As the world’s largest provider of data networking equipment and software, Cisco Systems (NASDAQ: CSCO) is the youngest member of the Dow 30. Since its admission into the index in mid-2009, shares of CSCO have returned just over 2 percent, compared to a 41 percent jump in the overall DJIA. Over this time period, Cisco has expanded upon its staple of products like routers and networking software to access newer areas of the tech market, like large-scale data servers and video conferencing. In 2011, the company also undertook a massive restructuring program aimed at increasing efficiency, though this also trimmed over 10,000 jobs. As part of this campaign, the company’s CEO John Chambers vowed to become a competitor in the cloud-computing arena, as CSCO has acquired a number of smaller competitors over the past year. While bears point to the company’s stagnant stock price as a sign that it may be losing its organizational focus, valuation metrics indicate that now may be the best time for investors to take a long position in the stock.
Since the recession, revenues in the data networking industry have shrunk at an average of 3.5 percent per year, but CSCO has seen top line growth of around 3 percent each year. This is also better than competitors like Hewlett-Packard (NYSE: HPQ) at 2.4% and Alcatel-Lucent (NYSE: ALU) at -3.4%, but below Juniper Networks (NYSE: JNPR) at 7.6%, F5 Networks (NASDAQ: FFIV) at 21.0%, and Riverbed Technology (NASDAQ: RVBD) at 29.7%. In Cisco’s case, the company has been able to translate a moderate revenue growth to the bottom-line, as it recently beat analyst earnings estimates for its third quarter of 2012. Specifically, the company reported a quarterly EPS of $0.48, which was 14 percent higher than the same quarter last year. This came on the shoulders of a better-than-expected sales increase of 7 percent from Q3 of 2011. Additionally, the company stated that they expected each of these figures to increase by 2 to 5 percent in Q4, though the Street expects a 7 percent growth. Even though this was just a forecast, the markets seemed to ignore Cisco’s actual Q3 results, instead focusing on disappointing projections for the next quarter. After this announcement, the company’s stock dropped over 10 percent on May 10th.
While this bearish behavior may be warranted, it could also present a buying opportunity for value investors. With a current P/E ratio of 12.8X, shares of CSCO look to be trading at a deep discount, as this is below the industry average P/E of 19.8X and the company’s own 10-year historical average P/E of 24.1X. When factoring in future earnings estimates, a similar picture is painted, as the company has a Forward P/E ratio of 8.5X that is below the majority of its competitors. Factoring growth into the equation strengthens this argument further, as CSCO’s PEG ratio is 0.8; remember, anything below 1.0 is typically undervalued.
Going further, it’s also important to analyze how investors are valuing a company’s cash flows, and in CSCO’s case, we’ll use the P/CF ratio. Currently, the company has a P/CF ratio of 8.0X, which is below the industry average of 10.4X and its own 10-year historical average of 16.2X. This is below the likes of ALU (21.3X), JNPR (11.1X), FFIV (19.9X), and RVBD (12.9X). Intriguingly, this under-appreciation does not seem warranted, as CSCO is currently sitting on more cash than any of its competitors. In dollar terms, the company’s present free cash flow is nearly $3 billion, which is three times larger than ALU, its nearest competitor. Additionally, CSCO’s cash hoard is 65 percent larger than it was three years ago, and has grown at a faster rate than any of its peers; HPQ (-73.3%), ALU (42.9%), JNPR (59.65%), FFIV (34.3%), and RVBD (-64.7%) have all seen their FCF grow by a smaller percentage.
Perhaps the most attractive piece of Cisco’s proverbial puzzle can be seen when looking at the company’s operating margins. After the company’s 2011 restructuring efforts, margins that varied wildly in the ‘teens’ are now north of 20 percent. In comparison, the industry average is 10 percent, and the majority of CSCO’s competitors are not up to par. Even though the company extracted nearly a quarter in profit from every dollar of sales in Q3 of 2012, investors chose to place emphasis on lower-than-expected revenue and EPS guidance numbers. It should be mentioned that this is not the first time that Cisco execs have pulled such a maneuver over the past few years, so it is possible that leadership is simply trying to make a lower hurdle to jump over.
From a macroeconomic standpoint, Cisco looks to be headed in the right direction just in time to capitalize on a precipitous rise in global data demand. Specifically, it is estimated that this will be driven by 80 percent annual growth in mobile data traffic over the next five years. It is also estimated that the number of total connections will be larger than the entire population of the world by 2014, and the number of data-using devices will eclipse 10 billion by 2016. In CSCO’s case, its immense infrastructure makes it the most prepared for this boom out of all of its competitors. Currently, it captures over 60 percent of this market. In fact, the company is estimating that this size advantage alone will yield them an extra $20 billion a year by the end of this five-year period.
In the hedge fund industry, there are a number of managers with unusually high portions of the stock in their portfolios. As of the end of last year, Kerr Neilson, Russell Hawkins, Sandy Nairn, and Alan Howard all held at least 6 percent of their 13F portfolios in CSCO, with Howard holding over one-fifth of his clients’ assets in the stock. While it is obvious that individual investors must perform their own research, the combination of Cisco’s attractive valuation, strong cash cushion, and improvements in operating efficiency have it looking like a good investment at the moment.