Cisco's Upgrade: Is Now The Time To Buy?

| About: Cisco Systems, (CSCO)
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Shares of Cisco Systems (NASDAQ:CSCO) saw nice gains after an upgrade from an analyst at JP Morgan. The rating was changed from a Neutral to an Overweight, and the price target was raised from $19 to $21. Shares finished the day up 3.4%, which contributed to nice gains in other tech names like Microsoft (MSFT).

Now before I get into any detail on this week's upgrade, I'd just like to point out that the "Neutral" rating on the stock was reiterated by this firm just one month ago, and that was a few weeks after the company's latest earnings report. So either things have gotten much better, or the analysts have realized that they've missed $5 of upside with a neutral rating. The stock really hasn't done much since the day after earnings when it rose $1 to $18.61. That didn't prevent the neutral rating reiteration a month ago, or yesterday's upgrade.

A couple of quotes from the note that I would like to point out:

After in depth analysis of multiple FY' 11 margin drivers, we conclude that switching transition and public sector weakness are each relatively small earnings drivers in isolation.

Cisco has undergone a serious restructuring over the past few quarters, and they did say in last quarter's report that they were nearly complete with the process. They also said the usual "we believe this puts us in a great position going forward" statement that most companies use. But I believe them. After many people had called the stock dead earlier this year, we've seen two good earnings reports, and the stock has bounced about $5 off its lows.

In fact, we believe Cisco encountered a perfect storm of multiple small issues in FY '11 which added up to a material year-over-year decline in gross margin," he adds. "We do not believe this is likely to repeat in FY '12 as many of these small problems have been addressed, in our opinion. In addition, our proprietary analysis of 30 U.S. Federal agency budgets implies that spending will increase in FY '12 after being down in FY '11 and may act as a tailwind for Cisco. As a result, we believe Cisco represents a relatively safe haven for communications equipment investors.

Yes, Cisco's margins did struggle in fiscal 2011.

Margins 2009 2010 2011
Gross 63.94% 64.04% 61.40%
Operating 20.27% 22.89% 17.76%
Profit 16.98% 19.40% 15.02%

While non-GAAP earnings rose 1 cent to $1.62 in fiscal year 2011, GAAP earnings declined 12% to $1.17. However, analysts are expecting a nice rebound, with $1.77 in non-GAAP earnings expected this year (ending in July) and $1.93 in the next fiscal year. Revenues are expected to grow at about 6%.

Margins still came down year over year for their fiscal first quarter of 2012. Gross margins fell from 62.84% to 61.21%, while operating margins decreased from 21.87% to 19.63%. The worst drop was in net (profit) margins, which declined from 17.95% to 15.79%. Operating income and net income were down year over year on a dollar basis.

I'm not quite sure that the company will see a huge rebound in margins during this fiscal year, as you need to realize that some of those EPS gains will be due to the company's continuation of its share repurchase program, as they had about $8.7 billion left on their program at the end of their latest quarter.

We believe some multiple expansion is possible at the same time that earnings revision risk is shifted positively.

Recent history would seem to support this statement. The following table shows the high and low P/E number for the fiscal year, given that year's earnings and high and low share prices (based on non-GAAP).

P/E 2008 2009 2010 2011 Average
High 17.77 18.39 17.23 13.79 16.47
Low 9.10 10.08 11.80 8.21 10.03

Given a 10 to 16 P/E range, and the current expectations for $1.77 in non-GAAP earnings, you would expect a range of $17.70 to $28. However, even if we only trade to last year's high P/E number of 13.79, you would still have a high price of $24.41. Yes, valuations can and certainly have been coming down, but there seems to be more upside in the name than downside currently.

While the recent upgrade is not a game changer for the stock, I think it reiterates the fact that this is a good company and perhaps a solid investment. While Cisco has seen some nice gains in the past few months, the stock has seen some nice support in the $17 to $18 range, and that is where I recommend you enter the name. Revenues are growing, and despite margins that might only be flat compared to last year's, earnings per share will grow as the company continues to buy back stock. I also would expect them to make a dividend raise announcement in the first quarter, so they may start paying 8 or 10 cents a quarter starting at the end of March. The company does not yet have the dividend yield of a Microsoft or Intel (NASDAQ:INTC), but the dividend program only started last year. It will increase over time. The company is also buying back shares like those other two tech giants, and the buyback program will be extended in the next couple of years.

I wouldn't jump in right now after Tuesday's pop, but I think this is a name to start accumulating on any pullback (see above range). A couple of analysts have started to recommend this name as a buy over the past few weeks, and yesterday's news only indicates that more upgrades are probably forthcoming.

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