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Shares of Cisco Systems (NASDAQ:CSCO) have dropped 16.80% over the past 3 months, primarily owing to management's downbeat guidance. Since the sharp plunge in May, the stock performance remains flat as the market appears to be waiting for clearer visibility into the firm's growth potential.

I believe investors' concern is likely overblown and the depressed valuation has created an excellent entry opportunity to this quality dividend investment. My view is based on the following five reasons:

  1. CSCO is substantially undervalued. Consensus estimates predict revenues, EBITDA, and EPS to rise by a solid 2-year CAGR of 5.8%, 14.6%, and 18.3%, respectively, over FY2012 and FY2013. At $16.94 per share, CSCO trades at 0.9x PEG, suggesting the price is at a slight discount to the growth prospects (see below). Compared with other major players in the network equipment sector (see below), CSCO's growth potential is fairly comparable to the peer averages, but the firm outperforms the peer group averages in almost all of the profitability and liquidity measures. In addition to the superior financials, the firm also enjoys a solid market position and competitive technology advantages, thus a valuation premium should be reasonably warranted. However, the current stock price of $16.94 represents a substantial 40% valuation discount on both the peer average P/E and EV/EBITDA multiples, which is hard to justify.

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  1. CSCO has an extremely healthy balance sheet as reflected by its highest current and quick ratios among the group. Even with a 24.2% debt to capitalization ratio, the robust EBIT margin helps the firm maintain an excellent interest coverage ratio at 17.3x. Additionally, CSCO's $32B net cash position indicates 35% of the market capitalization is in cash - another reason to believe the stock is significantly undervalued.

  2. (See below) The robust FCF generation allows the company to continue buyback shares and initiate its first dividend in 2011. At the current state of growth, it is easily anticipated that the dividend paid and stock repurchase will likely be sustained in the future, hence imposing a solid support to the stock price.

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  1. Analysts are generally quite bullish on CSCO as well. Of the 46 ratings, there are 11 strong buys, 15 buys, 17 holds, and only three underperforms. The mean target price of $21.31 represents a 26% upside. Barclays Capital recently upgraded its rating to overweight from equal weight and reiterated a target price at $21.

  2. (See below) It appears that there has been a long-term technical support between $14 and $16, and the current stock price is very close to that range.

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Bottom line, in light of the cheap valuations, healthy financials, and sustainable shareholder-friendly policies, CSCO deserves a position in your dividend portfolio. I recommend acquiring the stock at the current price or selling an out-of-money put option if you think a lower valuation is more attractive.

Comparable analysis table and FCF chart are created by author, stock price chart is sourced from Capital IQ, and all financial data is sourced from Morningstar, Yahoo Finance, FINVIZ.com and Capital IQ.

Source: Why Cisco Should Be Part Of Your Dividend Portfolio