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Get Four
|  | MAY 16, 2005
By Ari Bensinger Cisco's Growth Hits High GearThe networking giant is thriving in a rough environment thanks to its move into markets that play off its core strengths, says S&PSomeone obviously forgot to inform Cisco (CSCO ; ranked 5 STARS, or strong buy; recent price: $19) about the weakening enterprise spending market, because amid myriad negative pre-announcements from equipment vendor peers, the networking bellwether reported strong April-quarter results. Both sales and earnings were above the Street consensus. Total sales advanced 2% from the prior quarter, at the high end of prior guidance, despite a seasonally challenging quarter. During the past couple of years, Cisco has demonstrated, in our view, its ability to perform well in an intensely difficult environment, translating core strengths of manufacturing scale and efficiency into good profitability. We believe Cisco's results are even more impressive when considering its large revenue base. Quarterly sales came in at just over $6 billion, more than the budgets for some small countries. For the first time in several years, the company sold more than 2 billion products during the quarter. To put the numbers in context, it would take close competitor Juniper Networks (JNPR ; ranked 3 STARS, or hold; $24), at its current revenue run rate, nearly four years to generate the sales that Cisco posts in just one quarter. NO ONE BASKET. Blowing smoke in the face of the law of large numbers -- the larger you are, the more difficult the sales growth -- Cisco continues to post steady mid-double-digit increases. It maintained its full fiscal-year 2005 (ending July) guidance for sales growth in the middle of its stated long-term goal of 10% to 15%, which implies strong July-quarter sequential sales growth of 4% to 7%. Given its initial success with new products, increased service-provider penetration, and improved position in several advanced-technology segments, we think the full-year guidance is achievable. We believe that Cisco continues to benefit from a well-diversified product and customer base. In the first half of the fiscal year, Ethernet switching helped to offset some weakness in the routing division, which was going through a product transition phase. During the latest quarter, the reverse held true, as routers offset some weakness in enterprise switching demand. After factoring the advanced-technologies unit into the mix, which includes home networking, Internet Protocol (IP) telephony, optical networking, security, storage-area networking, and wireless technology, it's hard to find an equipment market Cisco does not have a hand in. HEALTHY MARGINS. Unlike many companies that try to stretch past their core competencies to boost their target market, Cisco, we believe, has entered into markets that play directly to its core strengths in switching and routing. Segments like security, wireless, and home networking have all become critical parts of an integrated network. It is our thesis that customers are increasingly looking for a complete enterprise product that can offer routing and switching connectivity, security applications, and voice over IP all in one box. Cisco believes that customers are better served by standardizing to a single vendor, with benefits like faster network deployment and lower operating maintenance. In addition, an integrated network typically improves performance speed, saves physical hardware space, and lowers overall product costs. We believe that this strategy is gaining customer traction, as evidenced by the strong growth experienced in the router and advanced-technologies segment. While revenue growth is important, profitability is critical, in our view. Not only does Cisco achieve profitability but it generates gross margins of 67%, well above the level of large peers like Lucent (LU ; ranked 3 STARS; $3) and Nortel (NT ; ranked 3 STARS; $3). Investors and analysts alike have waited for Cisco's gross margins to begin to deteriorate because of industry pricing pressure. However, the company's gross margins have remained resilient, aided by higher sales volume and continued component cost savings. We do not expect gross margins to vary far from the 67% level in the foreseeable future. OPTIONS PRICED IN. Since Cisco has a July fiscal year, it will begin to expense options starting in the upcoming October quarter. The company said it expects the impact of stock options in the future to be less than the current value reported in the latest 10-K and 10-Q filings. Furthermore, Cisco is seeking regulatory approval for letting the market determine the value of its employee stock options, which could potentially lessen the effect of option expensing on net income. Historically, the cumulative stock repurchases that it has made have dramatically exceeded exercises of options in the same period. We have incorporated an estimated option expense of 24 cents into our fiscal year 2006 operating EPS projection. The absolute negative impact of option expense on our estimated fiscal year 2006 operating EPS is 22%, which we think compares reasonably to Cisco's peers. The company's use of options should be considered when investing in Cisco, in our view. However, we think investors, given the level of media exposure on this issue, are well aware of the option overhang for Cisco and have largely discounted it in Cisco shares. GROWTH MARKETS. At 22 times our fiscal 2006 operating EPS of 85 cents (including 24 cents of option expense), the stock trades below its networking peers on a price-to-earnings basis. We believe that this discount reflects the company's core switching and routing business, which has a more mature growth profile than the industry average. However, we expect Cisco's sales mix to shift gradually to faster-growing market venues, as revenue from the advanced-technologies division begins to ramp up over the next couple of years. Based on our five-year earnings growth rate of 13%, the stock trades at a P/E-to-growth ratio of 1.7, below the industry average of 2.0. Our discounted cash flow model, which assumes a weighted average cost of capital of 11.9%, indicates intrinsic value over $23. Applying a blend of relative and intrinsic analyses, our 12-month target price is $23. We have a strong buy recommendation on the stock. Required Disclosures In the U.S. As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.8% of issuers with buy recommendations, 56.7% with hold recommendations and 12.5% with sell recommendations. 5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis. 4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis. 3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis. 2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain. 1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis. Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index. For All Regions: All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Additional information is available upon request. Other Disclosures This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; and in Sweden by Standard & Poor's AB ("S&P AB"). The research and analytical services performed by SPIAS, S&P LLC and S&P AB are each conducted separately from any other analytical activity of Standard & Poor's. S&P and/or one of its affiliates has performed services for and received compensation from CSCO, JNPR, LU and NT during the past 12 months. Disclaimers This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.  Analyst Bensinger follows telecommunications equipment stocks for Standard & Poor's Equity Research Services Edited by Karyn McCormack
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