A Cautious Strategy For Investing In Cisco Systems

| About: Cisco Systems, (CSCO)

Cisco Systems, Inc. (NASDAQ:CSCO) is one of the big technology companies that has been extensively written about in the investment community, including many articles in Seeking Alpha and the recent article in Barron's magazine. There is no doubt that the company has been very successful in its business, supplying gears for the internet and the telecommunication industry. As a result, most of the articles about the company are favorable, recommending it as a good investment. For example, the recent Barron's article argues that the company's stocks are 20% undervalued. Another example of Wall Street's bullish view on CSCO is that out of the 40 analysts covering CSCO, only three of them rate it "underperform."

While the arguments for the bullishness are well documented, there are reasons for caution in investing in CSCO in the near future, in the next 12 to 24 months, say. I should be clear upfront that my cautious view on the near-term outlook of CSCO does not mean I am bearish on CSCO. Instead, what I mean is that CSCO does not seem to have much growth potential in the near future, and thus, its stock price is likely to be range-bound. I will discuss my reasoning in this article and offer a strategy for investing in CSCO and for maximizing the investment return under this circumstance.

Significant Revenue Slowdown

For the latest quarter, CSCO reported significant slowdown in its business, as reflected in its quarterly revenue growth, and warned further revenue decreases for the coming quarters. Needless to say, this is a big deal since revenue growth is the very starting point of any growing business. To see how bad it is, the figure below plots CSCO's Y/Y quarterly revenue growth rates for the past two years, quoted from its 10-Q filings, together with the projected results for the next two quarters. Clearly, the norm for CSCO's quarterly revenue growth was about 5% until last quarter when it dropped to about 1.8%, and the decrease is expected to become much worse for the next two quarters, well into the negative territory. Without top-line growth, other metrics such as earnings and profit margin will also be under pressure, and it will be difficult to expect significant stock price appreciation under these conditions.

No Near-Term Catalysts for Growth

A few quarters of slow or negative growth would probably still be acceptable if there were catalysts on the horizon to reverse the revenue trends. For CSCO, its business is in the lucrative sector of supplying gears for the internet and telecommunication industry, but its main markets, the U.S. and Europe, are relatively mature with the current generation of gears. Large scale updates of the gears are not expected in the near future, and hence the short-term growth potential would be very limited.

One potential technology to disrupt the status quo in the long run is Software Defined Networks, or SDN. This is actually a double edged sword for CSCO. Putting it simply, the technology would commoditize network switches and routers, which has the potential to degrade CSCO's profit margins. Of course, CSCO will not just sit there and watch its products being replaced by cheaper ones from other companies. It will come up with its own versions of SDN, such as its Application Centric Infrastructure, which is claimed to be even cheaper than the commodity hardware for customers in the long run. Even if this new product can fend off others to keep CSCO's market share, CSCO will have to live with much smaller profit margins. In any case, whatever happens to SDN, it is not expected to have a significant impact on the network industry until 2017.

Another technology that has been generating a lot of buzz is the Internet of Everything or IoE for short. While I agree that the world is moving toward a connected one, I am not sure if any company can and has a concrete business plan to surely benefit from such a big trend. CSCO is taking steps to enhance its chances, such as beefing up its consulting service business, and it may well be a big part of the IoE development, but the kind of big picture talk from CSCO can be equally applied to any other company in the internet industry. It is a long term mega trend, but not something that can stimulate CSCO's growth in the near future.

Strong Competitive Pressure in Emerging Markets

Since there are no near-term catalysts in the U.S. and Europe for CSCO to grow, its only hope for growth lies in emerging markets such as China and Indian. Unfortunately, the high margin business model that has made CSCO a great successful story in the U.S. and Europe does not seem to be working in the emerging markets, where customers are very price sensitive. This has given companies such as Huawei of China an opportunity to sell their low cost gears, and hence, slowing down CSCO's expansion into these markets. Noticeably, in the same quarter when CSCO reported low revenue growth and warned further slowdown for the next few quarters, Huawei reported record revenue and earnings, benefiting mostly in the very same business segment as CSCO, indicating that Huawei is taking a large part of the emerging market business. CSCO certainly has the technical strength and financial resource to compete in the emerging markets, but the results so far suggests that a change of business model is in order.

Politics Induced Backlash

It is hard to deny the effects of the U.S. banning Huawei from selling network gears in the U.S., on security concerns, though it is also hard to quantify such an effect. Huawei's business results for the latest quarter show that the emerging markets have been buying a lot of network and communication gears, but they have not been buying from CSCO. In addition to the issue of pricing, there may be an element of backlash in the emerging markets on the decision by the U.S. government.

Yet another potential issue is the effect of Edward Snowden revealing the NSA's alleged spying activities on other countries. Though there is no evidence of CSCO or any other companies being involved in these alleged activities, the suspicion itself may have the potential to slow down the business of communication gears, as actively discussed in the business community. These kinds of politics-induced effects will eventually fade away, but they can slow down business in the near future if the news flow gets too negative.

