Why I'm Following Cisco’s Path to $30 in 2013

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

My log of potential breakout surprises in 2013 is starting to take shape. Though Cisco’s (NASDAQ: CSCO) valuation suggests that the market is not expecting much from the networking giant, after a solid fiscal Q1 earnings report it’s getting harder and harder to keep its name off the list.

Cisco will end 2012 lounging in the $20-ish area, representing a respectable gain of 14% on the year. While this performance may not rank in the “breathtaking” category, ask Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ) investors how they would feel about it. Still, with a bit of luck and a little patience that 14% has a chance to double, putting the stock in the range of $25 to $30 by the second half of 2013.

A Solid Start to Fiscal 2013

Cisco got its fiscal 2013 started on the right foot by logging its seventh consecutive earnings beat. The company reported net income of $2.6 billion, or 48 cents per share on revenues of $11.9 billion. Remarkably, not only did this represent 6% revenue growth, but Cisco’s profits surged 11%, which helped raise its cash pile to $45 billion.

The company’s cash position is important to note here, because quite a bit of my assumptions are based on its free cash flow projections. The stock today is undervalued by at least 20% when applying a modest 3% to 4% FCF growth above 2012 levels. There is evidence that the market is discounting this metric in favor of (of course) revenue and profit growth. Cisco appreciates that.

The company realized that its cash was growing, but revenues stayed at mid-single digit growth. Cisco also noticed that its service business is growing at an impressive rate, 12% year-over-year. But on the other hand, the company’s core routing and switching business continues to be weak. This has been a recurring theme, and the market doesn’t like it.

However, profitability continues to improve. Although a quarter of a point from 2011 was shed from gross margin, Cisco managed to advance gross margin sequentially by roughly half of a point, exceeding expectations. Likewise, that operating income surged 20% year-over-year speaks to how well management’s reorganization and fiscal restrictions have worked. But this only goes so far with analysts.

Creating Separation and Realizing Value

This continues to be the challenge for a company of Cisco’s size. In many respects, Cisco has become too big. Growth has not arrived in sufficient quantities, at least not to the extent that investors would like. Revenue growth has been roughly 6.5% between fiscal 2011 and fiscal 2012, far from extraordinary.

However, Cisco still appears more nimble than Hewlett-Packard, which has seen its market cap erode by 40% this year, helped by double digit drop-offs in its high end markets, the same markets where Cisco is seeing "modest" growth. Still, Cisco won’t deny that it can do better. This explains why the company has been investing in businesses that combine cloud-based services and enterprise LAN management. But will it work?

Q2 guidance for fiscal year 2013 suggests year-over-year growth of only 3.5% to 5.5%. With the top range of the outlook coming in a full point below Cisco’s historical average, this tells me that the company is not done doing deals. Why? Because the enterprise is always evolving. Plus Cisco’s recent acquisitions, which includes paying $141 million in cash for Cariden and another $1.2 billion for Meraki, suggest that Cisco aspires to give the market the growth it craves, regardless of cost.

With the cloud market expected to grow to $177 billion over the next three years, it would be foolish for Cisco not to execute in that direction and look for any opportunity that might present a competitive advantage. With its service business growing annually at 12%, this seems to be an area where the company can leverage its enterprise presence.

I’ve made this point once before and I’ll say it again, Cisco should consider acquiring Palo Alto Networks (NYSE: PANW). The company is young but growing at an incredible rate. However, Palo Alto’s story is more than just about performance. The company has pioneered what is considered next generation security along with one of the most innovative platforms in the industry.

What’s more, Palo Alto's recent stock decline now makes it even more attractive than before. Likewise, Dell's $1.2 billion acquisition of SonicWall speaks to the urgency with which these M&A security deals are beginning to move. If Cisco is not careful, it can miss out to Dell and likely HP, although I doubt HP has motivation for deals these days.

Along similar lines, Cisco’s aggressiveness in the area of wireless makes a company such as Aruba (NASDAQ: ARUN) very appealing. With shares of Aruba trading at $20, there is considerable value to be had. Also, Aruba’s fundamentals are solid. But will Cisco do it?

Bottom Line

At the very least, $25 seems to be Cisco’s fair value. This is 26% above Cisco’s current share price of $19.83. However, $30 remains a realistic target based on cash flow projections and sales trends, which includes 22% aggregate growth in services (advancing 130 basis points YOY). Also, with a strong balance sheet, respectable yield and very limited downside risk, Cisco will prove to be one of 2013’s top stories. 

rsaintvilus has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Cisco Systems. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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