Why You Should Switch to Cisco
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Apple (NASDAQ: AAPL) is blowing up once again thanks to an explosion in earnings and a parabolic move in the stock price. The company reported profit growth of more than 90% thanks to surging iEverything in China. China now makes up 20% of total sales and there is plenty of room for this to move higher. But, Apple isn’t the only technology stock that presents a compelling opportunity. I have highlighted two other potential technology investments this week that investors should consider, Texas Instruments as a more short-term, risk-on play and Intel as a core, long-term holding. In the last post on the subject, I present another core play that should have more appeal to investors with a long-term focus: Cisco Systems (NASDAQ: CSCO).
Background
Cisco Systems is the world’s largest supplier of data networking equipment and software. The company’s products include switches, routers, remote access devices, internet service devices, and network management software. A vast array of business is served by these products and includes, but is not limited to, governments, small businesses, utilities, telecommunication companies, and any company with a need for complex networking solutions.
Cisco Systems was founded in 1984 by two Stanford professors. The company would go public in 1990 and the stock would produce an average ANNUAL return of 98% for ten years until the bursting of the technology bubble. In that time, the stock would appreciate more than 1000 times and the company would become the world’s most valuable with a market capitalization of over $500 billion. Today, the company has a capitalization of “only” $100 billion and is the 24th largest company by capitalization in the S&P 500.
Pent-up Demand?
I am of the view that technology is one of the most attractive sectors for long-term investors. The sector has experienced a bear market for the better part of twelve years despite consistent earnings and cash flow growth. The extreme valuations have compressed and a situation is now present where investors have the opportunity to achieve BOTH earnings growth and multiple expansion. Favorable to Cisco is the same thesis that I applied to Texas Instruments, the fact that businesses might finally be starting to increase demand for communication gear following a pronounced and persistent downturn due to the onset of the Global Financial Crisis. Telecommunication capital expenditures as a ratio of sales has shown a consistent decline since the collapse of the Tech Bubble. Not only has this factor weighed on results, but communication equipment as a percentage of total technology investment has declined notably since 2006. There is plenty of pent-up demand and companies with a presence in communication-related products have an opportunity to produce better than expected results in the coming quarters. Early signs are evident with the March Durable Goods report being released today. Communication Equipment new orders were modest at 1.3%, but far outpaced the non-defense ex. aircraft orders which came in at -0.8%. And February was revised from +11% to +18%!
The valuation on this stock is exceptionally cheap from a number of different aspects. First, the often cited price-to-earnings ratio is just 14x trailing twelve months earnings-per-share. This is one of the lowest such ratios ever for the stock and should garner attention from portfolio managers to individual investors that often fixate on this ratio. Other, less well known, valuation criteria is also present. The free cash flow yield is an incredibly cheap 13.6%. Free cash flow growth has been muted of late, but the company is still producing about $10 billion annually. It is extremely uncommon for such a high free cash flow yield to be associated with a consistent, growing company. The stock gets an A on valuation.
Operationally, the company has done a good job. I often go to the ROIC (return on invested capital) numbers to tell the true story. Cisco consistently generates ROIC in the mid-teens, well above their weighted average cost of capital at 10%. This is usually a necessary ingredient for a stock to generate sustainable, long-term outperformance. Of note, this ratio has trended down slightly in recent years and bears monitoring. The same thing goes for the company’s operating margins, which remain excellent despite ticking down in recent years. I give the company a B on operating performance.
And lastly, I favor the dividend growth outlook that is present in the stock. Investors shouldn’t get enamored with the dividend yield, but rather the dividend growth of an investment. The company initiated a dividend in 2011 at 6 cents per share and increased it to 8 cents in 2012. The current yield of 1.6% is not bad and with a paltry payout ratio of 10%, there is plenty of room for continued dividend growth.
Cisco maintains a dominant market share in many categories, but there is some modest erosion on the edges. For instance, Juniper Networks (NYSE: JNPR) is trying to take share from Cisco’s coveted switching market. Juniper is the perennial number two player in networking solutions with annual revenues of $4 billion. Not bad, but just one-tenth the size of Cisco. Juniper has many new product cycles in their early stages and would be a more leveraged bet on increased communication equipment outlays. More aggressive investors might find this stock to their liking.
Bottom Line
Cisco is the clear leader in the networking solutions arena with significant market leading positions is numerous applications. They are positioned to take advantage of key trends such as cloud computing, server virtualization, and data storage consolidation. The company has finally reset sales growth expectations down from double-digits into the 5-9% range. Often companies try to hang on to growth targets that circle key numbers, e.g. 10% or 20%, and then the stock suffers when targets are not met. Cisco had previously tried to hang onto an unrealistic 12-17% top-line growth forecast. This headwind has finally been pushed aside and now this cheap stock offers plenty of upside for patient, long-term investors.
market8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
