Buy Cisco, But Be Weary of These 2 Sector Peers

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

Given how intense the competition has been in telecom, it should not be surprising to see increased takeover activity over the next few years. In order to take advantage of attractive multiples from a depressed macro period, companies will be on the hunt for targets; that's why I recommend backing the suppliers, namely communication equipment producers, that will benefit from this M&A environment. This bet, of course, should be made alongside bets in stable, high income-yielding producers.

Cisco (NASDAQ: CSCO) Undervalued Fundamentally And Based On Multiples

Though shares have risen more than 20% from the late-July low, Cisco is a fairly compelling stock at a respective 12.4x and 8.8x past and forward earnings. However, it also has the fundamentals. Equipped with an impressive quick ratio of 3.4x and $48.7 billion in cash, the firm has plenty of capital for takeover activity or reinvestments. I recommend backing the company as it expands and gains market power. It also helps that the company is now a large income generator with its double-digit dividend hike to 3%.

Management has also committed itself to returning half of its free cash flow back to shareholders. While margins have been on the decline since the first quarter, earnings are forecasted to grow by 8.7% annually over the next 5 years. In fact, all of the last 5 quarters have beaten analyst expectations (on average, actual EPS was 8.3% ahead of consensus).

One area that the company may expand into is satellite networks. Cisco recently partnered with Immarsat to offer video, cloud, and Internet capabilities via satellite. Should the company diversify in more segments away from the core IP-based networking in mainstream connections, I believe it will attract not only high-growth investors, but also risk-averse ones too.

Alcatel-Lucent (NYSE: ALU) Would Benefit From A Sprint (NYSE: S) -SoftBank Combination, But There's Too Much Doubt

Alcatel trades quite cheaply at 12.5x past earnings and 0.5x book value, given that it has just started to turn around with EPS of $0.08 over the twelve trailing months. But analysts still have reason to give the $2.3 billion company a rating of 3.3 out of 5 (where "5" is a "sell"). Operations have floundered, but I am optimistic about the potential gain from greater spending on Sprint's 4G LTE network, of which Alcatel is a prime builder.

In light of the firm's ability to turn around,  Japanese carrier SoftBank acquired a 70% stake in the business to help. With Verizon and AT&T leading a virtual duopoly on the smartphone market, a Softbank-Sprint full combination would add a fair amount of competition to the sector, and thus most likely be justifiable to anti-trust regulators. If SoftBank takes over Sprint, the resulting company will have plenty of capital to spend on catching up to Verizon and AT&T in 4G LTE. That means that Alcatel would see a nice stream of free cash flow to dissipate concerns over bankruptcy from a double dip.

While I believe that there is a lot of uncertainty surrounding Alcatel, risk often pays off. And I believe it has a good chance of paying off thanks to the degree of M&A activity that is being anticipated in telecom. After going through ups and downs with  a beta of 2.3, the stock has been overly beaten down. With that said, I encourage investing alongside a safer and cheap stock that offers a shareholder-friendly capital allocation policy, like Cisco.

Foolish Bottom Line

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TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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