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Which stocks are looking fine in ’09? Discover all our Foolish ideas for The Best Stocks for 2009.
Sure, Cisco Systems (Nasdaq: CSCO ) may not provide the market's single highest return in 2009. But despite the hurdles the networking stalwart faces in the year ahead, it's strong enough to rise closer to the top than many of its thousands of fellow stocks.
Here comes the credit crunch
With the U.S. economy in recession, we should expect all sectors to reduce their technology budgets accordingly. Furthermore, the banking sector, which is at the heart of the current crisis, is a massive customer for technology infrastructure and services.
Bankruptcies and mergers involving prominent broker-dealers and banks -- such as Bank of America (NYSE: BAC ) absorbing Merrill Lynch, JPMorgan Chase (NYSE: JPM ) swallowing Washington Mutual, or Wells Fargo (NYSE: WFC ) acquiring Wachovia -- will necessarily lead to smaller technology budgets, as the merged companies try to slim down their costs. The Tabb Group, a financial-markets consultancy, expects finance-industry technology spending to shrink by 20% to $17.6 billion in 2009, from an estimated $21.9 billion in 2008.
So if things seem that dire, why even look at Cisco to begin with? Valuation, balance sheet, and profitability -- in that order.
On Wednesday, Cisco shares closed at $16.84, less than 13 times trailing-12-month earnings. That's substantially below Cisco's previous low multiple for the past 15 years: 19.44, which the stock hit during the credit crisis' infancy in August 2006. Using the lowest analyst estimate for the current fiscal year, which ends July 2009, the stock is changing hands at only about 13 times forward earnings, too.
Another way to look at the valuation is to invert the earnings multiple. Cisco's free cash flow yield to equity investors (how much cash flow it generates as a percentage of its stock price) on a trailing-12-month basis is 6.9%.
At first glance, that seems a bit too similar to the 6.91% average yield on the Bloomberg US Investment Grade Corporate Bond Index. But keep in mind that Cisco's earnings per share are expected to grow at an annualized rate of 11.5% over the next five years. While bond returns are nominal returns, and thus prey to potential inflation, Cisco's free cash flow yield is like a turbocharged real return, better prepared to battle the effects of a weakening dollar.
Cisco's debt-to-equity ratio is less than 20%, and its cash and short-term investments of $26.8 billion dwarf its $6.9 billion in total debt. Cisco has a fortress of a balance sheet -- exactly what investors should be looking for in a credit climate like this one. In addition to giving the company much-needed flexibility, this fiscal strength is also a competitive advantage. In a precarious economic environment, companies prefer to do business with financially sound suppliers.
Return on assets greater than 10%? Check. Free cash flow margins in the mid-to-high teens? Check. Cisco is so solidly profitable that its numbers would make most chief financial officers weep with envy. Will the recession and credit crisis hurt Cisco's profitability in the immediate future? I'd expect so. If capacity exceeds the reduced demand for networking products, prices should fall.
However, over the medium-to-long-term, that should be a greater concern for less dominant firms. Cisco could very well emerge from crisis relatively stronger than when it entered.
It's your turn
Further Foolish tech talk: