The share price of Cisco Systems (CSCO) has risen by 6.1% year to date and recently reached its 52-week high. Despite the solid price appreciation, investors should consider buying the shares at the current level based on the following 5 reasons:
1. From a relative valuation perspective, Cisco shares are priced attractively based on the company's solid financial performance relative that of its peers (see chart below). Consensus estimates predict the company's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 5.8%, 11.5%, and 1.0%, respectively. The figures are notably below the averages of 13.5%, 55.9%, and 68.1%, respectively, for a group consisting of Cisco's primary peers in communications equipment sector. Similarly, Cisco's long-term earnings growth rate is forecasted to be 9.4%, below the group average at 15.5%. On the profit side, however, Cisco demonstrates a superior performance as most of the company's profitability margins and capital return metrics are considerably above par. Cisco's debt level is fairly in line with the peer group as reflected by its above-average debt to capitalization ratio but below-average debt to EBITDA rate. In terms of liquidity, Cisco's free cash flow margin is fairly comparable to the average. Both the firm's current and quick ratios are markedly above par, reflecting a healthy balance sheet condition.
To summarize, Cisco's relatively weaker growth potential would likely be the primary drag on the stock valuation. However, given the company's robust profitability, excellent liquidity position, as well as its significant global presence and operation scale, I believe the stock's fair value should only trade at a modest discount to the peer-average valuation level. Nevertheless, the current price multiples at 5.2x forward EBITDA (next 12 months) and 10.3x forward EPS (next 12 months) together represent an average discount of 40% to the same peer-average multiples. After accounting for Cisco's below-average long-term EPS growth estimate, the stock's PEG ratio of 1.10x is almost consistent with the peer average at 1.06x, suggesting that market has likely not given enough credits for Cisco's strong margin and liquidity performance and thus the shares are somewhat undervalued on a relative basis (see chart above).
2. Due to growth slowdown, Cisco's trailing P/E multiple is currently trading near its 3-year low (see chart below).
However, the market appears to underestimate some of the company's positive fundamentals. Over the past 3 years, Cisco has been able to sustain a steady ROA and ROIC performance and generate higher return on equity. The firm has also achieved a higher profitability as shown by the rising EBTDA margin in the 3-year period and the consensus estimate suggests a continued improving trend (see charts below).
3. Further, Cisco's forward P/E ratio is now trading at a 30% discount to the same multiple of S&P 500 Index, which stands at 14.6x. This presents a great entry opportunity as I believe Cisco shares should reasonably trade at a smaller discount to the market level provided that 1) the company's estimated long-term EPS growth rate at 9.4% is above the average estimate of 8.2% for the S&P 500 companies; 2) Cisco is a market leader in the communications equipment sector and enjoys a market-leading free cash flow margin and ROE performance; 3) the stock also offers a 2.7% dividend yield with a strong dividend growth prospect; and 4) the company has also been aggressively buying back shares.
4. Cisco share price will likely be supported by the company's strong commitment to return capital to shareholders. According to a research note written by Mark Sue at RBC Capital Markets (dated March 15, 2013 and sourced from Thomson One, Equity Research), Cisco's capital allocation plan is to return at least 50% of operating cash flow to shareholders through both dividends and stock buybacks. Since 2011, Cisco has raised the dividend per share twice by 33% and 75%, consecutively. Given the fact that the company's annual dividend payment only represented a small portion of the total free cash flow generated in the past few years (see chart below), I believe the company would have a sufficient capacity to maintain a double-digit dividend growth rate at least in the near term, which will likely drive up the dividend yield.
5. According to data provided by Thomson One, Cisco has consecutively beaten both the consensus revenue and EPS estimates over the past 8 quarters. The average consensus revenue, EBITDA, and EPS estimates have trended steadily over the past 6 months (see charts below), indicating a positive market sentiment.
Of the 40 stock ratings compiled by Thomson One, there are 10 strong buys and 18 buys. Mark Sue at RBC Capital Markets had some additional comments on Cisco's growth prospects, which I agree on (research note dated March 5, 2013 and sourced from Thomson One, Equity Research):
"Following our discussions with management, we've become increasingly confident in Cisco's improving execution across important measures of gross margins, operating expense control, and future dividend increases. With an improving macro backdrop, Cisco may see encouraging top-line growth near the upper band of its 4-6% range, while earnings are likely to grow more quickly."
Bottom line, investors should seriously consider acquiring Cisco shares in the light of the company's recovering growth prospects, solid financials, and compelling valuations.
All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.