3 Reasons Why Cisco is Oversold

| About: Cisco Systems, (CSCO)

Cisco’s (NASDAQ:CSCO) stock has plummeted after several of the last earnings announcements. From early February 2011, the price has dropped from around $22 to just over $15, a fall of over 30%. Following each of its post-earnings sell offs, the stock has made attempts to recover its pre-earnings levels sending a signal that some are optimistic that Cisco will recover in the near to medium-term. On that note, we present few reasons as to why Cisco may still be an attractive stock. The company competes with companies like Juniper (NYSE:JNPR), HP (NYSE:HPQ) and Alcatel-Lucent (NYSE:ALU) in the networking equipment business.

Our price estimate for Cisco stands at $22.69, implying a significant premium to the market price.

1) Consumer Business is Weak but a Small Contributor

One of the concerns that Cisco has expressed is that the consumer sector is seeing some weakness. Last year Cisco mentioned that it saw significant declines in its set-top box business, and this year the company closed down its flip camera business. This has led investors to question Cisco’s focus – but a more objective analysis reveals that these are just small businesses for Cisco.

We estimate that Linksys & Digital TV Boxes business constitutes a mere 5% to Cisco’s value. Even if Cisco were to shut these businesses, the impact would not be very material.

2) Plenty of Cash to Support the Business

We estimate that net cash contributes close to 21% to our price estimate for Cisco. This implies that Cisco has close to $27 billion of cash (net of debt) at its disposal. Given Cisco’s current market capitalization of close to $90 billion, does it mean that the investors think that Cisco’s value (excluding net cash) is just a $60+ billion? Does it make sense given the company’s revenues of over $40 billion annually? And also the fact that these revenues have doubled in last 6 years!

If we look at some technology companies and compare the ratio of their market capitalization (excluding net cash) to their annual revenues, we find that investors may be punishing Cisco’s stock a bit too much. This ratio stands at about 3.8x for Apple (NASDAQ:AAPL) and almost 4.0x for Juniper compared to just 1.5x for Cisco.

What we can also see here is that Cisco could use plenty of cash lying on its table to make investments in R&D or acquisitions to grow inorganically if it needs to. The company isn’t in ruins and perhaps its a temporary loss of focus which Cisco has itself acknowledged.

(Chart created by using Trefis' app)

3) Switching and Router Market Fundamentals Remain Strong

One of the concerns that Cisco mentioned during its last earnings calls was the weakness observed in the public sector. This sector represents about 20% of Cisco’s business and therefore weakness in this sector is of great concern and something that Cisco will not take lightly.

Yet, long-term expectations don’t materially change as underlying fundamentals remain strong. The data usage has increased tremendously and is expected to continue to grow. Even if public sector remains weak, we expect growth from private sector to compensate to some extent.

Margin and Share Weakness Priced In, The Ugly Case is Not That Ugly

Our price estimate already incorporates expected declines in market share and margins due to increasing competition. Despite these expectations, the price still stands at a healthy premium to the market price which leads us to believe that the drop is impulsive reaction of the market. As per our estimates, even a very pessimistic scenario for Cisco is not as bad as what market thinks about the stock.

You can access the “ugly case” scenario for Cisco here. You may note in this scenario that despite a significant decline in router and switching market growths as well as Cisco’s share within these markets, the estimated price still remains high when compared to market price.

Disclosure: No positions