Shares of networking giant Cisco Systems (NASDAQ:CSCO) rose last week when the company beat both revenue and earnings estimates. Stronger-than-expected guidance and product orders point toward a return to growth in the coming quarters. While there are certainly long-term threats to Cisco's business, the stock has been chronically undervalued for quite some time, especially given the company's dominant market share. Cisco is worth at least $30 per share, and here's why.
Demand for Cisco products is getting stronger
While quarterly product revenue declined by 7.7%, year over year, product orders were essentially flat. This suggests that product revenue in the coming quarters is set to recover, and the guidance for a total revenue decline of between 1%-3% next quarter bears this out. Total revenue has been declining in the high single-digits for the past couple of quarters, so this guidance is a marked improvement over the company's recent performance.
Product orders in the U.S. grew by 7%, with northern Europe growing by 4%. This partially made up for continued declines in emerging markets. Demand for Cisco's products in developed markets, along with the quarterly gross margin beating previous guidance, suggests that demand remains strong, with the exception of emerging markets.
Cisco recently launched a new line of switches that includes Cisco's take on software-defined networking, viewed as a threat to Cisco's core business. CEO John Chambers sounded genuinely excited about how quickly this new product, the Nexus 9000, was growing. He singled out competitor VMWare (NYSE:VMW) as a company that Cisco is taking back market share from with its SDN platform. VMWare launched its own SDN platform late last year, and while it has been gaining some traction, Chambers showed confidence that Cisco will lure those customers back:
The momentum feels very, very good on it and I think you'll just see us knock them off one after the other.
The switch to SDN will take many years, and Cisco is positioning itself to be the leader.
Trouble in emerging markets
There is one very big problem with Cisco's business, though, and it has nothing to do with the company itself. A recent report suggests that the National Security Agency has been intercepting shipments of Cisco gear, planting surveillance tools within the products, and then repackaging and sending the shipments to the end customers.
While this likely won't affect sales in the United States, especially given that Chinese networking equipment is suspected of being bugged as well, sales in emerging markets are severely threatened. Cisco's weakness in emerging markets as of late has been at least partly due to the NSA spying scandal, and this latest news certainly doesn't help. Chambers penned a letter to President Obama after the story broke stating that U.S. technology sales could be negatively affected due to the loss of trust brought on by the NSA's activities.
The case for at least $30 per share
While the NSA issues threaten Cisco's overseas business, the company remains the dominant leader in the networking market. Shares of Cisco trade for around $24 per share after the post-earnings rise, and with non-GAAP earnings expected to be around $2 per share for the full year, this puts the P/E ratio at around 12.
But Cisco is sitting on tens of billions of dollars in cash, and backing this cash out drives the true P/E ratio lower. Cisco has a net cash position of $29.6 billion, comprised of $50.5 billion in cash and investments and $20.9 billion in debt. This net cash works out to about $5.70 per share, and backing this out puts the true P/E ratio closer to 9.
A company like Cisco, with a dominant market share and serious competitive advantages, should not be trading at a cash-adjusted P/E ratio of 9. A cash-adjusted P/E ratio of 12 leads to a fair value of $30 per share, and 15 leads to $36 per share. Even without much real earnings growth, Cisco can drive EPS growth using share buybacks. It makes little sense for Cisco to be trading at such a rock-bottom valuation.
The bottom line
Cisco is one of the best values in tech, and all of the pessimism surrounding emerging markets and SDN has kept the stock from reaching its true potential. Cisco has managed to keep the effects of emerging-market weakness on earnings minimal so far, with cost cutting and share buybacks helping the cause. It's hard to say to what degree this new NSA scandal will affect Cisco, but so far Cisco has been able to weather the storm. SDN is still many years away from going mainstream, and Cisco is positioning itself to take advantage of that shift instead of falling victim to it. The threats to Cisco's business, while very real, are creating an opportunity for investors.
Cisco will profit from this trillion dollar revolution. Will you?
Let's face it, every investor wants to get in on revolutionary ideas before they hit it big. Like buying PC-maker Dell in the late 1980s, before the consumer computing boom. Or purchasing stock in e-commerce pioneer Amazon.com in the late 1990s, when it was nothing more than an upstart online bookstore. The problem is, most investors don't understand the key to investing in hyper-growth markets. The real trick is to find a small-cap "pure-play" and then watch as it grows in EXPLOSIVE lockstep with its industry. Our expert team of equity analysts has identified one stock that's poised to produce rocket-ship returns with the next $14.4 TRILLION industry. Click here to get the full story in this eye-opening report.
Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems and VMware. The Motley Fool owns shares of VMware. 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.