional.

 

 

Today, the financial headlines are consumed with Nvidia. It is the new golden child of the market and is even being touted as single-handedly keeping the US economy growing. The company sells specific computer chips that are at the heart of AI (artificial intelligence), fueling its exponential growth.  Nvidia just reported revenue for its 4^th quarter, growing 265% from last year to $22.1 billion. It, just like Cisco, is a very profitable business. Nvidia’s gross margins are 75%, so they too are a money machine. Wall Street loves a good story especially if it has lots of blue sky in it, so Nvidia’s market capitalization has reached $2 trillion (notice we are working with “T’s” now). For comparison, the US economy is $28 trillion. Nvidia now represents 7% of the US economy annually but with only a current annualized revenue run rate of $90 billion. That is not profit, but revenue. Based on current revenue, Nvidia captures .003% of the US economy’s annual output. Investors, however, are paying a price for Nvidia that suggests Nvidia will eventually own a large part of the world. Here are a few observations regarding Nvidia.

 

 

The similarities between the Cisco of 20 years ago and Nvidia are striking. One point that nobody seems to be mentioning, or worried about, is that Nvidia is a transaction business; they sell chips. Customers may buy another one at some point or they may not. Amazon, Microsoft, Apple, Google, etc., are all trying to get consumers into a subscription. They don’t want to have to continually create the best new product. In the tech world, it is almost impossible to recreate yourself indefinitely without eventually running into challenges. Several other microchip manufacturers would love to have Nvidia’s market and are active competitors. Betting entirely against the competition and expecting that Nvidia will always win may be naive.

 

 

When you have a company that doesn’t pay a dividend (.02% doesn’t count) and you need cash, your only option is to sell your stock to someone else for more than you paid for it. With a dividend, you can still go to the grocery store and buy food without selling anything (the store may even cash your dividend check). Over time you can also use your dividends to diversify your portfolio. Cash flow creates options, which is a concept that Warren Buffett has learned well.

 

 

Momentum is a powerful thing and Nvidia has plenty of momentum, so it may very well be a great investment over the next six months. However, the odds are extremely high that Nvidia will become a Cisco if the time horizon is a decade or more. If we are honest, we all want the big next six months and assume we will figure out the next decade later. However, that is probably why there are so few Warren Buffett’s and a lot of us.

 

Observations On The Market No.392