Cisco Building The Foundation For Its Future

| About: Cisco Systems, (CSCO)
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Cisco Systems is effectively building the foundation for its future.

The business is currently grossly undervalued by just about any measure.

New investors today can expect exceptional returns on their capital with an upside kicker.

Cisco Systems (NASDAQ:CSCO) has long dominated the market for routers and switches required to allow data to flow over the Internet and corporate networks. They have so solidly dominated this aspect of the data flow market that they are commonly referred to as the "plumber of the Internet."

With a market cap of $117.2 billion and an Internet and business IT infrastructure that is largely built out, Cisco has made the difficult transition from a hyper-growth technology company to what is now becoming referred to as one of the "digital utilities."

The digital utilities are similar in many ways to traditional utility providers except they are technology and software related. We now live in a world where we simply can't survive without our connected devices that keep us in touch with everything at every moment of our lives.

Compare our connected lives today to 25 years ago when the very first personal computers were making their way into the homes of consumers and the first login you performed was to access your operating system. Most likely MS-DOS.

It's almost inconceivable that we progressed so far in just 25 years.

Cisco Systems Plans To Dominate The Next Generation As Well

It has only been a few short years since I first heard the term "Internet of Things." It is now commonly used in day-to-day discussions. It refers to the interconnection and functionality of all of the personal devices we use in our lives.

We see the infrastructure for this being implemented all around us. We now have cars that can communicate with our phones. We have doorbells that connect to our video phones so we can see and communicate with someone at our door even if we are hundreds of miles away.

Appliance makers are producing refrigerators that can read the barcodes of the items we move in an out and then create a shopping list for us.

Most impressively, we have widespread testing of driverless cars being conducted.

Cisco has been very open in public regarding their belief that the future of their business is closely tied to this emerging trend and their plans to dominate this market the same way they have dominated the market for routers and switches.

Cisco Systems was an early proponent of the Internet of Things and set about years ago to assure their leadership role in this developing space. On February 3, 2016, they took what could be a very large step toward achieving their desired position as a leader in the Internet of Things with the announcement that they would acquire Jasper Technologies for approximately $1.4 billion.

Jasper Technologies is a privately held software business. Its products allow businesses to manage all of their connected devices. Keep in mind that "connected devices" is no longer a term that describes a physical connection. It simply means that one device knows another device exists and they can communicate with each other either through a hard connection or wirelessly.

Jasper's existing customers include well-known names such as Ford Motor Co., General Motors and IBM, among others. Cisco believes Jasper's products will integrate very well with their existing products and that their existing reach in the industry will allow them to introduce this new product line across the full range of their existing customer base.

So, unlike many acquisitions we see in the tech space, this one by Cisco seems to be a very good fit for their existing business and future direction.

Did Cisco Overpay For Jasper?

One of the most common objections I have when looking at acquisitions by large technology companies with truckloads of cash is they always seem to overpay for everything. And I don't mean just overpay by a bit. Tech giants with their huge cash balances seem to throw money at acquisitions at market tops and outrageous premiums.

In this case, we are in a very soft market for technology companies. So it would seem to be a good time to be shopping if you are a buyer. Jasper's last round of fundraising in 2014 placed a private valuation on the business comparable to the price Cisco is paying today.

Since the private market value has already been established at the approximate price Cisco is paying, it seems that Cisco is getting a fair value for their investment.

But it could be a better value than it appears at first glance. There has been some speculation that Jasper has been having some difficulty effectively marketing its products to some of Cisco's major clients. If that has been the case in the past, it certainly won't be in the future.

Will The Acquisition Strain Cisco's Balance Sheet?

Another negative aspect of acquisitions we often see are companies taking on large amounts of debt to acquire a business that is not generating cash.

That should not be much of an issue in this case. As of October 31, 2015, Cisco showed $59.107 billion of cash and short-term investments on its balance sheet. The company also listed total liabilities of only $51.788 billion.

Cisco could complete this acquisition, pay off all of its liabilities (short-term and long-term) and still have about $8 billion left over. This is not a deal that will even amount to a slight bump on the balance sheet of Cisco.

A Good Acquisition Does Make Fair Present Value

While I like the fact that Cisco is focused on building the future foundation of their business today, that does not mean that the stock is an attractive buy at today's valuation. Is it?

The chart below shows the recent earning history for Cisco compared to the expectations of analysts covering the stock. It shows the company has produced earnings of $2.25/share. Based upon its closing price of $23.10 on February 3rd, the stock is valued at 10.27 times trailing twelve months' earnings.

Considering the current P/E of the S&P 500 is 21.10 and Cisco's cash rich balance sheet, it appears that referring to this business as undervalued would be quite an understatement.

So based on the trailing twelve months and compared to the current valuation of the S&P 500 as a whole, Cisco Systems would appear to be just plain dirt cheap.

However, a low current valuation can be justified in the case of some anticipate future impairment to the performance of the business.

Based on the forward growth estimates of the analysts covering the stock, Cisco is expected to grow its profits by 9.25%/year for the next five years.

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One of my favored valuation methodologies is to project a rise in share price of a fairly valued business equal to the earnings growth rate plus the dividend yield. Cisco currently has an exceptionally attractive dividend yield of 3.58%. If this is added to the projected earnings growth rate of 9.25%, it would indicate that investors today could realistically expect annual returns on their capital of 12.83% even if the stock remains severely discounted to the broad market.

The current disconnect between the valuation of Cisco and the broad market should provide some level of downside protection in a down market and the potential for a great deal of capital appreciation in favorable market conditions.

Final Thoughts And Actionable Conclusions

Cisco Systems is a dominant business in its space today and is in the process of building the foundation for the future direction of the business tomorrow. Its current operations are nothing short of a cash register and the company is making acquisitions while the market is weak and only paying current fair value for them.

The stock is cheap compared to the broad market and the projected future earnings growth coupled with the existing dividend should provide new investors with a very attractive return on capital for the foreseeable future.

There also is the potential kicker of a market valuation more in-line with the S&P 500 which will either provide exceptional capital gains or protection in a falling market.

Cisco Systems is a screaming buy today and is an exceptional buy anywhere below $26.00/share. I rarely see a technology company that I believe you can buy and stick in a drawer for 5 or 10 years. I think Cisco Systems represents that kind of opportunity for investors today.

Disclosure: I am/we are 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.