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Using the Value Line Page: Cisco Systems September 24, 2010
The Business Description for Cisco Systems (CSCO – Free Analyst Report) states that the company is the leading supplier of high-performance internetworking products for linking local-area and wide-area networks of computer systems. Its products include routers, LAN and ATM switches, dial-up access servers, and network management software. The Cisco IOS software platform ties these products together, delivers network services, and enables networked applications. (A free copy of Cisco’s Value Line report is available here for use with this article.)
To non-experts, Cisco’s business description may sound like so much techno-babble. To the computer savvy, however, it says that Cisco sits at the crossroads of the Internet, with the company providing both the machines and the software that move data around networks and the web. In fact, the company’s most recent corporate push is in video, the use of which has been a driving force behind the increase of web traffic—importantly this includes traffic on mobile devices such as Apple’s (AAPL) iPad and iPhone. The long-term thesis of an investment in Cisco shares is fairly simple: as demand for video and web-based services continues its upward climb, it’s likely that Cisco will capture a material piece of the action. Thus, its revenues and earnings are set for a long uptrend as companies line up to buy its networking gear.
As the Analyst Commentary points out, management at Cisco is looking for annual revenue gains of 12% to 17% over the next three to five years. That’s a heady rate of top-line growth, considering its massive size and dominant market position in enterprise switching, and it could easily support similarly impressive bottom-line gains. If the company is able to achieve its goal, our long-term revenue and earnings estimates of $10.40 and $2.00 a share, respectively, would prove highly conservative. (These projections can be found to the far right of the Statistical Array.)
Value Line’s projections translate into a potential share price range of $35 to $45, as can be seen in the Projections box to the left of the graph. That range represents an advance of 65% on the low end and 110% on the high end. Also, the company is set to pay its first dividend later this year, as the Comment notes, which would result in an annualized total return (including projected price appreciation) of between 14% and 21%. That is a solid performance number at the low end and excellent at the high end.
Note, however, that Value Line’s projections are conservative relative to the company’s guidance. In fact, comparing our projections to Cisco’s internal goals, the Annual Rates box shows that our longer-term projections translate into “just” a 9% advance on both the top and bottom line. That’s three percentage points lower than the low end of management’s internal expectations for revenue growth. There could be some upside to our estimates if we’ve been too conservative.
Moreover, Cisco has backed up its projections with actions. For example, the company’s research and development spending made up almost 13% of revenues in 2009. Since the company is in the technology space, spending on new products and services is vital to future performance. Management has obviously made a large commitment to R&D in an effort to maintain its leadership position and back up its long-term financial goals. (Information about research and development spending can be found in the Business Description.)
A company having a positive outlook, however, doesn’t make its stock a good investment, which brings to mind two questions: valuation and financial strength. The company gets higher marks on both.
In terms of valuation, Cisco’s current price to earnings (p/e) ratio is 15.1, with a relative p/e of 1.01. This can be seen in the Top Label section of the Value Line page. (A relative p/e greater than 1.00 suggests a company trading at a premium to the market, a ratio below 1 suggests a discount.) While Cisco’s p/e suggests that the company’s shares are trading in line with the broader market, its valuation ratios sit at the low end of Cisco’s historical range, as can be seen from the historical section of the Statistical Array. So, the company’s shares appear to represent a reasonable value at the current quotation.
Cisco, meanwhile, earns Value Line’s highest possible score for Financial Strength, a proprietary Value Line measure. The A++ rating can be found in the Ratings box at the lower right of the page. This solid score stems from the company’s size, market presence, solid balance sheet, and massive cash hoard—which, as the Current Position box shows, stands at nearly $40 billion. True, the recently initiated dividend will cut into that stash, but the money provides a particularly large cushion for dealing with adverse market conditions and the proposed dividend level isn’t so large that it cannot be funded from cash flow.
Cisco’s earning power, however, may well make a “cushion” unnecessary. The most recent downturn, which some considered the deepest recession since The Great Depression, lasted 18 months. But Cisco’s revenues and earnings only really faltered for four quarters. A quick examination of the Quarterly Revenues and Earnings boxes shows that the year-long impact started in the second quarter of 2009 and lasted until the first quarter of 2010, when results began to strengthen again. Note that although the company’s quarter-over-quarter performances in that span were historically weak, never once did the company dip into the red. This type of performance is what results in the company’s top notch Safety Rank of 1 (this can be found in the Ranks box).
One area of concern may be the company’s use of debt, which represents just over 20% of its capital structure, as can be seen in the Capital Structure box on the left side of the page. As the historical component of the Statistical Array clearly shows, debt was not a part of the company’s business model until 2006. Since that time, the amount of leverage in use has almost doubled. At about 20% of the capital structure, however, the company appears to be taking a prudent approach to its debt issuance.
Another issue that some may consider a concern is the company’s material foreign exposure—which is more likely a long-term benefit. About 46% of 2009 revenues came from markets outside the United States, which provides revenue diversification for Cisco. In fact, since the company sells to other companies—the fortunes of which are often tied to broader business conditions—its foreign exposure helps insulate it from the impact of a downturn in any one nation. The United States will continue to have a disproportionately large impact, since it makes up more than 50% of revenues, but the foreign exposure, we think, should be viewed in a positive light, not a negative one. (Information about foreign sales can be found in the Business Description.)
Although Cisco’s is no longer a story of the fast-growing company, it is has transformed into a slower growing, but much more financially stable one. It is now the type of company that can carry a reasonable level of debt, pay dividends, and buy back shares instead of constantly issuing them to fund growth (this trend can be examined in the Statistical Array). Cisco is a growth-oriented technology company appropriate for a more conservative investor looking to hitch on to the continued growth of video and application traffic on the Internet. It is the Internet company for investors who don’t want to take on the risk of buying the next great tech flameout.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.