1 Communications Stock To Buy, 2 To Avoid

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

Communication businesses may all look attractive at first glance given their high dividend yields, but some are just not worth the risk. A good communications brand has strong strategic partnerships that it delivers solid free cash flow returns from; a bad communications brand (or one you want to avoid, in any event) is one that is tinkering with innovation. Below, I review 1 safe stock and 2 high-risk stocks in the industry.

Cisco's An Easy Sustainable "Buy"

As one of the most well-known brands in the communications business, Cisco (NASDAQ: CSCO) looks highly compelling at current levels. The stock trades below 16x past earnings and carries a good deal of safety in the sense that it is not going away any time soon. Partnerships with Apple and Microsoft help to further secure sustainability in an otherwise challenging market.

Consensus estimates forecast Cisco's EPS growing by 13.6% to $1.84 in 2012 and then by 7.6% and 8.1% in the following two years. At a 2013 EPS of $1.95, the stock would be worth $27.30 at a 14x multiple, which implies significant upside. In my DCF model on the business, I forecast the top-line growing by 8.7% annually over the next five years and 2.5% into perpetuity, consistent operating performance, and a discount rate of 10%. Based on these assumptions, I find that the company will generate more than $10 billion in free cash flow for 2015 and is currently worth $28.28 in present terms. In the past, management has used strong cash generation to finance share repurchases, but I believe the company should extend more in the virtualization market through takeover activity. As the dominant producer in networking, Cisco already stands to be one of the prime beneficiaries of the data consolidation and cloud computing. Still, slowing service spending on service providers will put pressure on margins unless Cisco acts to grow its market power.

Alcatel, Nokia Paint A More Rocky Ride

If you are looking for even greater upside then it makes sense to go after the riskiest businesses that are, perhaps, overly discounted due to investor uncertainty. Nokia (NYSE: NOK) and Alcatel (NYSE: ALU) are both in turnaround mode but have shown difficulty in getting back lost demand. The second half of this year, in particular, will be tough for Alcatel as it needs to have a stellar 6% EBIT margin to produce positive free cash flow. While it is certainly possible, the probability is that it will be another loss-making year given competitive pressure in CDMA.

Domestic spending on CDMA is thus likely to slow while Alcatel attempts to realize benefits from restructuring operations there.

At less than 5x forward earnings, Alcatel is a bargain basement stock. Let's think about what this multiple means: if you owned the business for just short of 5 years, you would be able to pay off the entire cost of acquiring (assuming no interest and growth forecasts are met). This would then leave you with a side business to produce passive income. Owning a portion of the business is ultimately the same, so there is obvious upside. However, after poor 1Q12 performance and deleterious margin declines, shareholder value is likely to continue to plummet.

Nokia similarly will struggle to stay alive in a challenging environment. Analysts forecast the company actually losing $0.19 per share in 2012 and only turning into positive territory of $0.14 in 2013. It would take a significant multiple for the stock price to gain value in future terms. With a BB+ debt rating, creditors have shown to be uncertain about the firm's future. Even a partnership with Microsoft in the Windows Phone has generated weaker-than-expected business. Accordingly, I recommend avoiding the stock until greater visibility emerges.

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