Another quarter is in the books and Cisco (CSCO) continues to affirm its resurgence as a technology bellwether. Upon completing its ninth consecutive earnings beat, Cisco is once again looking more like the company that dominated the 90s and could do no wrong. Still, the company is not without its share of detractors.
The Street remains broadly unimpressed by what the company has been able to do dating back more than eight quarters. But you can't keep a good stock down, especially one with a chip on its shoulder. As the stock currently sits right at its 52-week high of $24.24 (as of this writing), the major question for analysts continue to be, where is the value? If Cisco's third quarter serves as an indication, patient investors will be rewarded with more gains than they expect. $40 is where the stock is heading
A Dominant First Quarter
Despite the fact that the stock is trading at a 52-week high, I don't believe that Cisco's valuation reflects the company's long-term potential. And this has been the case for quite some time. The company still has not earned the Street's confidence. The fact that Juniper (JNPR) almost trades at a P/E that is three-times that of Cisco, is a perfect example. This is despite the fact that Cisco doubles Juniper in operating margin.
Nevertheless, Cisco takes this disrespect in stride. And on Wednesday, the Street had nowhere to run following a dominant performance - betting both top and bottom line estimates. Revenue surged 5.4% to $12.2 billion. John Chambers, Cisco's CEO noted the company managed to execute "in a slow, but steady economic environment."
The company posted a non-GAAP net income of $2.7 billion, which represents year-over-year growth of 4.7%, or 51 cents per share. Here again, Cisco topped Street estimates of 49 cents. What this tells me is despite the fact that carrier spending has adversely impacted this entire sector, which includes F5 Networks (FFIV), Cisco is still posting growth where others have not.
More impressively however, was Cisco's strong performance in gross margin, which indicates the company's competitive leverage, remained relatively steady at 61.4%, just 20 basis points below its levels in the year-ago quarter. While the slight decline would ordinarily raise a red flag, I don't believe there's anything to be concerned here, especially when Cisco's cash now stands at more than $47 billion.
It's hard to not have been impressed by this performance. Wall Street has an insatiable appetite for growth and for companies such as Cisco who is trying to get back to its once dominant level - it seems that its performance comes with even more scrutiny than it deserves. Remarkably, even after two dominant performances, the stock has underperformed the Nasdaq and the S&P 500.
This is because the Street is not fully sold on the company's transition in an environment where enterprise spending has not fully rebounded. While I don't disagree with the cautious tenor, it's gotten to the point where the bearishness seems overdone. To that end, Chambers also added, "we are starting to see some good signs in the US and other parts of the world which are encouraging."
Chambers didn't exactly give a glowing endorsement, but I think this is one sign that the company is beginning to move more vertically than laterally, which should bode well for the stock. Investors have to be pleased with the progress that the company is making, while also appreciating that there is still a lot of work left to be done. During the conference call, I also got the sense that Cisco was open to the idea of reinvesting its capital to make more acquisitions.
The case for $40
It's hard to not be impressed with Cisco's $12 billion in operating cash flow, which has helped Cisco amass more than $47 billion in cash. Plus, Cisco has shown no meaningful signs of slowing down. The company's cash position is important to note here because quite a bit of $40 assumptions are based on future free cash flow projections and acquisitions.
I think at the top of Cisco's lists of potential targets should be names like Aruba Networks (ARUN) and Palo Alto Networks (PANW), which have made excellent strides in mobile and security. I've raised this argument once before. The concern here is, as dominant as Cisco still is in its routing and switching businesses, these are no longer the pillars of the company's revenue - not to the extent that they once were.
Cisco needs to break new ground, and both Aruba and Palo Alto have excellent assets to help drive growth higher for the next 5 to 10 years. In that regard, when applying a modest 5 to 6% FCF growth above 2012 levels, it supports a $40 fair market value, or 60% higher from where the stock reached this morning ($24.24). Meanwhile, it seems that the market is discounting this metric in favor of top line growth. So, at minimum, the stock is already significantly undervalued.
However, management understands that revenue growth is important. Cisco is working towards the future and management is no longer playing tit-for-tat with rivals like Juniper and F5. But I don't believe that the company is content with posting just 5% revenue growth indefinitely. Not to discount the importance of 5%, but Cisco, by virtue of its recent acquisitions like Intucell, Cariden and Meraki, is not operating as a company that just wants to sit on its cash and pay a decent yield.