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Cisco's (CSCO) shares have been highly volatile this year. Starting the year with a bang, Cisco’s stock posted an almost 15% gain before the company announced its Q3 FY 2012 results and gave conservative guidance for the next quarter. This saw the stock shed more than 20% of its market capitalization in the next three months.

Since then, however, the stock has performed well gaining almost 20% from the year’s lows as the company managed to alleviate market fears with a strong Q4. The macroeconomic concerns surrounding the euro debt crisis continued to weigh on network spending in Europe, but it was largely offset by healthy growth posted in other regions, including the U.S.

The stock may have now recouped most of its losses, trading at about the same levels as at the start of the year, but we see far more value in the stock coming from Cisco’s renewed focus on its networking division. The networking giant has of late tried to scale back its ambitions to diversify into 30 new businesses and instead focus on those areas that add value to its core routing and switching businesses. As a result, it has restructured its operations and continues to cut jobs in areas that are not its core focus, making the organization leaner and more efficient.

We believe the company is going in the right direction since the move not only allows it to innovate faster, but also streamlines its businesses around its core networking products that contribute more than 40% to our estimated $26.50 fair value for Cisco, with cash contributing another 23%. At the same time, it helps Cisco benefit more from the long-term growth trends of data demand and cloud computing, which continue to remain sharp. Our price estimate is about 40% ahead of the current market price.

Margins Stabilizing

The cost-cutting and restructuring seems to be paying off for the company. The renewed focus is helping it post revenue market share gains in both routing and switching businesses this year. At the same time, its operating margins, which have fluctuated widely in recent quarters due to the restructuring, are stabilizing at >20% levels. This increases confidence in the management’s guidance of achieving long-term operating margins in the mid-20s and increasing profits at a faster pace than revenues. Cisco has already realized $1 billion of the total $1.1 billion of severance charges related to the workforce reduction program it had announced in July 2011, and the operating margins should remain fairly stable from here on out. With savings achieved on the operating side, Cisco will be able to make aggressive price cuts to compete better with low-cost rivals and gain even more market share.

However, the macroeconomic uncertainty surrounding the European debt crisis continues to be a significant overhang on enterprises' network spending, especially in Europe. Considering that Europe accounts for almost 20% of its revenues currently, this could have an impact on Cisco’s near-term growth. Still, longer term, Cisco’s outlook looks strong not only due to an industry-wide change of fortunes once the uncertainty eases but also the company’s bigger market share within the industry.

Fundamentals Drive Cisco’s Future Earnings

We also believe that Cisco’s fundamentals remain solid due to the strong ongoing transition from wired to wireless networks, the burgeoning usage of data on both mobile and wired networks, as well as a solid demand for cloud-computing routing solutions on the enterprise side. The company recently debuted its virtual cloud-routing and WAN optimization platform under the Cisco Cloud Connected Solution brand to enable businesses that are increasingly looking to move their applications to the cloud at a low cost (see "Cisco’s Worth $23 On Cloud Foray And Enterprise Strength"). It also recently acquired NDS Corp., a move that will help it drive device-agnostic video consumption and increase the demand for its routers and switches among service providers looking to monetize the booming data demand (see "Cisco’s NDS Acquisition Taps Video Demand To Boost Network Equipment Business").

Cisco also has tons of cash -- almost one-third of its current market capitalization. It has been generating huge positive cash flows in the order of billions from operations every quarter despite a challenging economic environment. A positive cash flow ensures that the company will able to return cash to shareholders through regular dividends and share repurchases as well as make strategic acquisitions.

While the macroeconomic environment may continue to be challenging (the company remains cautious in its guidance for the future) in the near term, we believe that Cisco has executed well on its turnaround plans so far and is well-positioned with its new-found focus to gain even higher ground going forward. The company’s dominant market position as well as aggressive price cuts have helped it gain market share from rivals in an uncertain economic environment so far, and could help it even further when the concerns subside.

Disclosure: No positions.

Source: Cisco Is Worth $26 As Margins Stabilize And Networking Focus Is Back