Cisco and Heinz

Cisco reported earnings last night. Once upon a time, the market would move according to what Cisco reported or had to say on their earnings conference call. Today, it barely noticed. Instead, a much stodgier company grabbed the stage. Heinz was being acquired by Warren Buffett and Brazilian private equity firm 3G Capital for $72.50, about a 20% premium to previous day's close.

In late 2000, when I was a mutual fund manager canvassing around the country and ballyhooing the worthiness of my own special blend of stocks and bonds, I surveyed a roomful of financial advisers. If they could hold one stock, what would that company be? For their one and only Valentine, most advisers chose Cisco. Of course at the time, Cisco was trading in the high 60's and carried a PE multiple in the triple digits. Heinz, being a food company, of course was never showered with such affection during the growth crazed years of 1999 and 2000. In late 2000, it carried a price around $40 per share and a PE multiple of  16.

Fast forward 13 years ahead, Cisco had grown revenue from $18.93 billion in fiscal 2000 to $46.06 billion in fiscal 2012 for a compound annual growth rate of 7.1%. Earnings per share had grown from $0.39 to $1.50 during the same period for an annual growth rate of 10.9%. Heinz, on the other hand, had grown, revenue, also on a fiscal year basis, from $8.94 billion to $11.65 billion equating to 2.1% annual growth. EPS had grown from $2.51 to $2.87, a minuscule growth rate of 1% annually. Now for the number that  really matters to investors, at today's stock price of around $21, Cisco had lost more than 70% of its value and Heinz had gained more than 80% at the buyout price.

So for lesson #1, the stock market has a propensity to overvalue growth. Overpaying even a great company can have acutely negative consequences for your portfolio.

Even before today's $12 climb, Heinz at $60 was trading at 21 times it latest fiscal year end earnings while Cisco only sports a multiple of 14. Cisco is by no means an inferior business compared to the ketchup king. During the latest fiscal year, Cisco had a gross margin of 61% and return on asset of 8.8% while Heinz had a gross margin of 34.3% and return on asset of 7.7%. The natural questions is of course, why does Cisco which grows faster and has superior return characteristics, trade at a much lower multiple than Heinz. The answer is  Heinz will still be selling Ketchup 10 years from now while Cisco may very well be supplanted by an emerging technology or may have to re-invent an entirely new product line.

So here is lesson #2, the stock market has a propensity to overvalue innovation. In fact, companies with long and stable product lines always have the superior business models over companies that had to re-invent themselves.

At $72.50, Mr. Buffett is paying 19 times Heinz fiscal 2014 earnings estimate, which I believe is overly optimistic. I think given his extremely low cost of capital, Mr. Buffett is paying a fair price for an extremely slow growth company. I also tend to think that the market is also over-estimating the business risk of Cisco who occupies a dominant position in networking and is well entrenched in enterprises and governments alike.

For my money, I will bet on Cisco at $21 over Heinz at $72 for the next 10 years.