Cisco announced it’s intention to sell $4 billion in debt, and unlike most following the company, we don’t think it is earmarked for acquisitions.

The Offering

The $4 billion in debt is divided equally between 10-year and 30-year notes, with the 10-year yielding 4.95% and the 30-year yielding 5.95%. This is +2.2% and +2.5% over U.S. Treasury yields. This cash will be used to supplement the $2.5B in domestic cash (Oct ‘08) Cisco has on hand. Of course, Cisco also has $24.3B (Oct ‘08) in overseas subsidiaries that hasn’t been repatriated to the USA in order to avoid corporate taxes.

Cisco last issued debt almost exactly 3 years ago. The $6.5B in notes issued then were used primarily to pay for the Scientific Atlanta acquisition. Cisco got a relative bargain then by today’s standard with the bonds yielding .75% to 1% above prevailing treasury rates at the time. Cisco had $15B in liquid assets then, most of it overseas.

We acknowledge it is entirely possible Cisco is filling a war chest for acquisitions. Everyone loves to play the who-will-Cisco-buy-next-game (our longstanding bet is Adtran). Cisco CEO John Chambers answered questions in his typical guarded way during an interview last month, indicating “The perfect target is a company with 100 people and a hot product that customers are saying they should go out and buy” and “We do not believe in the acquisition of large peers in any space.”

Cisco could fund such small acquisitions out of working capital, and any large acquisitions could be funded by a bond offering after the announcement, just as they did with Scientific Atlanta. This forces one to ask the question – why did Cisco just decide to triple the amount of cash it has for domestic use if we assume it isn’t for acquisitions?

The Environment

Cash is more valuable than ever because it is now very expensive to obtain for all but the best capitalized companies. Cisco can borrow against the billions in assets sitting offshore. The problem is that many of Cisco’s customers don’t have the same hefty balance sheets. Many of them can’t get money at all.

Contrary to what you would think, corporate bond issuance is up 38% in 2009. Corporate bond yield spreads have widened in the past 12 months but have retreated from the panic highs of fall 2008. Large, well capitalized companies are tapping the market’s demand for high grade debt.

It is a different story for companies with lower debt grades. While there has been some improvement in the past months, lower grade ‘junk’ debt is anywhere between 5-7% more expensive than it was a year ago- if a company can get money at all. The number one issue facing these companies in 2009 is the availability of cash.

Cisco’s channel partners, the folks who distribute Cisco to small and medium sized accounts, can no longer borrow at LIBOR +1%.  Many of the lines of credit they are using today would not be written today and if they were, written at much higher rates. In some cases lines of credit that existed one day simply vaporized the next- just ask anyone who had credit with Lehman brothers.

The Bank of Cisco

We believe Cisco is growing operating cash in order to serve as a lender of last resort to its distributors and customers. An expanded balance sheet will ensure adequate capital is available not just for its own operations, but also the operations of its channel partners and customers.

If a key distributor were to suddenly lose a line of credit because the bank underwriting it implodes, Cisco can step into the breach and act as lender. If a contract manufacturer cannot obtain inventory financing Cisco can extend terms. Just as the Federal Reserve is the lender of last resort for the nations banks, Cisco can become the lender of last resort for the supply and demand chain.

Section 6 of the Notes to Consolidated Financial Statements in Cisco’s 10Q details these financial commitments. Examination of these numbers shows that Cisco has increased its financing commitments in various areas by 50-75% over the previous year (October 08/07), a period in which total revenue grew only 5%. This is quantitative evidence that Cisco is stepping into the breach created by a collapse in the credit markets.

Competitive Advantage

There is no more powerful weapon than the cost of capital, a point often lost on the tech industry which tends to focus on datasheets and speeds and feeds. During the wars between England and France, England was able to consistently field more and better ships as a result of having a cost of capital 2% better than the French, due in part to the mercantilist nature of the English economy. Cisco, like England, is turning its lower cost of capital into a competitive weapon.

