Why Cisco Has 60% Upside As Lucent Struggles

| About: Cisco Systems, (CSCO)

Improving end market demand, leading brand, and conservative spending will help to make Cisco (NASDAQ:CSCO) a long-term winner in the market. As I have started earlier here, the communications equipment firm is substantially undervalued. Since I first published my bullish report on the company, the stock has risen by 13.6% and continues to be rated a "buy" on the Street. To contrast this Cisco with a struggling competitor, I consider Alcatel Lucent (ALU) and Juniper (NYSE:JNPR).

From a multiples perspective, Lucent is at the absolute low-end of peers. It trades at only a respective 6.3x and 4.9x past and forward earnings due to concerns over earnings and inventory controls. Juniper, on the other hand, trades at the high-end with a PE ratio of 21.7. Between these two is the market leader, Cisco. While commenters disagreed with my stance that the firm is "shareholder friendly" (see here), I continue to maintain this view. Being miserly is a virtue if you can prove strong fundamentals. Over the last 6 months, Cisco has soared by more than 25% while competitors Juniper and Lucent lost 35.1% and 72% of their respective value. Accordingly, management, in my view, should be praised.

Diametrically opposite of Cisco in this respect is Lucent. Despite vocal concerns from shareholders about burning cash, Lucent's CEO, Ben Verwaayen, insists it is making progress in the turnaround story:

"So first of all, we are making profitable progress in our journey, in our 3-year journey, and beyond. It's important to note that today I can tell you that all our segments are profitable. Our margins are up year-over-year. And if you take the first 9 months of 2011 and you compare it with the first 9 months of 2010, you will see that we have made an improvement of over EUR 400 million in profitability. So our profitability is doing pretty well.

And if you look to what we're doing from a margin management perspective, in making choices, in making choices where to invest, what type of projects to go after, how to deal with it, we're also making good progress. If you look to our costs, well, our costs are, I would say, starting to have a good impact in the organization".

Analysts rate the stock a "hold" and if Xilinx (NASDAQ:XLNX), Texas Instruments (NYSE:TXN) and Altera (NASDAQ:ALTR) are any indication, supply chain is still an issue. The bar has been set high in 2011 and a lot hinges on whether management can successfully reduce inventories. At the same time, capital expenditures are intended to increase slightly in 2012, which suggests confidence in end market demand. In terms of customer support, it is a mixed bag. Approximately one fifth of the business comes from Verizon (NYSE:VZ) and AT&T (NYSE:T). While the 4G outage in the former will challenge contract terms, a failed acquisition for T-Mobile in the latter will incentivize 4G spending.

Consensus estimates for Lucent's EPS are that it will turn positive in 2011 at $0.31, hold flat the following year, and then decline by 19.4% after that. Assuming that the multiple expands to 7x and a conservative 2012 EPS of $0.29, the stock has 28.9% upside. If the multiple contracts slightly to 6.1x and 2012 EPS turns out to be 25.8% below the consensus, the stock would fall by 11.4%.

Cisco is a considerably safer investment even considering greater multiples contraction and a miss in expectations. The firm will remain conservative on acquisitions, which will prevent EPS dilution. IC addition, the partnership with NetApp (NASDAQ:NTAP) and EMC (EMC) will help to further reduce risks by creating unified data center product. With the business mix shifting to services over products, margins are also likely to expand and will help to boost returns to scale increases. Lastly, third quarter routing and Ethernet switching sales indicated that the firm gained back some its previously lost share.

Consensus estimates for the firm's EPS are that it will grow by 9.3% to $1.77 in 2012 and then by 9% and 10.9% more in the following two years. Assuming a multiple of 16x and 2012 EPS of $1.89, the rough intrinsic value of the stock is $30.24, implying 59.8% upside. If the multiple were to plummet to 12x and 2012 EPS turns out to be an egregious 25.9% below the consensus, the stock would fall by 9.3%. Accordingly, reward far exceeds any reasonable risk assumptions.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours.