Cisco Systems (NASDAQ:CSCO) went down 7% after the latest earnings call on August 14. Considering that Cisco's latest quarter was pretty solid, with revenue rising 6.2% year-over-year and GAAP earnings per share increasing to $0.42 for the quarter, up from $0.36 in the same period last year, could this be market overreaction? More importantly, does the current negative market sentiment represent an excellent entry point for investors or is it the beginning of a bearish year?
Explaining the latest quarter and the weak forecast
Cisco stated at the beginning of the fiscal year that it aimed for a 5%-7% revenue growth rate. This was achieved in the fourth quarter, with revenue growing 6.2% year over year to $12.4 billion. Product revenue grew 6.4%, the fastest growth rate in the last six quarters.
Cisco's main businesses, routers and switches, grew just 3%. These are, after all, mature businesses. The remainder of Cisco's portfolio grew 11% according to Morningstar. The Data Center business grew an amazing 43%.
These results were strong enough to beat analyst estimates. However, probably because CEO John Chambers guided for 3%-5% revenue growth next quarter, the stock plummeted.
Source: Cisco Investors Relations, Presentation slides
However, there's an explanation for the moderate forecast. The business will account for a slow and consistent recovery of the global IT demand.
Also, Cisco's portfolio transition isn't over yet. In the short run, the negative effect of decreasing growth rates coming from core businesses is expected to offset the positive effect of increasing growth rates coming from new segments. Also, bear in mind that this is the beginning of a new fiscal year, and the first quarter is always challenging. That's why setting up a conservative short-term growth rate looks very responsible.
The upside is that in the long run, Cisco's forecast remains optimistic. The company expects revenue growth through calendar year 2017 in the 5% to 7% range. And in theory, the Data Center business could become the main revenue component in the next decade, adding more speed to growth.
The fact that the long run business forecast remains intact shows that the firm probably has not experienced any fundamental change in its competitive position.
Cisco's real value
Without taking into consideration the figures of the latest earnings calls, I ran a discounted cash flow valuation using Oldschoolvalue financial spreadsheets under the following assumptions: a 10% growth rate for the next 10 years (believe it or not, the past 10 year average growth rate is about 10%), a 12% discount rate, and a terminal growth rate of 3%.
With a net cash position of approximately $5.75 per share, Cisco's balance sheet shows very small default risk. That could be seen as a reason to use a lower discount rate. But I am using a relatively higher discount rate to explicitly decrease the margin of safety, because Cisco's a big industry leader. Notice that Buffett is said to use a 15% discount rate when buying big companies.
I obtained a fair value estimate of $33.82 per share, well above the current price of $24 per share. Because an average 10% growth rate for the next decade was assumed, the fair-value estimate is above Morningstar's estimate ($26) and the Street estimate. According to Yahoo! Finance, Cisco's average sell-side price target is $28 per share.
However, this value is consistent with the strong balance sheet of the company. Cisco ended the fourth quarter with $50.6 billion in cash and only $16.2 billion in debt. Management is using the cash to make strategic acquisitions in order to fuel growth. It is also increasing the dividends to shareholders and keeping share repurchases active. The stock yields ~2.8% at a 37% payout ratio.
Why Cisco shouldn't be afraid of competitors
Cisco's business portfolio has exposure to many segments, from core businesses that include modular switches and IP phones to new investments in technology that will deliver integrated solutions for mobile carriers and data centers. The upside is that even if Cisco's hardware becomes outdated, new technology could offset any negative effect on revenue.
The downside is that Cisco has to deal with a vast amount of competitors. One example is Alcatel-Lucent SA (UNKNOWN:ALU.DL). The company owns Bell Labs, one of the best R&D houses in the communications industry, with more than 29,000 patents.
Furthermore, according to the second quarter earnings presentation, the company experienced a 9% growth rate in network solutions, well above Cisco. With $19 billion in revenue per year, considering that the current market cap stands at $6 billion, Alcatel's low price/sales ratio of 0.3 could seem way more attractive than Cisco's 3.0 ratio.
Luckily for Cisco, Alcatel's margins of 1.79% are well below Cisco's outstanding 22% profitability. Alcatel is in the loss zone but its traditional strong research muscle and recent sales in China (the company expects to launch more than 200,000 LTE active base stations through China Mobile) should not be underestimated.
Owner of one of the most powerful network automation tools for data center operations, competitor Juniper Networks (NYSE:JNPR) should also be watched closely. Continuous improvements in its networks solutions caused revenue to jump 7.2% from the second quarter of 2012, as reported in the second quarter earnings for this fiscal year. The combined switch and router product revenue growth was 14% year over year, well above Cisco.
However, its network security product revenue declined 20% to $126 million. Clearly, Cisco's recent acquisition of cyber-security company Sourcefire for $2.7 billion won't make things easier for Juniper in this segment, as Sourcefire latest figures showed its revenue increased 35% year-over-year, probably at the expense of Juniper.
Finally, with a much higher price-to-earnings ratio than Cisco, Juniper will need to show the market it can grow fast enough to hold its market valuation. Such market pressure will be hard to deal if Cisco keeps acquiring early stars.
Final foolish thoughts
The latest earnings call showed solid results. Cisco's fundamentals remain strong. However, the market decided to pay more attention to the short-term moderate forecast. Here, it's important to remember that the recent forecast was weak not because fundamentals have changed, but because it accounts for a global contraction in demand for IT solutions and the current portfolio mix transition that Cisco is experiencing.
Cisco's long-run value remains intact. With one of the lowest price-to-earnings ratio in the industry, a strong balance sheet and safe growth rates for the next years, the current negative sentiment should be seen as nothing else but a great entry point.