By David Sterman
Careful readers of my articles will note a clear trend: I always want to buy the best companies, but I want them at bargain prices. That means watching and waiting and identifying positive potential catalysts when everyone else is running away. And right now, I can't think of any $100 billion (in market value) company that is as widely shunned as Cisco Systems (NASDAQ:CSCO). Business is tough right now for this former highflyer, but management is laying the foundation for better days ahead. For patient investors, that spells upside after more than a decade of downside.
Murphy's Law ("If anything can go wrong, it will") is in full force as it applies to Cisco: Governments in Europe and the United States, which typically account for more than 25% of sales, are in the midst of a deep spending freeze that has led Cisco to miss sales forecasts in three of the last five quarters.
- A decision to enter the server market has led to a reduction in business with new rivals Hewlett-Packard (NYSE:HPQ) and IBM.
- Cisco has lost market share in the TV set-top box market as rivals developed better products, forcing Cisco to revamp its product line.
- Telecom carriers have been slow to invest in the switches and routers needed to handle ever-increasing traffic volume.
- Gross margins have taken a hit as Cisco's newer products (such as servers) can't carry the company's historically premium pricing.
All of these factors aren't likely to go away in the next few quarters, but management is taking steps to rebuild market share and profit margins. Meanwhile, most analysts are throwing in the towel, known as "capitulation" in financial circles. Citigroup, for example, downgraded the stock from "buy" to "hold" in mid-February, noting that "shares will likely remain rangebound until investors regain confidence in the growth and margin trajectory." That kind of talk has taken its toll: shares hit a 52-week low on Tuesday, putting the stock back where it traded in 1998.
More than likely, Citigroup will wait to upgrade shares when Cisco is delivering more impressive quarterly results. But if you wait for that upgrade, you're likely to miss a potential 20% to 30% upward move. Here are the five reasons you can't count Cisco out, and why I see shares ultimately moving back up to $25, or 40% higher than current levels.
1. In the sweet spot. Cisco is well-positioned to capture some of the most robust aspects of tech spending, including cloud computing, smart-grid investments, video conferencing and ultra high-speed switching. These markets are still in their infancy and are likely to become major technology niches in the next few years.
2. The safest choice. Cisco's research and development investments, coupled with an acquisition spree, has made the company the only tech vendor to offer virtually every piece of hardware and software needed to run enterprisewide telecom and data systems. The company's sales pitch revolves around the ease and reliability of a "one-stop" shopping approach, instead of the need to work with many vendors to build out a technology platform. That point has been obscured in recent quarters, but a range of product upgrades could enable Cisco's sales staff to hammer that point home more sharply later in calendar 2010.
3. The gross margin trough. Cisco generated 64% gross margins for each of the last four fiscal years, but in fiscal (July) 2011 that figure is likely to fall closer to 62%. Operating margins are taking a commensurate hit. Yet, in the most recent conference call, CEO John Chambers frequently discussed the myriad ways Cisco can lower its own production costs. Simply put, the company has identified a lot of parts in its various products that can be made or bought more cheaply. As it is able to lower the cost of a lot of the products' sub-components, gross margins could eventually rebound. "Value engineering processes, which have yet to kick in, will enable gross margins to increase over the next four to six quarters," note analysts at Avian Securities.
4. Bounce-back in a pair of verticals. Cisco has always counted on robust spending from government and telecom customers, yet each of these customer groups has under-invested in technology in recent years. For governments, that means "catch-up spending" is likely to take place once budget pressures abate to ensure that systems remain capable of handling the latest technology standards and traffic requirements. For telecom customers, the spending snap-back should be especially pronounced as expectations for Internet-based video traffic are expected to keep rising at a fast rate in coming years.
5. Mountainous levels of cash. Even as Cisco deals with current headwinds, cash generation remains very strong: Cisco has generated at least $9 billion in free cash flow in each of the last three years, and net cash now approaches $5 a share. That's why Cisco announced plans in November to buy back another $10 billion in stock (after completing $67 billion in buybacks in the past decade). The fact that shares are touching 52-week lows simply means Cisco can absorb even more shares with that $10 billion. And all signs point to yet more buybacks once the current $10 billion effort is completed.
For the first time in its history as a public company, shares of Cisco Systems sport a PEG ratio (the P/E divided by next year's earnings growth rate) of less than 1.0. By my math, the buyback could enable EPS to rise from about $1.60 in fiscal (July) 2011 to around $1.85 in fiscal 2012. That represents 16% EPS growth, and a P/E ratio for fiscal 2012 of less than 10.
To be sure, shares could languish for a few more quarters, but don't wait until Cisco is once again on the operational upswing. That makes the coming weeks and months the perfect time to build a position in this tech giant. Turnarounds are often best bought before they are fully in evidence.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.