Cisco and the Golden Age of the Internet
Alvin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Cisco Systems (NASDAQ: CSCO) is a cash generating machine that is in a sector that is primed for strong growth. In its most recent quarter, Q2 of fiscal year 2012, Cisco reported record revenue of $11.5 billion, record earnings per share of $0.40, and an operating cash flow of $3.1 billion. Year over year, revenue increased by 11%, earnings per share increased by 48%, and operating cash flow increased by 19%. For a large cap company, that is impressive growth.
Golden Age of the Internet
What is even more impressive is Cisco’s potential to continue its most recent growth trend. Infonetics expects “double-digit percent revenue increases for the overall data center equipment market” in 2012 and in 2013 before tapering off. This bodes well for Cisco. Furthermore, Cisco has the potential to continue its growth past 2013 because of the continuing rise in internet traffic due to the growing number of users and the increasing use of online media streaming.
As most people probably know, the number of global internet users continues to grow. From 2000 to 2011, the number of internet users increased by over 500%. Furthermore, there is still plenty of room for growth because only about one third of the world population is using the internet. Also experiencing strong growth is the mobile-broadband subscriptions market. In the last four years, mobile broadband subscriptions have grown annually by 45%. To put the size of this market into perspective, in 2011, the number of mobile broadband subscriptions was double the number of fixed broadband subscriptions (International Telecommunication Union).
In addition, online media streaming is booming. The transition to online streaming is inevitable because it is convenient and provides easy access to viewers around the world. In February 2012, 179 million Americans watched an average of 21.8 hours of online video content. In addition, Americans watched 7.5 billion ads. In comparison, in February 2011, 170 million Americans watched an average of 13.6 hours of online video content and a total of 3.8 billion ads (Comscore). While the number of users only grew slightly, average hours watched increased by 60% and total ads watched increased by 97%. That is explosive growth.
Also contributing to the rise in internet traffic is the end users’ never ending demand for higher quality videos. This is evident in YouTube, where video quality has been trending up. YouTube videos have gone from 240p, to 360p, to 720p, to 1080p, and now 2304p (wow). Essentially, all of this paints a rosy picture for Cisco and its peers. Network traffic will continue to increase due to the rising number of users, the rising usage of online media streaming, and the rising quality of videos. All of these factors will drive upgrades and additions to current networking equipment.
Competition
Cisco offers a diverse set of products and services and has many competitors. In 2009 Cisco invaded the server market with its UCS servers, and made enemies out of IBM (NYSE: IBM), Hewlett-Packard (NYSE: HPQ), and Dell (NASDAQ: DELL). Oracle can be considered another competitor, but Cisco is partners with them. The big three of servers responded by invading networking. HP acquired 3Com for $2.7 billion, Dell acquired Force10 Networks for $700 million, and IBM acquired Blade Network Technologies for an undisclosed amount (networkworld). By declaring war with IBM, HP, and Dell, Cisco is taking a big risk. However, it appears the venture is paying off because UCS revenue was up 90% year of year in Q2 and added 1,783 new customers.
In routers, Cisco’s main competitor is still Juniper Networks (NYSE: JNPR). Juniper is not as big as IBM, Dell, or HP, but they do have more experience in networking. In 2011, Juniper generated about $2.3 billion in router product revenue, $493 million in switching product revenue, total revenue of $4.4 billion, and a net income of $425 million. In switches, Cisco’s main competitor is HP, but Huawei and Juniper are also in the market. In addition, IBM and Dell are also threats because of their switching acquisitions and their size.
When studying a business, it is important to look at competitive advantages. Cisco has significant advantages against its competitors because of its size and loyal customer base. Of the mentioned competitors, IBM is the only one that spends more money on R&D. In 2011, IBM spent about $6.3 billion in R&D, Cisco spent about $5.8 billion, HP spent about $3.3 billion, Juniper spent about $1 billion, and Dell spent about $860 million. In terms of net profit for 2011, IBM earned $15.9 billion, HP earned $7.1 billion, Cisco earned $6.5 billion, Dell earned $3.5 billion, and Juniper earned $425 million.
Recently, John Chambers, Cisco’s CEO, labeled Huawei as Cisco’s biggest rival. Huawei has the knowledge and the funds to battle Cisco. In 2010, Huawei generated $28 billion USD in revenue and $3.6 billion USD in net income. Furthermore, Huawei has global brand recognition and is based in and has a strong presence in China. However, Huawei’s ties to the Chinese government will probably continue to pose a significant hindrance as it tries to establish itself in the USA.
The way I see it, UCS servers are the real deal. However, Cisco’s competitors are very smart and business customers tend to be very loyal. UCS is gaining customers, but good competitive products have already emerged (e.g. HP BladeSystem Matrix). Thus, IBM, HP, and Dell will probably continue to lead the server market and Cisco will probably continue to lead networking. However, Cisco is well positioned because of its diverse product offering, presence in strong growth areas, high margins, and size.
Value
Currently, Cisco has a book value of about $9.16 per share. Therefore at its current price of $19.85, investors are paying a premium of $10.69 for Cisco’s earnings power. This premium is actually accounted for by Cisco’s current earnings. Assuming zero growth in net income and using discounted cash flow analysis, Cisco has an intrinsic value of about $21 per share. This is above the current share price. Therefore, Cisco is clearly underpriced because its business is primed for strong growth. Furthermore, Cisco recently finished $1 billion of reduction in costs and is focused on further increasing gross margins.
Assuming 10% annual growth for the next ten years and using discounted cash flow analysis, Cisco has an intrinsic value of about $33 per share. 10% might seem like an absurd assumption, but Cisco is present in multiple high growth areas such as UCS and enterprise video. Also internet traffic is growing rapidly. Furthermore, before the economy crashed in 2008, Cisco averaged a 13% annual growth in revenue and a 27% annual growth in net income from 2002 to 2008. Hence, at its current price of $19.85, Cisco is selling at a discount of almost 40%. Furthermore, Cisco has the potential to continue to grow even after ten years. In conclusion, Cisco is a good buy.
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