Cisco:33% Upside Likely In 2013

Jul.10.12 | About: Cisco Systems, (CSCO)

Cisco (NASDAQ:CSCO) recently announced that it has debuted its cloud-enabled routing and wide access network (WAN) platforms through the Cisco Cloud Connected Solution brand. This new platform will allow customers to extend their virtual private network into the cloud. The main concerns of its clients with the transition to cloud computing include speed performance issues and bandwidth levels. The company has addressed these issues with this new set of physical and virtual routers, software and services. These products are divided into three groups: Cloud Connectors, Cisco Cloud Services Routers and WAN optimization services.

These new capabilities will improve its cloud computing services and expand its reach to the increasing needs of its clients. In addition to that, channel partners and service providers may develop third-party cloud connectors to offer differentiated services. Finally, these developments give its clients lower and flexible scalable computing environment where they can spend lesser time managing and maintaining both its software and hardware environment.

This will boost the company's plan to become a leading software company over the next few years. For the last few years, the company has spent more than $8 billion acquiring software companies. The recent acquisitions were software companies related to network data analysis, software service provider manager of residential and mobile devices and content security solutions. These companies include Truviso, Clear Access and NDS Group.

Recently, Cisco has experienced some temporary setbacks from this new set of cloud computing service. In response to outcry of its customers, Cisco adjusted its approach to home routers cloud service. It will now change the settings on its routers, EA4500 and EA2700 so that these routers will no longer default to its Cloud Connect Service. The issue with the default connection is that customers have objected to its terms of service, which stepped into client's privacy.

Clients can move their routers to an earlier version of its software or firmware. This will immediately appease angry customers and its effects will not have impact to the company's sales.

Catalysts: Turnaround is about Data Centers

The stock is currently down by more than 7% for this year. Cisco is in the middle of its turnaround plan. It has moved to a more decentralized organization. It has also viewed its operating environment through big trends. Its data centers have evolved from a mere physical hardware to virtualized systems to cloud computing. It believes that building servers and networking in a single package will allow channel distributors to pay for its services. Thus, the concept of cloud computing total package will drive earnings higher in the future.

Cisco's operating margins have not recovered since 2008. Operating margins have fallen to 17% from 23% in 2008. Its competitors have put pressures on its margins. The likes of Hewlett-Packard (NYSE:HPQ), Juniper (NYSE:JNPR) and Huawei have snatched market share from Cisco. Given its strong performance on its latest quarterly results, it seems that the company has figured out how to ward off its competitors.

Possible re-rating from the market

Several analysts have expressed their bullishness on the stock. The recent upgrade was from BMO Capital. It increased Cisco's rating from market perform to outperform. The investment firm believes that its data center business offers the most growth potential. It expects that the data center will drive the company's earnings growth this year.

The firm also down played fears of increased competition from Hewlett-Packard and Juniper Network. It further added that the new switching products have kept competitors at bay as core routers have seen steady gains and services remained a bright spot.

Analysts expect Cisco to grow its earnings by 13% to $1.84 this year. This is higher than the growth estimates of its competitors. Hewlett-Packard is forecast to earn $4.07 per share this year, implying a growth rate of 8%. Separately, Juniper Network is expected to earn $0.82 per share. This is a decline of 37% compared with the previous year.

Its strong cash generation ability with free cash flow of $10 billion will enable it to repurchase shares in the open market as well as increase dividends. The stock is currently trading at 12 times earnings, lower than the average price earnings band of 13 to 24 times. A repurchase program will definitely increase shareholder's wealth.

Dividend payout ratio is at 19%, lower than the industry's average dividend payout of 25%. Based on current prices, dividend yield is at 1.91%. I believe that its payout ratio should match its industry peers, given that capital spending growth is low at 8% over the last 5 years.

However, a lot of investors believe that the company should reinvest its cash flow back to business. The market is concerned the company's acquisition spree has not been successful. In fact, CEO John Chambers admitted that the company needed to re-focus its efforts on profitable ventures such as switching, data center products, collaboration, video and services.

Other technology peers are trading higher. Juniper Network trades at 26 times earnings. Motorola Solutions (NYSE:MSI) is valued at 29 times earnings and Polycom (NASDAQ:PLCM) is valued at 15 times earnings. The undervaluation of Cisco's shares is due to expectations. Investors were used to Cisco's historical growth rates north of 40%. Its diversification strategy has also failed, giving investors the right to question the recent acquisitions. Cisco investors demand that management should prove that future acquisition will be value-accretive to them. However, these acquisitions have just started to pay off.

There is opportunity at these levels. Believers could be right. Its turnaround plan is starting to gain traction. Assuming earnings per share of $1.91 next year and a stable earnings multiple, I think the stock could reach $22 per share. This suggests an upside of 33% based on today's prices. Of course, a strong quarterly performance will not have an immediate impact on investors. It would probably take a couple of years before these types of gains can be realized.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.