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Do You Know The Way To San Jose? Buy Cisco (CSCO)

 May 17, 2012 11:26 AM
 


(By Kevin Donovan) The information technology world has beaten a well-worn path to San Jose, Calif., and the door of Cisco Systems Inc. (CSCO), long the bell cow of enterprise tech gear and a darling of tech investors.  It's still far and away the leader, but can it reclaim its investment allure? 

Though Cisco beat fiscal third quarter earnings and revenue estimates, its shares tumbled, dogged by management's cautionary tales of weakness in Europe and guidance that was less than enthusiastic.

VALUATION

At $16.67 per share, Cisco is down 17.5% in the last month after having hit a 52-week high in April of $21.30.  We believe the punishment is overdone.  On a trailing 12-months' basis, its price to earnings multiple is 12.3 vs. the S&P 500 multiple of 15.5.  On a forward basis, CSCO's discount to the market is even steeper at 8.7 vs. 12.9.  Applying a market multiple to the First Call fiscal 2013 consensus earnings estimate of $1.92, we derive a price target of $25.  We think this is achievable if the macroeconomic pie continues to grow, admittedly a big if.

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THE LAW OF LARGE NUMBERS

As an investment, here's where Cisco could run into a wall.  The industry leader already has a 75% share of the enterprise routing market and a 67% share in Ethernet switching.  Growth will be difficult if the world economy, led on its not so merry way by Europe this time, swerves into a ditch.  Our view, however, is that the U.S. and China will be strong enough horses to keep the wagon moving forward.

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THE BUSINESS

Cisco designs, manufactures, and sells Internet Protocol-based networking and other products related to the communications and information technology industry and provides services associated with these products, most conspicuously routers and switches.  Routing technology is fundamental to the Internet, and this technology interconnects public and private IP networks for mobile, data, voice, and video applications.

GROWTH OUTLOOK

Gartner Inc., the information technology research outfit, estimates 2012 global IT spending growth at 2.5% in current U.S. dollars, down from its previous forecast of 3.7%. However, stripping out the effect of exchange rate fluctuations, which Gartner considers the more meaningful metric, global IT spending growth in 2012 is forecast at 5.2%, up from a previous forecast of 4.6%.

A key area for growth could be telecommunications networking.  More smart phones mean more demand for data speed.  Gartner forecasts constant dollar growth in telecom equipment spending of 10.3% in 2012, up from its previous forecast of 8.1%.  This should play to Cisco's strength in this sector with products such as the super-fast CRS-3 carrier routing system. 

POTENTIAL PITFALLS

Competition is vigorous in the internet routing space.  Cisco's rivals include not only domestic firms such as F5, Juniper Networks and Riverbed Technology, but also China's Huawei.  These firms and others have put pressure on pricing.

Also, global economic growth is far from assured.  A double-dip recession in Europe, a hard landing in China and a U.S. fiscal crunch if sequestration kicks in next year could all hurt IT budgets.  Any damage will be limited, though, by easy monetary policy at the world's central banks, in our view

In sum, we think the Cisco haircut has been too severe and would be buyers at current levels.

 

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