Factors to Consider in Buying These Three Communication Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you are looking to get into communication stocks, there are several variables you should consider. I recommend looking at the track record with R&D against growth and then gauging whether the momentum will be enough to drive meaningful stock returns. In addition, if the company has plenty of cash, what kind of acquisitions can it make to drive revenue and cost synergies? Below, I review three stocks with these variables in mind.
A Mixed Bag for Juniper Networks (NYSE: JNPR)
At 1.3x book value, Juniper Network is getting several bullish calls on the Street. ISI Group has a "buy" rating and a $28 price target. Then, in early November, Cantor Fitzgerald upped its rating to a "buy" with a $21 price target. With forecasts for 40.5% annual EPS growth over the next five years, the communication device producer has plenty of upward potential. But will the company be successful in meeting its targets?
There are several secular predictions to be made. First, I find that the communication market will be consolidated as producers seek accretion sooner rather than later. Management has guided for no meaningful improvement in spending in the near-term. Customers are largely on the fence. The top-line for routing products is expected to fall 7% y-o-y from market share losses to Cisco (NASDAQ: CSCO), while security is expected to fall 9% from market share losses to Palo Alto Networks. With that said, the company is turning a tide. New routing products have been performing well despite a challenging networking environment; and it is now ranked #2 in the market. Third quarter results came in 4% above the high-end of revenue guidance, but margins took a hit from the costs of innovation. This active R&D expenditures, however, represents a major long-term catalyst.
Bear in mind, however, how successful the company has been with previous R&D. In the last five years, R&D has grown by 73% with acceleration between 2010 and late 2011. During the same time, free cash flow fell 48.3% with deceleration towards late 2011--precisely when the benefits from innovation should have been realized. With a free cash flow yield of just 3.6%, the stock is largely a mixed bag.
Buy Cisco, Ericsson (NASDAQ: ERIC) Instead
There are cheaper producers out there that are gaining market share. Cisco trades at a respective 12.2x and 9.1x past and forward earnings. R&D has grown 12.8% over the past five years, while free cash flow grew by 132 bps less--not nearly the kind of gap Juniper has seen. With a quick ratio of 3.3x and $45 billion in cash, Cisco has a war chest that could be used to pursue accretive takeover activity. Already the company is producing free cash flow of $10.5 billion, which amounts to an excellent yield of 10.5%. It has 31.1% upside to the Greenblatt fair value and 50.8% upside to the Graham intrinsic value calculation.
There are several catalysts that will drive Cisco higher. Indeed, management has sought to build value through acquisition. It recently purchased a software-defined networking producer, Cariden, to complements its ONE platform, which enables remote controlling hardware. The deal came in at $141 million in cash plus undisclosed incentive payments. Furthermore, the $1.2 billion purchase of Meraki will complement the cloud-based management software in better servicing servers. Meraki is an enterprise Wi-Fi equipment vendor, and it now stands to be much more competitive against its main rival, Aruba Networks--a company that fell 4.7% following the announcement. The purchase price of both companies was likely very advantageous in light of the challenged IT market, which is only forecasted to grow by 2.5% globally next year.
I also recommend backing LM Ericsson to tap into the high-growth smartphone market. At 15.2x past earnings, the tech company is way too cheap for its growth prospects. Analyst forecast 9.6% annual EPS growth over the next five years. Assuming expectations are met, 2016 EPS will come out to $0.84. At a multiple of 16x, this translates to a future stock value of $12.65. When complemented by the 4% dividend yield, this represents an average 11% return--more than enough to justify an investment.
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