12 Years After The Bubble, Cisco Is Ripe For The Taking - An Update

| About: Cisco Systems, (CSCO)
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In August, we profiled Cisco Systems (NASDAQ:CSCO), and at the time we believed the stock was materially undervalued. Since then the stock has traded nicely higher, but has come down as fears of a weak global economy and its impact on Cisco's clients' spending programs have hurt the perception of the stock. As the stock dropped below $17, we've been aggressively selling long-term put options because we think the stock offers a large margin of safety at current prices. While I don't believe Cisco will go back to its high growth rate of the past, I do believe that the company's durable competitive advantages will enable it to grow earnings per share by 8%-10% per annum. At the current valuation, long-term investors are positioned to do quite well.

On Nov. 13, the company reported very strong first-quarter earnings that further illuminate the good job Cisco's management has done to improve its operations. Revenue was up 6% year over year to $11.9 billion, and net income of $2.1 billion GAAP was up 18% year over year. Non-GAAP income was $2.6 billion, or $0.48 per share, and was up 11% since last year at the same time. Impressively, non-GAAP operating expenses increased only 1% to $4.1 billion, highlighting the increased operating leverage that the company has generated through expense management initiatives. Cash flows from operations were $2.5 billion, up from $2.3 billion year over year. During the quarter the company paid out $0.14 per common share as a dividend or $744 million, and the company also repurchased 15 million shares at an average price of $16.44, totaling $253 million. Free cash flow was a very strong $2.2 billion in the quarter. It is important to put this strong performance in the context of a really terrible global economic environment, where the U.S. has been anemic, Europe is a disaster, and China is slowing substantially.

In the Americas revenue grew by 7%, Asia-Pacific was up 10%, and EMEA was about flat year over year. Total product revenue was up 4% to $9.3 billion. Total service revenue was $2.6 billion, up around 12% from the same time last year. Management highlighted that the services business has achieved a compound annual growth rate of approximately 12% over the last decade. The advance services business grew over 20%, as Cisco continues to make headway on large architecture build-outs for corporate clients. Non-GAAP gross margins were 62.7% in the quarter, up 0.8% sequentially and 0.3% year over year. Service gross margins are higher, so the mix of business is obviously extremely important in the overall numbers. Non-GAAP operating margin was 27.9% in the first quarter, up 13%, significantly outpacing top-line growth.

Cisco achieved this strong growth despite a lackluster environment for its core switching and routing businesses. Switching revenues declined by 2%, but the company did see solid growth in the Nexus data center switching with the Nexus 2000, 5000, and 7000 lines all growing in the high teens or better. The business faced challenges from a decline in U.S. public sector spending and unsurprisingly European issues. Cisco is a large provider to the public sector so it will likely take some time to see prolonged progress in that market, as there is quite a bit of work to be done in adjusting budgets across the developed markets. Importantly, margins actually improved slightly highlighting the company's ability to innovate and add value. Total revenue for the routing business declined by 2%, primarily due to weakness in EMEA. The service provider sector posed some challenges, as did declines in optical networking due to product migration to faster speeds. Edge routing was up by double-digits, and management highlighted the performance of ASR 9000, which was up 80% year over year. SP mobility grew by 86% and should continue to perform well due to the capacity requirement associated with the usage of smartphones and tablets. Wireless was up 38% and experienced its fourth consecutive quarter of record revenue.

Security grew 6% in the quarter, driven by high-end and mid-range router firewall platforms, growth in web security and the adoption of the company's identity services engine. Cisco's outperformance has continued in the data center where the unit grew by a whopping 61%. The company is now No. 4 in the overall server market, where it had very little presence several years ago. The collaboration business declined by 8% and the Telepresence business was down in the mid-teens. The company is going to pull together its TelePresence, unified communication and WebEx offerings into an integrated open architecture that enables communication with any device to any other. I worry about this business as I believe there is a lot of competition, and I'm not sure that Cisco has a real competitive advantage like it does in its core businesses. Total service provider video revenue was up 30% with NDS contributing about 20%. The acquisition of NDS was expensive, but it should help margins and it allows the company to provide a more comprehensive architecture to service providers.

For the second quarter, Cisco projects revenue growth to be in the range of 3.5%-5.5% on a year-over-year basis. Non-GAAP gross margins are expected to be between 61% and 62%, and non-GAAP operating margins are expected to be between 26.5% and 27.5%. The company believes it can attain non-GAAP EPS in the range of $0.47-$0.48, and GAAP earnings will be $0.08-$0.11 per share lower than non-GAAP.

Cisco is becoming much more of a comprehensive IT solutions providers, as opposed to a seller of boxes. This is evident in the fact that the services business has been growing at double digits with businesses utilizing Cisco's expertise to build their technological infrastructures. The services business continues to become a large portion of the company's operations, which will have a long-term positive impact on margins. The company spent approximately $4.9 billion on the acquisition of NDS during the quarter, which combined with the dividend and buybacks, decreased the net cash and investments per share to $5.38. We used $45 billion in cash and investments and subtracted the $16.272 billion in long-term debt to arrive at a net cash total of $28.728 billion, and divided the total by 5.334 billion shares to arrive at that number. Only $7.5 billion of that cash was available in the United States.

Even after the stock rallied today to close to $18, the company only possesses a market capitalization of $95 billion. If you back out the cash, the enterprise value of the company is about $66.272 billion. Now certainly there are some tax implications in utilizing that large cash hoard, but the stock is simply too cheap. The business has generated about $10 billion in free cash flow over the last 12 months, so the company has a free cash flow yield net of cash of around 15%. Once again I'll reiterate my call for Cisco to materially decrease the share count. John Chambers needs to be exceptionally disciplined in terms of acquisitions as that has been extremely destructive overall in the last decade, as far as building shareholder value. With a current dividend yield of around 3%, the company would be wise to issue about $5 billion in debt to buy back shares at current prices.

Yesterday we sold the $18 puts for January 2014 for $3.15 per option. This investment was particularly attractive because if the option expires worthless we will make greater than 20% on the maximum risk, and our breakeven price is $14.85, leaving us with ample upside potential. Those same options are going for $2.51 today, so we still find the trade fairly attractive. Cisco is also an excellent covered call candidate with the $22 calls for January 2014 going for around $0.65 per contract. While these strategies do reduce your upside potential if the stock were to go to the mid-$20s or low $30s, we believe that the higher probability of success and still attractive returns makes it a worthwhile venture.

Disclosure: I am long CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.