Cisco's stock has recently performed terribly. However, as discussed below, the current risk/reward indicates that now is the time to start building a position in the stock.
Fundamentals – Many articles describing various aspects of the fundamental value of Cisco (CSCO) shares have been written recently. One point many of these article raise is the low P/E for the stock. Per Yahoo Finance, the trailing P/E is 12.9 and the forward P/E is 9.7. Taking that one step further, Yahoo Finance also indicates that Cisco has over $7 in cash/share on its balance sheet, and the average analyst earnings estimate for this fiscal year is $1.59/share. With the stock trading a little over $17, that means that the earnings stream costs less than $10 to buy, and the P/E after adjusting for cash could be viewed as less than 7. In the long term, this type of value should rationally mean there is upside in the stock. However, as has been shown many times, the market can remain irrational longer than an investor can remain solvent/patient. While the fundamental valuation is good, that by itself may not mean it is time to buy. Rather, these good fundamentals put somewhat of a floor under the stock and minimize downside risk.
Technical – The charts are starting to show some reason to buy the stock. The current $17 appears to be a short term support level on the chart, and relative strength indicators are emitting buy signs. The rather dramatic change of perception in the stock that has occurred over the past year may make positive technical indicators a little less relevant than normal, but Wall Street technicians will still pick up on these signals. They will start to market this information to their client base. At some point in time, this will improve the investor demand for this stock.
Common Sense – Looking beyond the above normal Wall Street indicators there are some main street, common sense reason to consider initiating a position in the stock.
Three strikes and you are out - Cisco's earnings announcements disappointed the street the last two quarters. Management will be under a lot of pressure not to disappoint three times in a row. If they do disappoint again, they could be out of a job. There is nothing like the fear of losing your job to improve the prospects of good news being sent. Management will have likely provided extra conservative guidance last quarter, and so should be able to meet/beat that guidance. They will carefully choose their words to describe the rest of the year. Expect positive news this quarter.
Product vs. process – Understanding the technological pros and cons of Cisco products is challenging for most investors. This article will not try to debate the merits of product details in the network marketplace. However, at the macro level, Cisco has a large market share in many market segments. That is concrete evidence that Cisco's products are more than good enough to continue to keep its share of the market. What seems to have changed recently is the scope of Cisco's and its competitors' product offerings. It seems that in the past, Cisco would be a non-competitive partner with companies like IBM (IBM), Oracle (ORCL), etc. But now the company can find itself in “coopetition” with these market players. That means Cisco may have to find another way to adjust its sales process. While that can prove challenging, addressing challenges in the sales force, messaging, pricing, etc. can be done relatively quickly as compared to addressing problems with the product. If Cisco's issues are indeed more related to process than product, the chances of stabilization in the earnings news are greatly increased.
Transition to new stock owners – The past disappointments drove away the growth investor who owned the stock with the hope of seeing large jumps in earnings. This has created selling pressure on the stock. Value investors are conservative in nature and will be waiting for one to two quarters of stabilization in earnings before they start to acquire the stock en masse. Recently, this has resulted in a poor supply/demand imbalance for the stock. However, this could change as value investors gain the confidence to start buying the stock. The recent initiation of the dividend could also be a trigger for value investors to create demand for the stock. New stock owner coming to the market and buying ahead of that demand could find it profitable.
Good Risk/Reward – Given the above information it seems possible that the stock could return to low $20s by year end. That is about 20% up from here. More importantly, 20% down from here does not seem nearly as likely. That is because lots of bad news is already priced into the stock; that type of fall in price would put the stock below the support level defined by the 2008 low. Further, this type of drop would likely create even more favorable fundamentals, and provide further encouragement for value investors to buy the stock. Hence, this appears to be a case where upside potential outweighs downside risk, and that is generally the best time to invest.
Given that the stock's fundamental levels provide some downside limits and the volatility in the stock is relatively low, it seems appropriate to initiate a position in the stock via deep in the money calls. Specifically, by buying the January 12 $10 calls. Last week with the stock trading around $17.30, these options were selling for about $7.40. There is almost no premium in them, and the leverage they offer seems attractive. To lower the cost of entry into a position in the stock even further the May $18 calls could have been sold against them for about $.45. That makes the total capital required to control the first lot of shares to be just under $7.00.
The May 18 calls expire after the Q1 earnings announcement scheduled for May 11. The earnings announcement will likely be the first catalyst to drive further decisions about holding this stock. Likely scenarios are:
Worse case. The above analysis is totally wrong and the stock continues its drop. The portfolio is then long its first lot of Cisco at essentially $17.00 with leverage. That is 2 % downside protection from the trade price at the time of entry into the option trade. Depending on the news from earnings, you can either cut the losses or find a way to enter into the second lot of the position.
Best case – the stock zooms after earnings past $18 and the position should be able to be closed for about $8.00 or about a 14% gain in two months! As mentioned above, even with good earnings, it seems unlikely the stock will react that fast, but it would be nice.
Expected Case – The stock stabilizes with a $17 handle, the above thesis remains intact, and a second lot can be added with some increased degree of confidence.
Disclaimer: This posting is for informational, educational and entertainment purposes only and should not be considered investment advice.