Takeover Targets & Undervalued Stocks in Communications
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Innovation within communications is creating substantial opportunities for equipment producers. However, this has brought in greater competition. Some have fallen victim to these pressures and rallied beyond investor expectations. Others are already well established economically, but could do even better in penetrating secular changes through acquiring cheap competitors. Below, I highlight three companies--one of which I see as a possible takeover or breakup play.
Cisco Systems: Undervalued
Over the last 6 months, Cisco (NASDAQ: CSCO) has gained 7.8% in value. The $95.4 billion communications equipment producer generated $10.5 billion in free cash flow for the TTM ending 3Q12, or an excellent 11% yield. FCF has also risen dramatically from $4.5 billion in 3Q04--a 11.2% CAGR. It trades at a respective 12.1x and 8.7x past and forward earnings and has an excellent balance sheet. There is little net debt and a quick ratio of 3.4x. MKM Partners recently issued a "buy" rating with a $24 price target, well above the prevailing price.
Management is taking the necessary steps to unlock shareholder value. The decision to purchase Cloupia, a software developer, for $125 million was a good step towards faster-growing segments. Cloud management has a bright growth curve that will help to expand the multiple for the entire company, and the deal will be complementary for Cisco's Unified Computing System. Nexus data center switches have done well relative to the competition while systems management software has not. At the same time, meaningful steps have been taken to contain costs and thereby grow margins. Even still, the company is guiding for light 2Q13 margins.
All in all, execution has been very strong. Revenue growth of 6% in the recent quarter was strong in light of the market transition. The strong relationship with Sprint is also likely to pay dividends in light of greater support from SoftBank. And even though Europe remains a headwind, long-term service provider spending is getting better and better.
Alcatel Lucent: Takeover Target
And what about high-risk Alcatel Lucent (NYSE: ALU) and Juniper? While Alcatel sells for around half of book value, it does so for a reason: it looks like a money loser. However, when you dig into the fundamentals, you will see that free cash flow (ttm) was negative between 2007 and mid-2012, but has recently entered positive territory. In 3Q12, the company generated $770 million in free cash flow, and the company is only worth $2.3 billion.
To maximize value, management should consider selling the business or selling off assets to the highest bidder. Net debt is only $10 million, so financing a deal would not be very tough. It should consider at least selling assets to Juniper (NYSE: JNPR), which is worth $8.6 billion and is badly in need of a growth catalyst. Juniper is particularly weary about Alcatel's move in the core router market. Cisco also feels threatened. Alcatel has decided to release a family of core routers, Extensible Routing System 7950, which is a bigger package that is 5 times faster and 66% more powerful than the competition. This will receive excellent momentum from the secular transition towards cloud computing and 4G LTE networks. Accordingly, a buyout bid on an already-cheap Alcatel may substantially benefit Cisco and Juniper through revenue synergies and greater market penetration.
Juniper itself is fairly expensive. Analysts rate it a 2.7 out 5 where "5" is a "sell," and, at 14.7x forward earnings, it is expensive relative to peer levels. During the past 5 years, EPS slipped 1.6% annually. Free cash flow has also noticeably slipped from the $880 million level that was achieved around one year ago on a TTM-basis (it is $330.7 million today). A catalyst and expanded margins from reduced competition could help change this trajectory.
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