One of my top picks for 2012 is Cisco (CSCO). The company trades significantly below intrinsic value with the bar set low from a growth perspective. In this article, I will run you through my DCF analysis on the firm and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Alcatel-Lucent (ALU) and Juniper Networks (JNPR).
As a provider of investor relations services, I also understand the effect that news flow can have on smaller firms. Once inaccurate press about Ditech Networks (DITC) and Network Equipment Technologies (NWK) rightfully dissipates and is replaced by fair reviews, I expect significant appreciation. These two firms have attractive fundamentals, compelling growth stories, and are led by strong management teams.
But, we'll focus on the larger company, Cisco, for now. First, let's start with an assumption about revenues. Cisco finished FY2011 with $42.2B in revenue, which represented a 7.9% gain off of the preceding year. Analysts model a growth rate of 8.7% over the next five years, and I view this as pessimistic given that it is around 200 bps below what is expected for the S&P 500. I nevertheless accept the projection for the sake of being safe.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat 37% of revenues versus 27% for SG&A, 13.5% for R&D, and 2.7% for capex. Taxes are also estimated at around 20% of adjusted EBIT.
We then need to subtract out net increases in working capital. I model accounts receivable as 18% of revenue; inventories as 9% of COGS; accounts payable as 2.5% of OPEX; and accrued expenses as 27% of SG&A.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $28.28, implying 40% upside. This discount rate is overly high considering that the unlevered beta of 0.92 implies that cost of equity is around 8.5% while none of Cisco's bonds have a yield above 5.5%. This cost of equity is found by multiplying the unlevered beta by the equity market risk premium and adding in the risk-free rate of secure debt (~3.06%). In short, Cisco is a significant value play.
All of this falls under the context of excellent momentum:
"We continue to make very solid progress in Q2, both in terms of our results and execution in the second quarter of our three-year plan. Our performance in Q2 exceeded the guidance we provided last quarter for both revenues and earnings per share. We had record quarterly revenue of $11.5 billion, an 11% increase year-over-year compared to our guidance of 7% to 8%.
Non-GAAP earnings per share was a record $0.47, again, above our guidance, a year-over-year increase of 27%. GAAP earnings per share was also a record at $0.40, a year-over-year increase of 48%. Non-GAAP total gross margins were 62.4%, a little higher than our original expectations, while non-GAAP product gross margins were 60.9%. Our entire company continues to focus on gross margin improvements."
From a multiples perspective, Cisco is equally as attractive. It trades at 15.8x past earnings but only 10.3x forward earnings. Juniper trades at a respective 27.3x and 17.2x past and forward earnings versus 7.4x and 7.2x for Lucent. Assuming a multiple of 16x and a conservative 2013 EPS of $1.89, the rough intrinsic value of the stock is $30.24.
Juniper, on the other hand, has had significant downward revisions. Consensus estimates for its EPS forecast are that it will decline by 20.2% to $0.95 in 2012 and then grow by 30.5% and 33.1% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $1.19, the stock has slight downside. On the bright side, the company has secured impressive design wins and strong secular trends in cloud computing will keep multiples elevated.
Lucent is the riskiest of the three, as it is undergoing a turnaround. Supply chains are still a concern and a lot of the firm's fate hinges on whether it can successfully cut back on inventories. Capex is expected to increase modestly in 2012 and the fundamentals should benefit from greater 4G spending. One-fifth of business comes from Verizon (VZ) and AT&T (T).
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.