Cisco (NASDAQ:CSCO) sold about $8 billion worth of bonds on Monday, taking advantage of low interest rates to raise cheap debt and finance share buybacks. The company issued debt in seven tranches of fixed- and variable-rate securities, with maturities varying from 18 months to 10 years, in what was its first such offering in three years. The appetite for investment-grade corporate debt offerings has risen in recent months, with blue-chip companies such as Verizon (NYSE:VZ) and Apple (NASDAQ:AAPL) also accessing the debt market to raise even bigger sums of capital over the past year. Demand for Cisco’s offering was so huge that it outstripped supply by almost 2.5 times despite the low premiums on offer. Even the most expensive of Cisco’s debt, which has a maturity of 10 years, was priced at a coupon rate of 3.63% – only about 90 basis points ahead of the current ten-year Treasury rate.
Overall, the effective interest rates applicable on Cisco’s new debt in the first few years will be about 2%, which is relatively low as the company only issued bonds with shorter-term maturities. When compared to the government-backed Treasury bills maturing in five years (the average maturity of Cisco’s new debt), Cisco is paying a premium of only 50 bps. With interest rates expected to climb further as the economy improves and the Fed tapers down its QE program, Cisco seems to have done well in tapping the debt markets at the right time. The cheap debt will help bolster Cisco’s cash holdings in the U.S, lower the cost of capital for the company and also lead to some cash savings as it repurchases shares at relatively valuations. Our $26 price estimate for Cisco is about 18% ahead of its current market price.
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Lack Of Onshore Cash Fuels Debt Sale
Cisco plans to use some of the debt proceeds to repay about $3.75 billion of debt maturing this year, and the rest to fund its share buybacks. With revenues declining on the back of macroeconomic concerns in emerging markets and product transitions, Cisco is looking to support its share price through aggressive buybacks. In November 2013, Cisco announced an addition of $15 billion to its stock repurchase program, and followed it up with buybacks worth about $4 billion in the January-ending quarter. This leaves Cisco with another $12 billion worth of authorized share repurchases remaining, with no termination date. However, in order to fund this capital return program, Cisco would have to repatriate some of its cash hoard sitting overseas, which would be highly tax-inefficient. More than 90% of its $47 billion cash lies in foreign accounts, leaving Cisco with only about $3.3 billion U.S. cash to fund its dividend payouts and share repurchases. Raising debt at this juncture allows the company to meet its target payouts while waiting for a tax holiday to repatriate the overseas cash.
It is likely just a bonus for management that Cisco was able to raise debt at such low interest rates. With an average coupon of 2.3% for the 5-year notes, Cisco’s interest rate is lower than its dividend yield of 3.45% (4*quarterly dividends of $0.19 / current market price of $22). This means that as Cisco repurchases more of its own stock using the newly issued debt, it actually saves more on dividend payouts than it is obligated to pay as interest, as every share that Cisco repurchases at the current market price leads to one fewer share for which Cisco would pay a dividend. This implies positive pre-tax savings of 1.15% of the share price (3.45%-2.3%) as compared to if the company hadn’t raised U.S. debt, in which case it would have limited flexibility in funding near-term share buybacks. We expect Cisco to continue to generate positive savings from debt-funded share purchases as long as the stock price remains below $33 (at which point its dividend yield would approach 2.3%) due to the low rates at which it has borrowed money.
Impact On Price Estimate
Since interest payments are tax deductible, the actual savings from this move are even greater than the above example. Assuming a corporate tax rate of 35%, Cisco’s effective interest rate on the newly issued 5-year notes decreases to 1.5% after accounting for the tax shield. For Cisco’s dividend yield to fall to 1.5%, its shares would have to surge beyond $50 assuming that the company keeps its dividend per share constant. This implies that Cisco can continue to add value by repurchasing shares using the new debt as long as its stock remains below $50. Assuming that shares continue to trade at current levels, Cisco can also raise additional debt to repurchase shares if it doesn’t have enough onshore cash, so long as it can issue bonds at a coupon of 5.3% (dividend yield of 3.45% / (1-corporate tax rate of 35%)). At 5.3%, interest on new debt becomes costly enough to offset any cash savings that the company might realize from lower dividend payouts.
It is noteworthy that we have taken the 5-year 2.3% coupon rate to make the above calculations. In the first few years, however, Cisco will be incurring an average interest rate of only about 2% due to the low interest nature of the short-term debt it has issued. As far as our model for Cisco is concerned, we will incorporate the effect of the new debt on our discount rate estimates. Taking on cheap debt has decreased Cisco’s cost of capital, which will in turn unlock more value for the company. However, its existing cost of debt is already fairly low, so the move is unlikely to have a substantial impact on the company’s value. However, by helping fund share repurchases, of which Cisco plans to do another $12 billion more of in the coming years, it helps send the right signals to the market about management being confident in the company’s future growth trajectory. Considering that Cisco’s shares are currently trading about 15% below our price estimate for the company’s stock, this appears to be a smart move by management.