Take for instance, Hewlett Packard. Much hay has been made in the recent press about how HP is going to have a run at Cisco’s mid-range Enterprise business. But in the fiscal environment of 2009-2010 this isn’t a technology fight. It is a balance sheet fight. And Cisco can deploy billions more in working capital simply because HP is already significantly more leveraged than Cisco.

It is no secret that Huawei is aggressively taking global market share, particularly in second and third world nations. Many people mistakenly believe this is because they offer cheap prices. This is not always the case. What Huawei does consistently offer are attractive credit terms, and are often the only equipment vendor doing so. While Alcatel and Ericsson still feel the vendor financing wounds of 2001-2 Huawei has no such memory.

Case in point – Telecom Malaysia (TMNET) selected vendors for a well publicized FTTH rollout and initially selected GE-PON. Huawei, at the time, was a laggard in GE-PON technology and pushed GPON. While additional information is forthcoming from TMNET in Q109 we believe Huawei won the business with GPON not based on technical superiority but on the willingness to underwrite the financing for the deal.

Strong balance sheets are powerful weapons during times of tight credit and Cisco just loaded a fresh clip.

1. Dell
2. AT&T
3. HP
4. Verizon
5. Microsoft
6. Cisco
7. Comcast
8. Intel
9. Google
10. Apple

Highlight the area below with your mouse to see the answer.

1. Microsoft – $295BB
2. Cisco – $163BB
3. Google – $154BB
4. Intel – $126BB
5. AT&T – $125BB
6. HP – $109BB
7. Verizon – $103BB
8. Comcast – $85BB
9. Apple – $75BB
10. Dell – $57BB

How many of you had Google ranked in the top 3? How many of you had Comcast and Verizon ranked nearly the same?

I feel like I am turning up good scenarios where companies are tactically or structurally overvalued. I feel like I’ve found good value plays in the tech sector, particularly if my consolidation models work out. I can even reconcile the valuations of big companies like Microsoft (MSFT), Broadcom (BRCM), and Intel (INTC) based on the enormous opportunities that exist as more sectors of the economy and more segments of our lives transition from analog to digital.

But at the end of the day, there seems to be a lack of home-run ideas in Telecom infrastructure. I challenge anyone here to name a publicly traded Telecom component or equipment company that will be worth 10x what it is today in five years based on fundamental growth. Another way to look at it – name a public company that will increase revenues by 10x without eroding margins.

It was not always this hard. Where do the big 10x opportunities exist in the telecom & communications sector today? Nothing jumps out, at least to me.

I think it is pretty clear the whole industry is ripe for some major disruption. Rather than be pessimistic, it’s time to be optimistic, and identify what trends could reverse the industries fortunes.

Let’s look at the key ingredients for stratospheric growth.

1. Relatively small market cap today. It’s a lot easier to grow from $1BB to $10BB than it is to go from $10BB to $100B. So throw out many of your household component and equipment names.
2. Defensible concept. Optical module makers like Finisar (FNSR) and Avanex (AVNX) may be a big and vertically integrated but as of today there are few barriers to entry. Toss out most of the component vendors.
3. Fat margins. Usually the result of #2. Intel, Broadcom, Cisco (CSCO) are good examples.
4. Sticky. Once embedded, can’t be cleansed. Microsoft Windows. Your home phone number. The first email address you used widely. It’s hard to throw out a Broadcom Ethernet switch because the software investment, not the silicon itself.

Yeah, yeah, I know it’s a Five Forces ripoff.

It is exceptionally hard to identify existing communication infrastructure companies that meet these criteria. Many opportunities exist for 2-3x valuation based on consolidation. But where is the home run based on growth, and not decomposition? A critical look at the criteria above bring to mind a software company, not a hardware company.

It is increasingly clear to me that the growth opportunity in Telecom is going to be on the software side, not the hardware side.

Much like sexy big-iron computing hardware was commoditized into a common platform by Microsoft, sexy big-iron Telecom will follow the same path. The worst offenders appear to be specialty hardware boxes for specific applications, like Video Servers, Core Routers, or softswitches. Why not buy a few racks of bladeservers that can do all of the above?

