Cisco Is Still Undervalued Despite Year End Rally

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Having had a roller-coaster ride in 2012 as macroeconomic uncertainty surrounding the Eurozone crisis took a heavy toll on network spending, Cisco ( CSCO ) seems prepared for a much better 2013. Not only are its restructuring initiatives taking hold, but things are also looking brighter on the U.S. front. While Europe accounts for close to 20% of Cisco's revenues and remains a worry, we believe that a sustained, strong showing from the U.S. which is a much bigger revenue contributor as well as healthy growth in emerging markets will help more than offset the losses sustained on the European front.

In line with our long-term view of the company, Cisco's stock has risen more than 20% since it announced a solid set of Q1 FY 2013 results in November. Despite rallying 20% since its November lows, we still believe that the company is being undervalued at these levels and see far more value in the stock coming from Cisco's renewed focus on its networking division. The networking giant has of late tried to scale back its ambitions to diversify into 30 new businesses and instead focus on those areas that add value to its core routing and switching businesses. As a result, it has restructured its operations and cut jobs in areas that are not its core focus, making the organization leaner and more efficient.

See our full analysis on Cisco

We believe the company is going in the right direction since the moves not only allow it to innovate faster but also streamline its businesses around its core networking products that contribute almost 40% to our estimated $26.50 fair value for Cisco , with cash contributing another 20%. At the same time, it helps Cisco benefit more from the long-term growth trends of data demand and cloud computing which continue to remain sharp. Our price estimate is about 30% ahead of the current market price.

Margins stabilizing

The cost cutting and restructuring initiatives are slowly paying off as the company has managed to gain market share in its core networking areas (routers and switches) and is also seeing its operating margins stabilize at >20% levels, after having fluctuated widely in the recent past. This increases confidence in the management's guidance of achieving a long-term operating margin in the mid-20s and increasing profits at a faster pace than revenues. Cisco has realized almost all of the expected $1.1 billion in severance charges related to the workforce reduction program it had announced in July 2011, and the operating margins should remain fairly stable hereon. With savings achieved on the operating side, Cisco will be able to make aggressive price cuts to compete better with low-cost rivals such as Huawei and gain even more market share.

Fundamentals drive Cisco's future earnings

As for top-line growth, we believe Cisco's fundamentals remain solid due to the ongoing transition from wired to wireless networks, the burgeoning usage of data on both mobile and wired networks as well as a strong demand for cloud-computing routing solutions on the enterprise side. The company recently debuted its virtual cloud-routing and WAN optimization platform under the Cisco Cloud Connected Solution brand to enable businesses that are increasingly looking to move their applications to the cloud at a low cost. (see Cisco's Worth $23 On Cloud Foray And Enterprise Strength ) Its recent move to acquire NDS Corp was made to drive device-agnostic video consumption and increase the demand for its routers and switches among service providers that are looking to monetize the booming data demand. (see Cisco's NDS Acquisition Taps Video Demand To Boost Network Equipment Business)

Cisco has also announced the acquisition of Meraki, a smaller networking firm that provides multiple cloud-based services to small and mid-sized companies. The acquisition gives Cisco a big opportunity to tap into the fast growing mid-market segment as well as use Meraki's product line to create a compelling cloud-based platform for bigger customers down the road. While Meraki's primary product continues to be WLAN gear, it has diversified its cloud-based portfolio to include switching, security and mobile device management services as well. With businesses increasingly looking to move to the cloud and networks becoming more software and cloud-focused, Cisco's move will help it address changing trends and compete better with fast-growing rivals such as Aruba Networks. (see Cisco Buys Meraki: Bets On A Cloud-Based Networking Future)

Additionally, the U.S.' return to strength in recent quarters is a big boost for Cisco, since almost 60% of its revenues come from the region. Last quarter, Cisco's revenues from enterprises and service providers in the U.S. saw a strong y-o-y growth of 9% and 13% respectively. Moreover, with wireless carriers such as AT&T recently announcing almost $14 billion in network spending over the next three years and Sprint building out its LTE network aggressively, emboldened by the recent Softbank deal, Cisco's revenues from the U.S. could see a nice boost in the coming years.

Overall, we believe that Cisco has executed well on its turnaround plans so far and is well-positioned with its new-found focus to gain even higher ground going forward. (see Cisco Shares Deeply Undervalued As U.S. Spending Returns And Margins Stabilize) The company's dominant market position as well as aggressive price cuts have helped it gain market share from rivals Juniper and Alcatel-Lucent in an uncertain economic environment so far, and could help it even further when the concerns subside.  However, Alcatel Lucent's recent foray into core routers poses a downside risk for Cisco as the former enjoys #2 position in edge routers - a position of strength that  it can effectively leverage to provide an end-to-end solution to its customers.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: ALU , CSCO , JNPR , SAP

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