Footnotes Diligence Drives CSCO Pick

If you bought Cisco Systems Inc CSCO last August when I recommended it to investors, or when I recommended it again in January, or any time between May 10, 2012 and now when the stock has had my Very Attractive rating, then yesterday wasa good day for you. CSCO shares surged 13% on the day, driven by better than expected quarterly earnings.

My analysis of the Financial Footnotes to CSCO’s Form 10-K for 2012 revealed that CSCO’s GAAP net income actually understated its profitability and growth. A variety of unusual expenses hidden in operating items totaling $530 million dollars (over 5% of net income after tax) caused CSCO’s GAAP net income to be $8 billion while its true net operating profit after tax (NOPAT) was over $8.5 billion. In addition, CSCO’s true economic earnings per share grew by 58% in 2012, more than double the 28% growth in its reported earnings per share.

In addition, CSCO has several signs of high-quality management: a top quintile return on invested capital (ROIC) of 18%, few asset write-downs (less than 10% of net assets), and a compound annual growth rate for NOPAT of 26% over the past 10 years.

The good news for investors is that CSCO, even after yesterday's surge, is still cheap. At Wednesday's closing value of ~$21.21/share, it had a price to economic book value ratio (P/EBV) of 0.7, implying a permanent 30% decrease in NOPAT. At its current value of ~23.97, CSCO’s (P/EBV) has only gone up to 0.8.

CSCO stock is still very cheap, and everything that made me recommend it to investors still applies. I’ve said before that quarterly earnings can be misleading. Investors focused on the reported earnings could never see this surprise coming as we did. The stock’s super-cheap valuation suggests that too many analysts do not understand the true earnings of this business and underrate this company’s profitability. Astute investors should pounce on this opportunity.

New Constructs’ database of accounting distortions in over 50,000 annual reports across over 3000 stocks provides investors with unrivalled research. We do the diligence on the “big data” in the voluminous disclosures in annual reports so our clients can meet their fiduciary responsibilities with confidence.

First Trust NASDAQ Technology Dividend Index Fund TDIV gets my Attractive rating and allocates over 7.5% of its assets to CSCO.

Sam McBride contributed to this article

Disclosure: David Trainer owns CSCO. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.