Seeking Alpha
Long/short equity, newsletter provider, valuentum
Profile| Send Message|
( followers)  

Summary

  • We think Cisco is fairly valued at $27 per share, representing over 20% upside from today's levels, based on our point fair value estimate.
  • The company’s free cash flow generation is simply astounding.
  • Cisco is certainly one for any investor's watch list, particularly considering the size of its dividend yield (3.4%).

As part of our process, we perform a rigorous discounted cash flow methodology that dives into the true intrinsic worth of companies. In Cisco's (NASDAQ:CSCO) case, we think the firm is ridiculously underpriced. We think it is fairly valued at $27 per share, representing over 20% upside from today's levels, based on our point fair value estimate. The high end of our fair value range of the firm indicates even more upside potential.

Let's offer a little background to help with the understanding of the article. We think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Please take a look at this video here of President Brian Nelson to see why we think the Valuentum way is one of the best ways to invest.

(click to enlarge)

If a company is undervalued, both on a DCF and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Cisco posts a Valuentum Buying Index score of 3 on our scale, reflecting our "undervalued" DCF assessment of the firm, its neutral relative valuation versus peers, and very bearish technicals. Though imperfect, we compare Cisco to peers Aruba Networks (NASDAQ:ARUN), Finisar (NASDAQ:FNSR), and Juniper Networks (NYSE:JNPR) for perspective across the communications space. Still, the foundation of our process at Valuentum rests on in-depth intrinsic valuation analysis. In this regard, Cisco is significantly underpriced. Let's take a look at the company's report below.

Valuentum's Report on Cisco

Investment Considerations

Investment Highlights

  • Cisco's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders, with relatively stable operating results for the past few years, a combination we view very positively.
  • Cisco sells Internet Protocol (IP)-based networking and other products related to the communications and information technology industry. The firm provides a broad line of products for transporting data, voice, and video.
  • Cisco has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 24.2% in coming years. Total debt-to-EBITDA was 1.3 last year, while debt-to-book capitalization stood at 24.1%.
  • Cisco's revenue growth trajectory continues to shift lower. We fully expect the company to use its newly authorized share buyback program to aid in earnings per-share expansion in coming periods. If the firm misses bottom line numbers, we'd grow more and more concerned about a loss of focus at the executive suite of the firm.
  • Future revenue growth at Cisco is now expected to be in the range of 3%-6% during the next 3-5 years. This is down from the 5%-7% annual growth expectations it set during its conference in 2011.

Business Quality

Recent Investor Update

Cisco hosted its 2013 Financial Analyst Conference, and management's commentary during the meeting wasn't encouraging. The firm's fiscal first-quarter 2014 results, released mid-November, had showcased significant order weakness, and commentary on the company's fiscal first-quarter conference call indicated that the firm did not anticipate material improvement in its order growth during the second quarter, but CEO John Chambers' reiteration of his view today that emerging markets remain "extremely challenged," particularly in Brazil and Russia, has sent shockwaves across much of the networking industry. It appears the market had been building in expectations that some order stabilization would occur at this point during the quarter, and Chambers' comments may have mitigated this enthusiasm. Though it may take some time to right the course, management thinks emerging countries will grow at a nice 6%-10% annual clip.

(click to enlarge)

Image Source: Cisco

Adding fuel to the fire was a slide from CFO Frank Calderoni's presentation that showed future revenue growth at Cisco is now expected to be in the range of 3%-6% during the next 3-5 years. This is down from the 5%-7% annual growth expectations it set during its conference in 2011, on headwinds ranging from macroeconomic uncertainty to conservative customer budgets. Though a percentage point or two of growth may not seem like a lot, it can have significant implications on smaller players within the networking space, and speaks to a growth trajectory that is moving in the wrong direction. Services revenue expansion is expected to grow at a 7%-10% pace during the next 3-5 years, down from 9%-11% previously. Services gross margins are a few percentage points better than product gross margins, and were 66.6% on a non-GAAP basis in the fiscal first quarter. Lost revenue in this area will have a greater impact on profits than weakened growth in product sales.

(click to enlarge)

Image Source: Cisco

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Cisco's 3-year historical return on invested capital (without goodwill) is 59.5%, which is above the estimate of its cost of capital of 10.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Cisco's free cash flow margin has averaged about 22% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Cisco, cash flow from operations increased about 13% from levels registered two years ago, while capital expenditures expanded about 12% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Cisco's shares are worth between $22.00-$32.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Investors should view the $32 mark as upside potential under optimistic forecasts. The estimated fair value of $27 per share (the middle of the range) represents a price-to-earnings (P/E) ratio of about 18.1 times last year's earnings and an implied EV/EBITDA multiple of about 8.8 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 0.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 8.4%. Our model reflects a 5-year projected average operating margin of 27.6%, which is above Cisco's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.7% for the next 15 years, and 3% in perpetuity. For Cisco, we use a 10.9% weighted average cost of capital to discount future free cash flows.

(click to enlarge)

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $27 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Cisco. We think the firm is attractive below $22 per share (the green line), but quite expensive above $32 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Cisco's fair value at this point in time to be about $27 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Cisco's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $34 per share in Year 3 represents our existing fair value per share of $27 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

The Bottom Line

Cisco's revenue growth trajectory continues to shift lower, and it appears business has not turned upward thus far through the current year at the networking behemoth. Still, the company's free cash flow generation is astounding, and its dividend remains solid. We fully expect the company to use its newly authorized share buyback program to aid in earnings per share expansion in coming periods. If the firm misses bottom line numbers, we'd grow more and more concerned about a loss of focus at the executive suite of the networking behemoth. Shares are cheap at current levels, but consistent with our stock selection methodology, we're waiting for an improvement in the firm's technical/momentum indicators before considering opening a position in either of our actively-managed portfolios. The opportunity may come sooner than later; we're keeping a close eye on shares. The company is certainly one for any investor's watch list, particularly considering the size of its dividend yield (3.4%).

Pro Forma Financial Statements

(click to enlarge)

(click to enlarge)

(click to enlarge)

Source: Why Cisco Is Ridiculously Underpriced