When I think of Telecom companies today, just like analysts in 1980 thought of computers, I think of tricked out hardware. But there appears to be much more upside in turning communications equipment in a commodity and moving the value into software.

People think of Cisco as a hardware company. Take away 25% of Cisco’s operating income from marking up optical modules, and look at where the value really is. It’s IOS, the software that welds together all of their systems. The hardware exists only to monetize that software monopoly. Maybe they should just sell the software and let Huawei/3Com (COMS), HP (HPQ), and Dell (DELL) kill each other building the hardware.

Today, I can name 5 communication hardware companies for every software company. In 10 years, I expect this will invert. I intend to start focusing more of my time to understanding this transition.

Inspired by Martin Geddes excellent post “IMS is just an application“.

Your broker neglected to mention that the biblical Four Horsemen of the Apocalypse were steered by four riders – Conqueror, War, Famine and Death. I’ll leave it to my readers to pair them appropriately.

Today, I like to refer to Google (GOOG), Apple (AAPL), HP (HPQ), and AMD (AMD) as the new Four Horsemen of Web 2.0. Reading and listening to the media chatter about these companies induces an uncomfortable dot-com deja vu.

Bill Gates, CEO of Microsoft (MSFT) and Paul Ottellini, CEO of Intel Corp. (INTC) co-wrote an editorial in today’s WSJ. Clearly they are appealing to those who have fled their equities for the promises of Web 2.0.

Recently, we’ve read on the pages of The Wall Street Journal that we’ve reached the end of the personal computer era and that the open, broad industry approach that has enabled today’s rich computing experiences doesn’t apply to the world of digital devices.

The reality is a little different. The truth is that the model which has fueled the incredible popularity and affordability of the PC will continue to drive innovation and choice in the burgeoning area of personal devices such as cell phones, digital players and mobile PCs. As such, the PC is becoming more important and popular as a key enabler for these new digital scenarios in every corner of the world, from Indianapolis to Istanbul. If anything, it is, to paraphrase Churchill, perhaps the end of the beginning…

Gates and Otellini have a very valid point. While MP3 players, digital cameras, phones, and web based applications have stolen the show in the marketplace, all of them still rely on the PC as a digital hub. Nothing has emerged that will replace it. The only threat is the ‘thin-client’ web based application model, an idea that gets trotted out every few years and then is subsequently put back in the barn.

In addition to Intel and Microsoft, two other big-cap companies that have suffered as a result of this shift in perception are Dell Inc. (DELL) and Yahoo! Inc. (YHOO).

Competitively, all four of these companies are still forces to be reckoned with.

• Yahoo earned more money than Google in the trailing twelve months from a more diversified business model.
• Dell’s supply chain for electronics rivals Wal Mart’s in terms of efficiency and they will eventually succeed in their efforts to commoditize the consumer electronics space. The current market’s perception that PC’s are anything but commodities is a brief vacation from reality, and Dell is the best commodity producer out there. I believe the cost structure of Dell’s supply chain and web retailing model will beat HP’s.
• Intel will rip the throat out of AMD with their new low power designs for servers. They have a much bigger capital base to borrow from to build next generation fabs if (when?) money becomes more expensive. Otellini realizes the company has become too free-spending. AMD isn’t going away but the earnings multiple gap between the two is absurd.
• Microsoft has been cornered before and recovered. The Vista upgrade cycle will re-energize the cash machine. Over half of all Smartphones now run Windows Mobile 5.0 (Yes, more than Blackberry and Palm combined). Xbox 360 is looking to take share from Sony and has the best online service hands down. Meanwhile, Apple trundles along with a 5% market share in PC’s and 1/4th the valuation of Microsoft.

This is what the market cap vs. P/E multiple relationship looks like.

While the new ‘Four Horsemen’ may be the preferred growth engines of Web 2.0, I think these four out-of-favor companies represent a better investment vehicle for the next five years. Those with more exotic tastes can hedge by selling AMD, AAPL, HPQ, GOOG short while going long INTC, MSFT, DELL, and YHOO. This is a more market neutral strategy.

Inspiration and some data: USA TODAY

Disclaimer