Cisco: Compelling at These Levels

 |  Includes: CSCO, WEBX
by: Asif Suria

On a recent call with a regional manager from web conferencing company WebEx, (WEBX) I asked him how things were going at WebEx and he told me that business was great. It reminded me of the last recession when business travel fell off a cliff after the dot com bust and web conferencing companies were doing brisk business. That brisk business attracted networking giant Cisco, (NASDAQ:CSCO) prompting the company to acquire WebEx in 2007 even as it eyed bigger fish with its more expensive high-end videoconferencing product called TelePresence.

WebEx generated $380 million in 2006 annual revenues, the year before Cisco's $3.2 billion acquisition. Even if revenue has more than doubled since then, WebEx would account for less than 2% of Cisco's $39.54 billion fiscal 2008 annual revenue.

What attracted me to Cisco had little to do with WebEx and a lot to do with Cisco's current valuation. With a product portfolio ranging from enterprise routers, switches and hardware firewalls to consumer facing products like Linksys wireless routers and WebEx, the company generated over $12 billion in operating cash flow last year. The company has a stellar balance sheet with over $31 billion in cash and investments when compared to less than $7 billion in debt, representing net cash of over $4/share. Inventory levels have been dropping over the last four quarters and Cisco is positioning itself for negative growth this year and potentially next.

Valuation: Cisco's P/E ratio hit a 10 year low on March 9, 2009 when it dipped to 10.81. Since then the stock has rebounded more than 20% and trades at a current P/E ratio of 13.38 or an EV/FCF ratio of just 6.95 The company posted a 16% drop in year-over-year non-GAAP quarterly earnings and gross margins have also been contracting. Net margins are holding steady due to cost cutting initiatives that will eliminate nearly $1 billion in annual expenses at the current run rate.

To arrive at a value for Cisco, I decided to use a discounted cash flow (DCF) analysis model and used very conservative numbers to arrive at a price of $22.17 ($18.17 from the model and $4 in net cash). In case you are interested, the inputs into the model were $1.88/share in free cash flow over the trailing twelve month period, negative earnings growth of 5% for the next two years followed by a conservative 5% growth rate for the next 3 years (current analyst estimates are 9.85% for the next five year), a conservative 2% terminal growth rate and a 12% discount rate. Obviously changing any of these inputs will yield different values. The current stock price for Cisco represents a 32% discount to this $22.17 value and I think Cisco could be a compelling stock to own at these levels.

Conclusion: After the strong market rally over the last three weeks, I am expecting the market to pull back and consolidate in the coming weeks. Hence I am going to add Cisco to the watch list for now and will post an entry on the blog (or tweet) should I decide to start a position in the company.