5 Reasons Cisco Is My Top Tech Pick For 2013

| About: Cisco Systems, (CSCO)
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By David Sterman

In the past four to five years, investors have been more squarely focused on the consumer end of the tech landscape, bidding upshares of Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG), Amazon.com (Nasdaq:AMZN) and others. But on the business end of high-tech, the big winners haven't been such industry leaders. Instead, most gains have come from small, but growing software and data-storage providers. But this theme may be upended in 2013, as one of the most dominant companies in the enterprise space regains its mojo.

I'm talking about Cisco Systems (Nasdaq: CSCO), which has had little to show investors during the past five years.

Blocking and tackling
Although the stock chart may give the impression of a company slowly losing relevance, nothing could be further from the truth. Cisco's operational performance has been quite solid in recent years, especially when compared with stumbling giants such as Hewlett-Packard (NYSE: HPQ), Dell (Nasdaq: DELL), Computer Sciences (NYSE: CSC), and especially when compared to more direct networking competitors such as Juniper Networks (Nasdaq: JNPR). Consider that Cisco has generated a whopping $46 billion in cumulative free cash flow during the past five years.

But Cisco can be taken to task for being a little too content to simply squeeze out cash from a largely mature business. Indeed, shares fell out of bed in the summer of 2011 simply because investors could no longer see a long-term path to growth. A number of the company's recent acquisitions had failed to deliver promised growth, and Cisco's end markets -- most notably in government and telecom -- weren't looking all that perky.

Yet in recent quarters, management has begun to talk about a sharper game plan that will likely help solidify Cisco's role in so many markets. The plan involves a number of small steps that are unlikely to lead to explosive sales growth, but should fuel a steady expansion in profit margins and a more linear trend of profit growth.

Here are the five small steps that should add up to solid gains for Cisco's shareholders in 2013.

1. Going where the action is

Cisco is typically thought of as a networking giant, known for producing the software, switches and routers that run corporate and telecom data networks. But thanks to heavy spending on research and development and certain acquisitions, Cisco is now very well positioned for industry leadership in mobile computing, cloud computing, video-delivery services, network security, web conferencing and network storage. No other vendor in the world can offer clients this comprehensive suite of offerings, a key consideration when information technology managers worry about the interoperability of various technology components in their corporate ecosystem. "The market is moving to buying solutions rather than buying standalone boxes, playing to Cisco's core strength," noted analysts at Merrill Lynch.

2. A rising focus on software

The company has set an ambitious target of doubling the revenue it derives from software in the next five years. This, in turn, should lead to a rising take rate for its expanding suite of service offerings. This is a page right out of the IBM (NYSE: IBM) playbook. Cisco's CEO John Chambers is surely aware of IBM's 100% stock price gain during the past five years, as investors have come to embrace Big Blue's linear growth.

You can't blame Chambers for a bit of IBM envy. IBM carries similar margins today, but its enterprise value-to-sales (EV/Sales) ratio is 40% higher than Cisco's. That's why emulating IBM is a wise move.

Furthering the IBM analogy, Chambers understands that IBM's focus on long-term service contracts leads to much smoother revenue and profit streams. The company aims to boost service revenue from a current 21% of the sales mix to more than 25% within three years.

3. Squeezing out costs and other margin boosters

Cisco has at times been accused of a bit of "porkiness." The company has grudgingly embarked on a few major layoffs in its history, but nobody would call Cisco a lean enterprise. In recent meetings with analysts, however, Chambers has discussed plans to trim down and/or reap synergies where possible in coming quarters. This helps partially explain why he expects operating profits to grow 3-4 percentage points faster than sales growth in the next few years. (The rising mix of software is another factor). Chambers also understands that profit gains need to be linear if they are to be applauded by Wall Street (another lesson taught by Big Blue). The fact that Cisco's operating profits fell by $2 billion in fiscal (July) 2009, rose by a similar amount in 2010, fell again in 2011 and rose anew in 2012 is a clear impediment for investors that crave linearity.

4. Tapping emerging markets

Chambers now spends a considerable amount of time on the road in Latin America and Asia. He's directed his sales force to treat these markets as a top priority. The timing is good as many of these markets are now increasingly home to large domestically-grown companies, and not simply the foreign divisions of firms like Wal-Mart (NYSE: WMT) and Coca-Cola (NYSE: KO). Emerging markets currently represent about $9 billion in annual sales (20% of the entire sales base), though Cisco aims to boost that figure by 10% annually in the next three to five years. To get there, Cisco is developing lower-cost solutions for these price-sensitive markets.

5. Free Cash Flow = Buybacks

Any discussion of Cisco has to touch on the prodigious free cash flow and the long run of share buybacks they have fueled. The share count has already fallen from 6.8 billion in fiscal 2004 to 5.4 billion at the end of 2011, and considering management's plan to spend 60% of future cash flow on buybacks and dividends, this trend should continue.

Risks to Consider: To augment growth, Cisco has signaled plans to pursue a fairly hefty acquisition in coming quarters, and such deals can sometimes spook investors.

Even with all of these growth-inducing steps, Cisco is only likely to boost sales in the mid-to-upper single digits each year, while per-share profit growth is unlikely to exceed 10%. But by delivering these kinds of gains in a steady linear fashion, investors are likely to reward this stock with an ever-higher multiple. When you include Cisco's massive $33 billion net cash pile, this becomes a low-multiple stock with a fairly low level of embedded expectations. This means 2013 should represent a fresh perspective for this one-time highflyer as growth kicks in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: StreetAuthority LLC owns shares of CSCO in one or more of its “real money” portfolios.

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