Cisco Systems (CSCO) is considered the leader in enterprise networking solutions and internet technology. On March 15, Cisco announced its intent to purchase NDS Group Limited, a leading provider in video software and secure content streaming to various media devices for $5 billion. One of NDS' larger clients is DirecTV. Analysts' reaction to the announcement was immediate, receiving both praise and rebuke. The primary criticism was that the acquisition would lead Cisco back down a path of distraction and away from focusing on its core competency.
In April 2011, Cisco announced it was shuttering its Flip video camera division, a business that it had acquired barely two years earlier. A similar area that received criticism as being outside of Cisco's core competency is Linksys, a business Cisco purchased that focuses of residential connectivity products. John Chambers, Cisco's Chairman and CEO was quoted in the company's corporate overview presentation (pdf) as saying that "Cisco's strategy is based on catching market transitions - the market transitions that affect our customers. With the proliferation of video and collaborative Web 2.0 technologies, the network continues to evolve from the plumbing of the Internet-providing connectivity - to the platform that will change the way we work, live, play and learn." The acquisition of NDS should further enhance and accelerate Cisco's current video platform Videoscape, part of Cisco's Service Provider Video Technology Group, while also expanding the company's reach into China and India where NDS already has an established customer base. The nagging question that remains is whether this expansion of Cisco's video platform is truly catching market transitions or just another distraction that continues to justify the company's recent weak stock performance.
In Cisco's 10-Q filed on February 21, the company cited an increasingly competitive landscape in the enterprise data center market, with competitors bringing their own new services and technologies to the market. Cisco's closest competitors, which include Juniper Networks (JNPR), Hewlett Packard (HPQ), and Alcatel-Lucent (ALU) appear to be working to develop new technologies at an increasingly regular pace.
Juniper recently launched QFabric, an enterprise data center architecture solution. Recent independent testing showed that QFabric could perform at record speeds managing network traffic at a rate of 15.3 terabits per second. Juniper is much smaller than Cisco at nearly 1/10th its revenue and market cap. In my opinion, many IT professionals consider Juniper the innovation leader and QFabric may become a game changer in the industry. A not-so-small competitor, Hewlett-Packard announced on March 26, that it was launching two new unified communications (UC) offerings: HP AppSystem for Microsoft® Lync and HP and Polycom® Rich Media Communications. These two new products are designed to help customers more effectively unify their virtual workspace, while still customizing mobile, video, web and instant message capabilities.
Alcatel-Lucent made a similar announcement on March 26, stating that the company was bringing new technology to market, which would make it easier for employees to use their own communication devices for work and business communications. This new software called OpenTouch Conversation "leverages the power of smart devices and reconciles all the modes of communication in one place in an intuitive, easy-to-use interface" according to Eric Penisson, vice president and general manager of Alcatel-Lucent Enterprise Communications business. Cisco is still the dominate player with nearly 70% market share and has the scale, scope and treasure to keep its competition at bay in the near term. In the longer-term, innovation drives revenue growth and Cisco needs to ensure it is capturing only true market transitions and not value destroying distractions.
There is no doubt that Cisco has stumbled over the last three years, but Cisco has righted the ship in the past. If the current restructuring is successful, this transformation may provide one of the best opportunities for investors to buy one of the pioneers of the internet at its cheapest value in nearly a decade. On February 8, Cisco announced results for the fiscal second quarter 2012 ended January 28, 2012. Cisco reported a 10.8% increase in net sales from the same quarter the previous year, $11.5 billion in Q2-2012, up from $10.8 billion in Q2-2011. Net income improved 43.5% from $1.5 billion in Q2-2011 to $2.2 billion in Q2-2012. Other operational and financial highlights for the quarter included increased cash flow of $3.1 billion, an increase both from the previous quarter and year-over-year, as well as improvements in Days Sales Outstanding (DSO) a measure of accounts receivable management. Again, focusing on video technology and cloud computing, Cisco announced that the Videoscape platform would now allow "video in the cloud" services.
Cisco's 52-week range is $13.30 to $20.49. The company has participated in the recent bull rally with its shares increasing from its low in August 2011 to near $20 today, which roughly matched the return of the S&P 500 (SPY) during the same time period. Cisco currently trades near 15 times 2011 earnings, which is on the low end of its price-to-earnings range over the last five years. For mature technology companies that have a history of positive earnings, I like to use the price-to-earnings multiple as a starting point for valuing the firm. I estimated that earnings for fiscal 2012 (year ending July 2012) will be approximately $1.80 per share, which equates to roughly an 11 times earnings multiple. Although CISCO continues to mature and it has stumbled over the last three years, I have faith in the management team and its ability to right the ship. In my opinion, Cisco's fair value is closer to a price-to-earnings ratio of 15 times forward earnings, which when applied to 2012 estimated earnings of $1.80 equates to a fair value per share of $27.
I generally like to use a discounted dividend model as a baseline for valuation, but for technology firms such as Cisco a discounted cash flow works well due to the small or zero dividend payments these firms typically pay. Most discounted cash flow keys off of revenue assumptions as the primary driver. Cisco issued a three-year turnaround plan, which estimated revenue growth of 7% going forward. Although management has an incentive to provide conservative estimates, they remain the best source for initial projections. I believe a 7% baseline revenue growth estimate for the next three years ramped up to 10% by year four and five to be a conservative approach. Discounting the resulting free cash flows by an estimated weighted average cost of capital of 12.6% results in a fair value per share of $25. Cisco's beta remains above the market beta at 1.40, which pulls down estimated fair value. I believe there is potential for a declining beta, which would likely add an extra $2 per share to the value of the stock.
Discounted cash flow remains the best approach for determining the value of the equity for a publicly traded firm like Cisco. The fact that a multiples approach to valuation results in similar pricing helps validate that Cisco's shares likely have a fair value price of $25 to $27.
Currently, Cisco trades at a discount to fair value of approximately 20%. As Cisco operates in the technology industry where a company's life expectancy is shorter than in more staple businesses, I require a 30% margin of safety before investing. For long-term investors, this would imply that an entry point into the stock would be between $17 and $19 a share or approximately $1 to $3 lower than Cisco's current price. Given the above market beta, any minor pull back in the market would allow investors to pick up this stalwart of technology at very reasonable valuations.