Stock Price Valuation

One of the often used bullish arguments for CSCO is its stock price valuation. At the closing price of $22.2 on Jan. 24, 2014, its price-to-earnings ratio is about 11, depending whether 2014 earnings or 2015 earnings is referenced. This is indeed lower than the P/E of the general market. It is not high compared with other large technology companies either, as illustrated in the figure below, which plots the P/E comparison of a group of large technology companies, including Intel Corp. (NASDAQ:INTC), Microsoft Corp. (NASDAQ:MSFT), Qualcomm, Inc. (NASDAQ:QCOM), Juniper Networks, Inc. (NYSE:JNPR), International Business Machines Corp. (NYSE:IBM), Hewlett-Packard Co. (NYSE:HPQ), and Oracle Corp. (NYSE:ORCL). The P/E values are computed using the closing prices of the stocks on Jan. 24, 2014, and the projected respective earnings for the years of 2014 and 2015.

It should be pointed out that the P/E ratio is how, at least partially, the stock market awards a company's growth potential; low P/E values are usually associated with low growth potentials. For the same group of large technology companies, the projected Y/Y earnings growth rates for the next year are plotted in the figure below. The correlation between P/E and earnings growth rate is very clear.

To see if CSCO indeed has an attractive valuation in reference to its growth potential, the data in the two figures above can be combined to compute the PEG ratio (P/E divided by growth rate). This is given in the figure below, for the same group of companies. Clearly, CSCO does not seem to be cheap compared with other large technology companies, based on the PEG ratio valuation.

A Cautious Investment Strategy

The discussions presented above indicate that CSCO will have very limited business growth in the near future -- say, in the next 12 to 24 months -- and it is difficult to expect significant upward momentum in its stock price. On the other hand, I don't see its stock price collapse either, which can be supported by the bullish arguments well documented in the investment community, and thus, will not be repeated here. Under these conditions, I expect that CSCO will trade within a price range, probably plus and minus 20% from its current price of $22.2. The question is then how to invest in CSCO and maximize the investment return, while holding it as a long term investment and waiting for its future growth.

A strategy can be constructed by selling covered calls and puts to bracket CSCO's current stock price respectively from above and below. The transaction will generates premium as investment income. If the stock price moves within the price range bounded by the covered calls and puts, the premium income is for the investor to keep. If CSCO moves outside this price range, the total investment will either give up some gains or suffer from extra loss, depending on whether CSCO breaks out of this price range upward or downward, and by how mush. Thus, the premium from selling the covered calls and puts can be viewed either as an enhancement of the investment return if the stock price moves higher or as a cushion if it drifts downward.

The table below lists CSCO's stock price on Jan. 24, 2014, as well as the premium income for the January 2015 25 calls and the January 2015 20 puts. The transaction involves buying CSCO at $22.2 (or holding it if you are already long on it), selling its January 2015 25 call, and selling its January 2015 20 put. The premium from selling the options, together with the $0.68 dividend, will generated $2.66 per share if CSCO is held to January 2015, a year from now, which amounts to approximately 12% of its current price.

Stock Price on 1/24/2014

$ 22.20

January 2015 25 Call

$ 0.80

January 2015 20 Put

$ 1.18


$ 0.68

The total return of the investment will of course depend on the stock price next January. The calculations are given in the figure below, which plots the total return as a function of CSCO's stock price on Jan. 17, 2015, when the options expire. For comparison, the blue diamond symbols represent the return for holding CSCO stocks alone without the option selling strategy, and the red squares are the results with the option premium income. A simple way to explain this figure is that if CSCO moves around its current price of $22.2, the option selling strategy will come out about 9% ahead of the case of holding the stock alone. If you are convinced by my arguments that CSCO will be range-bound in the next year or so, this 9% extra is clearly not insignificant.

The outcome of the investment will be a little more complicated if CSCO moves far away from its current price. As the two curves show in the figure, if CSCO is above about $27 next January, the option strategy will start to make less money than the stock alone case. Similarly, if CSCO moves below about $18, the option strategy will start to loss more than the stock alone case. Though both of these cases are possible, I don't think the probabilities for them to happen are high, for the reasons I discussed above in this article. To further illustrate this, the total return comparison is re-plotted in the figure below as a function of CSCO's stock price appreciation. The main point of this figure is that the option selling strategy will be worse than the stock alone case only if CSCO moves more than 20%, either upward or downward, from its current price in the next year. It is also worth noting that the option selling strategy will start to have negative return only after the stock price itself has decreased more than 10%, a nice cushion in case CSCO drifts down.


CSCO may be considered as a technology holding for long term investment, but its growth potential in the next year or so seems to be very limited. Thus, its stock price is likely to be range-bound. Under these conditions, selling options can be a good strategy to enhance the total return. The strategy discussed in this article can enhance the return by about 9% if CSCO trade plus and minus 10% from its current price, and it will come out ahead of the stock-alone case as long as CSCO is within plus and minus 20% of its current price by next January, a very likely scenario due to the reasons discussed in this article.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours. I may also implement the option strategy after establishing a long position in 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.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Networking & Communication Devices
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here