Footnotes Diligence Drives Cisco Pick

| About: Cisco Systems, (CSCO)

I have been bullish on Cisco Systems (NASDAQ:CSCO) for a while, so yesterday's 12.5% increase in its share price was gratifying for me to see. CSCO's big surge came on the heels of better-than-expected quarterly earnings. Even with the surge in its stock price yesterday, however, CSCO is still very undervalued due to GAAP earnings that understate the true profitability of the company.

My analysis of the financial footnotes to CSCO's Form 10-K for 2012 revealed that CSCO's GAAP net income actually understated its profitability and growth. A variety of unusual expenses hidden in operating items totaling $530 million (over 5% of net income after tax) caused CSCO's GAAP net income to be $8 billion, while its true net operating profit after tax (NOPAT) was over $8.5 billion. In addition, CSCO's true economic earnings per share grew by 58% in 2012, more than double the 28% growth in its reported earnings per share. In addition, CSCO has several signs of high-quality management: a top quintile return on invested capital (ROIC) of 18%, few asset writedowns (less than 10% of net assets), and a compound annual growth rate for NOPAT of 26% over the past 10 years.

The good news for investors is that CSCO, even after yesterday's surge, is still cheap. At Wednesday's closing value of ~$21.21/share, it had a price-to-economic-book-value ratio (P/EBV) of 0.7, implying a permanent 30% decrease in NOPAT. At its current value of ~$23.97/share, CSCO's P/EBV has only gone up to 0.8.

CSCO stock is still very cheap, and everything that made me recommend it to investors still applies. I've said before that quarterly earnings can be misleading. Investors focused on the reported earnings could never see this surprise coming as we did. The stock's super-cheap valuation suggests that too many analysts do not understand the true earnings of this business and underrate this company's profitability. Astute investors should pounce on this opportunity.

First Trust NASDAQ Technology Dividend Index Fund (NASDAQ:TDIV) gets my Attractive rating, and allocates over 7.5% of its assets to CSCO.

Sam McBride contributed to this article.

Disclosure: I am long CSCO. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme. I have no business relationship with any company whose stock is mentioned in this article.