Cisco Is Still A Long-Term Buy

| About: Cisco Systems, (CSCO)

In today's digital world, Cisco Systems Inc. (NASDAQ:CSCO) stands as a digital leader in the industry. Cisco is a frontrunner in the industry and is known for its ground-breaking tech products, networking services and powerful digital strategies. It is one of the market leaders and strives to stay a cut above its competitors. However, Cisco revised its earnings guidance for upcoming quarters because of sluggish growth in Japan and China. Therefore, I aim to study whether Cisco will be able to offer healthy results in the future in spite of weak growth prospects. Moreover, I have conducted a detailed analysis of its financial records and I also studied its growth prospects in order to determine whether the company is a good investment or not.

Historical

Business Model

Cisco designs, manufactures and sells Internet protocol based networking and other products related to communication and the IT industry. It also provides services associated with these products and their use. The company provides a wide range of products for transporting data, voice and video around the world.

Performance

As shown in the following graph, the company generated 58.92% revenue from the United States. The Europe, Middle East and Africa "EMEA" region contributed 25.12% of revenues while the remaining 15.96% came from the Asia-Pacific, Japan and China "APJC" region.

SOURCE: Company's financials

Cisco generated 78.32% revenue from sales while the remaining portion of revenue was garnered from its services.

SOURCE: Company's financials

Compared to 2012, total revenue increased by 5.53% in fiscal year 2013. The revenue increase was primarily driven by its acquisition of NDS as well as increased demand for Data Center and wireless products. Moreover, product revenue from the Americas increased by 7% in fiscal year 2013 compared to fiscal year 2012. Product revenue in the EMEA segment was flat in fiscal year 2013 compared to fiscal year 2012. Cisco experienced a 3% increase in product revenue from the APJC segment. The company experienced a significant growth in countries such as Australia, South Korea and India, but this growth was partially offset by the decline in revenues from China and Japan.

Cisco reported solid results in fiscal year 2013. In a challenging and inconsistent global macroeconomic environment the company's profit grew and experienced a higher percentage in its revenues in fiscal year 2013 compared to fiscal year 2012.

Cisco's cost of revenue increased, not only in absolute terms, but also as a percentage of revenue. Due to an increase in cost of revenue, as a percentage of revenue, the company's gross margin declined by 0.68%. The company successfully controlled operating expenses in fiscal year 2013 compared with fiscal 2012. Therefore, lower operating expenses, as a percentage of revenue, helped the company to report a higher operating margin in fiscal year 2013 compared with fiscal year 2012. Also, the company's net profit increased by 24.15% in fiscal year 2013. The increase in the net profit margin is mainly attributed to a decrease in the effective interest rate in fiscal year 2013 compared to fiscal year 2012.

SOURCE: morningstar.com

Industry

Overall, the company's performance exceeded the industry's reported results. Its revenue grew with a CAGR of 5.60% compared with the industry CAGR of 1.50% over the last three years. Net income grew at a much faster pace than the industry's average net income.

Moreover the company's debt/equity ratio is 0.2 times, which is lower than the industry average of 0.4 times. Despite having lower financial leverage than the industry, the company's ROE was 23.90%, which is well above the industry average of 1.90%. A higher ROE is attributed to the higher net margin of the company. As shown in the following chart, the company's operating margin, in the last 12 months, is 9.60%, which is more than three times higher than the industry average of 3.00%.

Click to enlarge

SOURCE: Company's financials

Growth Prospects

Cisco's earnings and revenues grew in fiscal year 2013, compared with fiscal year 2012, as demand for its computer networking equipment increased.

Cisco predicted revenue growth to be in the range of 3-5 percent in the coming quarters while analysts estimate a revenue growth of at least 5%. However, the company is expecting weak growth in the coming quarters. Therefore, the company announced it would lay off 4,000 employees in order to overcome the problem of sluggish growth in the short run.

Cisco's policy of cost containment helped it to achieve higher net margins despite sluggish growth in the past. Therefore, I believe Cisco's policy of curbing cost will help to produce fruitful results in upcoming quarters.

Moreover, to cater to the sluggish growth, in the short run, the company has announced it will acquire SSD device maker WHIPTAIL. This to me, appears to be a smart tactic since SSD devices are becoming more popular in the global storage market compared to other storage devices like HDDs.

Features such as high data transfer rate, lower power consumption and better physical properties offer users an edge over other storage devices. I believe that the company will be able to report healthy results in the future owing to its cost containment policy and acquisition of WHIPTAIL.

Moreover, significant customer switching costs and scale advantage give the company a long-lasting competitive advantage in its core market of switching and routing.

Valuation

In order to calculate the intrinsic value of the stock, I have applied the free cash flow model. The company is expecting slow growth in the future, therefore I believe the company's operating cash flows and capital spending will decline in the near future. As shown in the following diagram, I have used 1.50% long-term growth rate to calculate terminal value. Using a beta of 1.39, a risk free rate of 2.69% and market return of 8.48%, the cost of equity is calculated as 10.74%. After tax,the cost of debt of Cisco is 2.78%. By using these costs of capital the company's WACC is 9.83%.

Using the free cash flow model, the intrinsic value of the stock equals $28.03, which offers a 20.40% capital return.

Click to enlarge

The free cash flow model is dependent upon two key factors: long-term growth and WACC. Therefore, in order to sensitize the fair value of the stock I have utilized these two key components of the model.

As shown in the following table, stock prices are more sensitive to WACC. The stock has an upside potential of 37.25% while its downside potential is only 14.93%.

Final Call

Cisco has performed better not only on a standalone basis but also in comparison to industry averages. Moreover, Cisco's PEG ratio is 1 times, which is much lower than the industry average of 1.68 times.

Cisco's policy of curbing costs will enable the company to report healthy results in the future despite its slow-moving growth rate. Moreover, its recent acquisition of WHIPTAIL will also help the company to obtain healthy margins.

According to my valuation Cisco is undervalued. Its intrinsic stock value is $28.03, which offers 20.40% of capital return. The stock has an upside potential of 37.25% while its downside potential is 14.93%. Therefore, based on fundamental analysis, I would recommend buying the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.