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Why Cisco's shares look like bargains
Cisco has problems, chief among them slowing growth. But look again. It has some new irons in the fire, including some high-growth technology businesses.
By Michael Brush
Whats wrong with Cisco Systems? The stock, once a technology bellwether, closed 2005 with a 10% loss, even as tech stocks overall had a reasonable year, with average gains of about 6%.
On the surface, you can blame back-to-back quarters of tepid guidance from Cisco Systems (CSCO, news, msgs) -- including projections that revenue growth will dip below 10% this quarter for the first time in nearly two years. Thats well below the peak of 26% in the summer of 2004.
But Ciscos detractors have other problems with the stock. Chiefly, they worry that Cisco is simply too big to grow. You dont see the above-average growth that growth managers look for, says Michael Binger, explaining why the Cisco holdings in his Thrivent Large Cap Growth Fund (AAAGX, news, msgs) don't match the company's representation in the Russell 1000 growth-stock index ($RLG.X).
Others worry that Ciscos move into consumer markets -- selling home-networking equipment and cable set-top boxes -- will taint its enviable gross margins, which have hovered in the upper 60% range. Consumer products typically carry much lower profit margins. Those margins just cant stay up in the stratosphere, says Erick Maronak, chief investment officer at Victory NewBridge, which recently threw in the towel on a Cisco position it had held faithfully since 1992.
All of these challenges look real enough. But at this point, investors may be worrying too much. Since last summer, theyve knocked the stock down to about $17 from $20. Down here, Cisco looks too cheap to pass up.
Related news and commentary on MSN Money
Rebuilding for faster growth
After all, the company isnt just resting on its laurels. Instead, it has been using its considerable financial clout to buy or develop a presence in several high-growth businesses like Voice over Internet protocol (VoIP) phone service, data storage and security systems for companies. And, yes, the company also is moving into home networking and cable boxes.
Cisco recognized that growth would slow and it took the proper approach when you have a lot of capital," says Marc Klee, a portfolio manager at American Fund Advisors. "You use it to develop new businesses.
At $17.20 per share, the market doesnt seem to be giving Cisco credit for its potential. If you subtract the $2.20 a share Cisco holds in cash, the stock trades for 13.6 times the $1.10 that Wall Street analysts project it will make in 2006.
Cisco looks cheap compared to the S&P 500 ($INX). Investors are paying 14.7 times next year's earnings for S&P 500 stocks, whose earnings are expected to grow 13.1% next year. Cisco should be able to book annual earnings growth in the 12% to 15% range for several years to come.
Ciscos router and switch business -- where it has more than a 70% share of the global market -- accounts for about 60% of revenue. Its growing in the 7% to 8% range a year, estimates Aaron Rakers, an A.G. Edwards analyst, who has a "buy" rating on Cisco and thinks the stock could climb 30% over the next 12 to 18 months.
Cisco has been using its huge cash hoard to either purchase or develop new technologies with its Advanced Technology Group. Here, the company focuses on lines of technology it believes can, in the near future, bring in at least $1 billion in annual sales. To put that in context, Cisco is expected to have revenue of $30 billion in 2006.
Not all of Ciscos "advanced" technologies will turn into billion-dollar lines of business. But several are already there, and they are continuing to grow at a rapid clip. Heres a look at some of the highlights.
The digital home
Cisco's sales of Linksys wireless home-networking gear hit $220 million last quarter, making this, on an annual basis, nearly a billion-dollar business. Rakers believes this segment will grow at about 19% a year for the next three years.
Cisco also recently announced plans to purchase Scientific-Atlanta (SFA, news, msgs), which sells cable set-top boxes and gear used by cable companies in their transmission systems. This positions Cisco to play a big role in digital video -- as services like on-demand and high-definition TV put more demands on bandwidth.
These are the consumer-oriented businesses that doubters believe will weigh down Cisco's margins. But Klee, whose firm owns Cisco shares, isnt too worried about this. He thinks overall sales growth will make up for the lower margins. If the pie gets bigger and you can bring more dollars to the bottom line, then it is worth giving up margins, he says.
VoIP
Cisco made a name for itself in routers and switches. But it has built on its expertise in Internet data transmission to develop a healthy VoIP phone division, which sells chiefly to businesses. Cisco took in about $280 million from this line of business in the most recent quarter, estimates Raker. But there is much more to come, as businesses warm up to the cost savings that come from using VoIP. Raker looks for yearly sales growth of 32% in the medium term. Ciscos VoIP business also creates sales leads for networking gear. Raker estimates that for every $1 in VoIP sales, Cisco gets an additional $4 in networking-equipment sales.
Business services
Behind the scenes, Ciscos fast-growing Advanced Technology Group offers businesses products and services such as data storage, sales of which doubled last quarter. Security-related products -- another billion-dollar category -- grew by more than 25%.
Cisco also recently announced it will be offering small businesses an all-in-one system of Internet-based voice, data and video services called Linksys One. It will start off small but has the potential to be another billion-dollar business in a few years. Another new offering helps companies manage their network capacity growth.
All told, revenue at the Advanced Technology Group grew a healthy 25% in the last quarter. Rakers is looking for annual growth of around 17% over the next three years.
A motivated management team
Cisco detractors have another beef with the company: Cisco may be a maturing tech company, but its been doling out stock options like a startup. Chief Executive John Chambers has 111 million options, and the company gave options equal to nearly 3% of shares outstanding during its fiscal 2004 and 2005, by Morningstars count.
Critics worry that this dilutes earnings. But Cisco has been using its powerful cash flow -- $1.4 billion last quarter -- to buy back stock, which offsets damage done by the options. The company bought $3.5 billion worth of stock, or 194 million shares, at an average price of $18.03 last quarter. Since September 2001, it has purchased $30.7 billion worth, 1.7 billion shares, at an average price of $18.14, reducing share count by 15.3%.
Those share buybacks help investors in another way. To me, an average purchase price of $18 suggests management thinks shares are a bargain at the current $17.20.
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