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Rising Star Buy: Cisco Systems

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This article is part of our Rising Star portfolio series.

Normally in my Rising Star, real-money Motley Fool portfolio, I try to buy stocks that I feel will benefit from some sort of macroeconomic or global trend. I buy steel manufacturers, oil drillers, and water solution providers.

However, last month I bought a stake in Google -- going outside of my comfort zone a bit because I thought the valuation was just too good to be true.

This month I'm doing the same, as I've decided to purchase shares of Cisco Systems (Nasdaq: CSCO  ) -- the $82 billion company that's trading about 42% off its 52-week high.

Let's clear the air
Before I get into the reasons why I'm buying Cisco, let's just get this out of the way: Yes, there are many, many risks with this purchase, and there is no shortage of articles thrashing Cisco's recent earnings and letting you know why this company is in major trouble. So in order to not just regurgitate every other talking head who currently hates Cisco, I'm just going to quickly lay out the major risks facing the company right now:

  1. Cisco's recent earnings report shows several signs of fragility. Gross margins fell by 1.5 percentage points year over year, and net income plummeted by 17.6% from 2010. These were disappointing figures that resulted from a more competitive landscape, necessary sales discounts, and restructuring associated with their consumer business.
  2. Switches, which comprise a lion's share of Cisco's revenues, have seen increased competition. Hewlett-Packard (NYSE: HPQ  ) has become more aggressive in the space, and Cisco is losing ground to others such as Juniper (NYSE: JNPR  ) and Brocade (Nasdaq: BRCD  ) .
  3. The same can be said for the router market. Although Cisco still leads in market share, it's seeing that number shrink. Customers are buying down as companies like Huawei shoot for lower-end gear.
  4. Cisco has been too slow to take advantage of other key areas of networking growth such as WAN optimization, application delivery controllers, and session border controllers. Companies such as F5 Network (Nasdaq: FFIV  ) , Riverbed Technology (Nasdaq: RVBD  ) , and Acme Packet (Nasdaq: APKT  ) are taking share where Cisco should have been at the forefront of innovation and customer delivery.

So what's the good news?
The good news is that (a) management realizes its follies over the past few years, and (b) the market is pricing Cisco for total catastrophe.

Yes, Cisco took its eye off the ball, delving into consumer markets and letting small upstarts get in the game where it should have never occurred. But beginning with the company killing the Flip video recorder and ending with it assessing its core video technology, Cisco seems to be acknowledging its mistakes.

In its recent quarterly report, management asserted that it will "divest or exit underperforming operations" and promises to refocus on its core businesses: routing, switching, and other services (cloud, virtualization, and mobility solutions).

Furthermore, Cisco is still the gold standard and the go-to when it comes to overall enterprise solutions. IT departments are typically risk-averse, and they've been using Cisco's products for years, so customer switching costs still remain high. And being the biggest kid on the block gives Cisco scale advantages that others can't compete with, including massive sales forces and pricing power.

Lastly, this valuation is beyond a screaming cheap buy. The company is trading for a P/E of 11.7, while its five-year average is closer to 21. Cisco churns out gobs of free cash flow every year, and currently it's trading for an EV/FCF ratio of 6.1. That's just plain ridiculous.

Currently, the stock is hovering around the $15 range, and with $26.6 billion in net cash, that means that about one-third of the stock price is pure cash. For a company with such a historically wide moat, a great brand name, and dominating market share in several key areas, the downside seems very limited while the upside could be 30%-50%.

The Foolish bottom line
Management has already stated that gross margins might decline in the near future and that net income will remain relatively flat next quarter. The bad news seemed to be baked in to today's share price. If management can truly redirect its focus on its bread-and-butter operations and avoid making silly acquisitions, then there's a real reason to be a believer in Cisco. In the meantime, you can sit back and enjoy the 1.6% dividend (with plenty of room for growth) and the potential for further share buybacks.

This article is part of our Rising Star portfolio series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Jordan DiPietro owns no shares of the companies mentioned above. The Fool has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Riverbed Technology, Acme Packet, and Cisco Systems. Motley Fool newsletter services have recommended shorting Juniper Networks. 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.

Read/Post Comments (5) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2011, at 3:27 PM, mracz425 wrote:

    Good Buy.

  • Report this Comment On June 21, 2011, at 4:10 PM, kutani123 wrote:

    Probably a bit early but good move anyway..

    I want to see how Cisco early retirements program goes (ping insider as this week for sign paper work and last day is July 8), what the lay-off number and future strategy will be announced by Chambers, ping insider, as probably July 1st.

    I personally want a big numbers of lay-off, lot of useless, incompetent layers of management (NOT engineers) and especially 6,7 Indian layer of management, dump entire consumers business, drop many many junk, garbage projects which wasted money, resource and will NEVER be number 1,2 player in the market or hit $1b as expected by Chambers

    I hope Chamber will bite a bullet and do the right thing as he has his last chance of his career DO or DIE as well as save Cisco, re-built credibility with its investors and its employee.

    Else it'll be looooong time for cisco to recover hence spend $$ somewhere else as it's NOT WORTH to buy CSCO.

  • Report this Comment On June 21, 2011, at 5:17 PM, plvo38 wrote:

    csco - great buy , great value

  • Report this Comment On June 21, 2011, at 5:18 PM, srivatsan123 wrote:

    Letting go only engineers is usually a bad option. The problem is deep inside the hierarchy. Loads and loads of flab in terms of VPs, Directors (no responsibility, accountability). Once time comes they'll let go engineers and happily keep do the same thing. For CSCO to recover and flourish again this has to stop. What the company needs is a simpler, more transparent and accountable structure.

  • Report this Comment On June 21, 2011, at 5:29 PM, cisco2035 wrote:

    We've been covering Cisco in the future through the year 2035. Stock price? Not bad. Not good. Just typical. No surprises here.

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