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Introduction

Networking companies did well during the last decade, selling routing and switching equipment to the world. However, the products were bound to become a commodity and the profitability of the industry declined as a result. The leading networking company, Cisco Systems (NASDAQ:CSCO), is currently selling at attractive valuations. It is much more favorably positioned as compared with some of its competitors, such as Alcatel-Lucent (NYSE:ALU) and Juniper (NYSE:JNPR). This article discusses which company is a winning bet among the stocks in the networking industry.

Analysis

The networking industry is going to go through a phase of turbulent change. Many indicators show that Cisco is best-positioned to remain the sector leader in the future. What has perhaps confused the stock market is that Cisco has been betting on multiple and diverse projects such as video conferencing and even virtual networking, without the use of hardware. This has been interpreted by analysts to mean that although Cisco is the market leader, it is not sure about the segment that will emerge as the hot networking technology of the future. Cisco has money invested in many diverse projects.

Yet, buying a Cisco stock at current stock prices still appears to be a much stronger bet than trying to guess the hot networking technology on your own. If Cisco is not sure about it despite being the leader, outsiders have a very long shot. The company has already demonstrated its ability to retain its leadership position in a new segment, when it successfully adapted its products to switching (being traditionally a stronger player in routing).

It is easy to conceptualize networking companies similar to Cisco as the suppliers of routers and switches, needed to direct traffic through any network. However, these companies also provide services to customers such as helping them maintain the networks, which is a higher margin business. The success in the services business is reflected in the higher margins of Cisco as compared with its peers. The gross margins of Cisco have been in the range of 60% -70% in the last 10 years and the operating margins have been consistently close to 25%. Juniper has similarly high (but more fluctuating gross margins) but its operating margins are poor. Alcatel-Lucent has been struggling with gross margins close to 30%. (Juniper and Alcatel-Lucent are the closest competitors of Cisco in terms of market capitalization). Service customers are also more sticky which means that there are less chances that revenues will dwindle rapidly (and perhaps explain how Cisco has managed to be consistent with its revenues and margins all these years).

Cisco is selling cheaply if we look at the relative multiples. The P/E ratio of the stock is well below the industry and historical averages and dividend yield at the current stock price is a reasonable 2.1. There are other cheaper bargains in the sector, such as Alcatel-Lucent. Nevertheless, Cisco is not only the largest player in the sector (with more than 50% market share in multiple segments), it has also been the most consistent in the last decade.

P/S

P/B

P/E

Dividend Yield

Alcatel-Lucent

0.2

1.5

-13.9

-

Cisco

2.4

2.1

13.6

2.1

Juniper

2.8

1.6

64.1

-

Industry average

1.6

2.2

30.5

1.8

If we compare the three companies by trying to assess how much cash they have generated for their shareholders, Cisco has performed more consistently when compared with Alcatel-Lucent and Juniper. The cash generated by the owners is assessed by using the metric owners' earnings. Owners' earnings are calculated as Net income + Depreciation & Amortization - all Capital Expenditure (including working capital). Cisco has maintained its operating earnings in the turbulent five-year period between 2007 and 2012. This is important as only the company which is generating cash from current operations can invest some of it in projects that could take off in a big way in the future (an example being video conferencing).

All numbers are in dollar millions.

Owners Earnings

2007-08

2008-09

2009-11

2010-11

2011-12

Alcatel-Lucent

-3276

-5365

-250

-37

1349

Cisco

8528

6897

8789

7144

8016

Juniper

407

514

112

588

329

Analysis of Return on Invested Capital (NASDAQ:ROIC) for the three companies also favors Cisco as its profitability has been higher than the other two for most of the past five-year period.

ROIC

2007-08

2008-09

2009-11

2010-11

2011-12

Alcatel-Lucent

-10.40%

-19.09%

-2.20%

-1.34%

4.52%

Cisco

13.71%

9.00%

9.57%

7.45%

8.76%

Juniper

5.24%

7.12%

1.54%

7.30%

4.26%

To further understand the profitability of the companies, consider the break-up of ROIC into turnover and margin. Cisco has a better turnover as well as better margins than its competitors.

ROIC = margin *turnover

2007-08

2008-09

2009-11

2010-11

2011-12

Alcatel-Lucent

Margin

-19.78%

-30.71%

-3.46%

-2.09%

7.14%

Turnover

52.59%

62.19%

63.56%

64.30%

63.33%

Cisco

Margin

20.36%

16.98%

19.40%

15.02%

17.46%

Turnover

67.32%

53.01%

49.35%

49.62%

50.20%

Juniper

Margin

12.73%

14.33%

3.53%

15.10%

9.55%

Turnover

41.19%

49.70%

43.69%

48.33%

44.56%

Another measure of profitability - ROE, favors Cisco in both magnitude and consistency.

ROE

2007-08

2008-09

2009-11

2010-11

2011-12

Alcatel-Lucent

-31.32%

-112.56%

-14.01%

-9.42%

28.41%

Cisco

23.44%

15.87%

17.55%

13.74%

15.68%

Juniper

6.74%

8.68%

2.01%

9.35%

6.00%

Cisco and most of its peers in the industry are conservatively financed with minimal debt-to-equity ratio. If we assume that these companies would be comfortable with a coverage ratio of 4 and assume that the companies can service this debt at 10% interest rate (a very conservative figure given the coverage ratios), we can estimate the value of a company by calculating its debt capacity. A simple rule of valuation says that a company should be worth at least 75% more than the debt it can comfortably service. These calculations of debt capacity are summed up in the next table (all dollar numbers are in millions) for Cisco as well as for Juniper and Alcatel-Lucent.

Indicators

Alcatel-Lucent

Cisco

Juniper

Typical interest coverage ratio in the sector

4

4

4

Maximum Interest Paid in Last 5 years

404

628

50

Average Cash flow from Operations (NASDAQ:CFO)

17.6

10745.8

851.4

Interest rate on debt issued by corporation

10%

10%

10%

Last five year average CFO / Typical Interest Coverage ratio (Interest that can be readily serviced)

4.4

2686.45

212.85

Debt service capacity (Interest that can be readily serviced/ Interest rate on debt)

$ 44.00

$ 26,864.50

$ 2,128.50

Value of business ( 175% debt capacity + Surplus cash)

$. 5,357.00

$ 73,247.88

$ 5,680.88

Value of business ( 175% debt capacity + Surplus cash) as percentage of market capitalization

137.36%

65.23%

48.97%

The Bottom Line

This metric suggests that Alcatel-Lucent is undervalued. However, one look at the numbers presented in the article itself (and given that the networking industry is expected to see some dynamic changes in the future) would make a very strong case against investing in that company. Cisco does not come out as undervalued; however, it is still reasonably priced. You can buy Cisco at this price with a good chance that one of its many capital allocations will be fruitful.

Source: Cisco Systems, Alcatel-Lucent, Juniper: Which Networking Company Is The Best Bet For Now?