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Cisco Systems: Transition Phase Creates Opportunity To Own Shares

 December 12, 2012 03:10 PM
 


(By Mani) Cisco Systems, Inc. (NASDAQ: CSCO) is a company in transition, making strides toward becoming the No. 1 player in IT. Its focus is on recurring revenue streams and to generate stable margins through investment in software and services. This transition phase creates an opportunity to own shares at a low price.

Cisco remains the dominant networking vendor, with strong underlying fundamentals, given very strong traffic growth, data center consolidation and virtualization.

"We believe Cisco's revenue targets leave room for upside from M&A initiatives and through growth in under-penetrated emerging markets. To us, no other competitor's strategy encompasses a fully integrated architecture approach equivalent to Cisco's," Oppenheimer analyst Ittai Kidron said in a client note.

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While other players struggle with poor execution and product gaps, there is room for Cisco to gain share leveraging its core switching/routing portfolio.

Cisco, at its analyst day, stressed improving visibility and holding margins through software and services sales, and expects software revenue to grow 14-16 percent, while services revenue to rise 9-11 percent in the next 3-5 years.

"We believe Cisco can integrate SW/services throughout the stack, keeping margins in check while building on core switching/routing," Kidron noted.

Cisco targets 5-7 percent top-line growth by shifting its sales mix toward data center, mobility, video and security. This goal excludes M&A and, in addition, Cisco is focused on growing beyond the top 5 emerging markets where it is under-penetrated. Both suggest upside to revenue targets.

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In addition, Cisco has set a gross margin bar of 61-62 percent, which should alleviate a top concern among investors.

"We feel more comfortable Cisco can offset pressures (mix, discounts) through investment in SW/services, and with tight op-ex control, Cisco should be able to hit its goal of holding OM% in the high 20's," the analyst said.

Though, Cisco could achieve its No.1 IT company goal, it could take time and execution remains key. Other players face downward secular trends, are executing poorly and have portfolio gaps.

'Cisco's integrated architecture is a superior approach to the data center," Kidron wrote.

Though macro concerns have yet to evaporate, Cisco is executing on its strategy, leveraging a full architecture approach to become the No. 1 IT player. There is still room for share gains while amid potential firm margins and improved revenue visibility.

"We see Cisco as among the best positioned for the next-generation virtualized data center given its history of strong execution and M&A, product breadth, geographic diversity and scale advantages," Kidron noted.

Cisco is on the cusp of several growth opportunities, including virtualization, collaboration, video and UCS, but macro uncertainty, intensifying competition and potential market share losses represent negative headwinds. However, these concerns are already reflected in consensus estimates and the share price reflecting a bearish investor sentiment surrounding Cisco.

Year-to-date, Cisco shares have under-performed S&P 500 by posting a gain of 6 percent versus 12 percent. Cisco shares are trading at 9.9x its consensus EPS estimate of $1.96, compared to Cisco's networking peer group of about 16x, its data center/storage peers of about 18x and the company's five-year forward P/E average of about 15x.

"With valuation near trough levels and share repurchases helping to support shares over the near term, we see an opportunity to own Cisco," Kidron added.

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