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Cisco (CSCO): What Is The Fair Valuation And Where Is The Trading/Investment Opportunity?

|Includes: Cisco Systems, Inc. (CSCO)

A decade ago in February (Feb 2004), broad market was in the first year of a new bull market, and Cisco had a 12m TTM earning of about 60c (30% of last fiscal year), and revenue of roughly 20b (40% of last fiscal year). Guess what the stock price was back to then? In the range of $24-$25, about 10% over what is now. Converting to P/E multiple, we have an 11 for now and roughly 40 back to then.

Old story: Cisco hasn't been a growth-oriented stock for a while. If your investment is intended to find one in that category, leave it alone.

As of Feb 2013, current S&P500 P/E ratio stands around 19. A very typical blue chip company as WalMart (YOY revenue growth in low single digit and earning growth in single digit) is with a TTM P/E ratio in 14-15 range. In comparison, 11 of Cisco stands as a 25% discount, which implies that Cisco is not even considered a slow-growth blue-chip company bothered by product saturation and growth potential.

There is a reason for that low-valuation, and probably a justified one. You may argue that for each and every low-valued company in the market. The key is how you look at it and where you set your line.

Or ask yourself a question: how low is too low? What is going to be the sign of stabilization of even a turn-around?

Lack of growth is one part of Cisco's problem, and one shared by a few other tech behemoths (e.g. Intel, Microsoft). The company, as its tradition shows, keeps buying start-up tech firms and investing into new fields to diversify its reliance on switch/router business. It also manages to increase revenue source from service by signing long-term service package on the top of product sale (think about models of IBM). At this point, there have been a few bright spots (including percentage and real number growth from its service revenue), but none to change the big picture considerably. A few years ago, it made a serious misstep attempting to inroad into consumer electronics business, but has rescinded all that efforts for a while.

However the core problem of the company is not about the inability to grow its revenue by a big number. It is about a prediction/speculation that it will become the next Sun Microsystems, of even a RIM. Cisco used to be a winner to take all, and many people are afraid it will lose all with the emergence of SDN (Software-Defined-Network).

That is the true reason why Cisco is valued so low, because people don't see a good chance of the demise of Wal-Mart in the foreseeable future while they do consider a legitimate chance for Cisco. Some people argue that SDN will seriously compromise Cisco's lofty profit margin in switch/router business if not totally destroy it, thus affecting both the top line and bottom line of the company in a very negative way.

To make things worse, recent quarter's switch/router sector revenue decline (declared last November out of expectation) feeds the worst-scenario speculation very well. Emerging market weakness, the lose-lose fight against HuaWei, product transition period- Mr. Chambers might cite a variety of reasons to account for that decline, but what market fears most is that it is the early sign of the effect of SDN challenge.

Actually Cisco doesn't sit to watch that challenge, instead it has launched its own version of SDN product, and argued that it is not only better, but also cost-saving over the long term compared to the product combining cheap hardware from nobody and software from some big name competitors (such as VMW). Is that true? We have to wait and see.

I have read some "experts" analysis (including that bullish one from Barron), and talked to a few friends in the industry. Here is my prediction/judgment: in the foreseeable future (3year frame for the least) SDN from competitors won't take major shares from Cisco. As to whether or not Cisco could win this round of fight with its own version of SDN products, there is nothing better than a pure speculation. Again, we have to wait and see.

Then, my bottom line is set quite clear- it is too early to call the "death" of Cisco, or the repeat of story of Sun/RIM for the time now. Actually I don't think it is going to happen in the next 3 years.

However, we have to wait to see if they could turn things around, and sail smoothly in an extended time period. Cisco's price reached as high as $26.4 ahead of August earning report (P/E ratio around 13) before Chambers declared a 4k job cut to surprise everybody I knew. The subsequent declaration of revenue decline puts fire on fuel. In the big picture, this is not the first time since this broad bull market started in 2009. The company was hit big by unexpected bad news in 2010. The loss of confidence in the company to perform well on a regular basis is also a major drag for its valuation at this point.

On the final note, just take a look at 10-year monthly chart of this stock

Obviously it stays in a channel between $16 and $28 for most of time. And I don't think that channel will be broken without substantial fundamental changes (I haven't seen that and I don't think it will occur soon).

Conclusions

Overall, my conclusions and strategies are as below

  1. At this point Cisco is NOT a good candidate for a long-term investment from fundamental perspective because of uncertainties.
  2. I would love to make some mid-term trading/investment upon 2 scenarios
    1. Overselling sent the price below or close to line of $20
    2. Change-of-the-sentiment after a specific earning report convincing investors the worst has been left behind. For the upside, I think $26 is a well-set target price zone.
    3. Technically I think it would be running within its high/low price boundaries for extended period of time.

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