Cisco: Nothing to Sniff At


By Ari Bensinger The law of large numbers dictates that the bigger the company, the more difficult it is to grow sales. And in the communications-equipment industry, no company is bigger than Cisco (CSCO

; buy; recent price: $19.50). Indeed, our sales-growth estimates for 14% and 12% in fiscal years (ending July) 2004 and 2005, respectively, won't exactly knock the socks off growth-oriented investors.

We think Cisco offers investors a unique opportunity to invest in a business with dominant market share in several important communication-networking segments. Investors will be hard-pressed to find another outfit that enjoys such leading positions across so many vital technology markets. Furthermore, we believe Cisco has demonstrated its ability to maintain stellar profitability, with gross and operating margins of 70% and 30%, respectively -- some of the best ratios in the industry. Also, we think mid-teens sales expansion on a revenue base of more than $20 billion is nothing to sniff at.

SWITCHING GEARS Cisco is the preeminent equipment supplier in the $22 billion enterprise network routing and switching arenas, with roughly 70% of the overall market. It's also becoming a market leader in such high-growth segments as Internet telephony, home networking, and security. We view the outfit's economies of scale, broad product portfolio, large installed customer base, and considerable research and development resources as significant competitive advantages. Cisco's long-term growth potential will likely depend largely on the health of enterprise-technology spending. In the near term, however, we see several key growth drivers for the company.

First, there's an upgrade cycle in the $11 billion ethernet-switching market. With the last significant equipment-replacement cycle more than five years old, we believe that the giant's core switching market is set to upgrade from Fast Ethernet to Gigabit Ethernet. Cisco has become the de facto choice in the field, with a 70%-plus market share.

Although the routing segment typically gets the most press attention, Cisco's switching gear provides the majority of revenue. We view the concern's large customer base as a significant competitive advantage, especially in cases of modular switching, where it's extremely difficult for competitors to displace the large modular chassis equipment. During fiscal year 2004, Cisco's switches segment represented 48% of total sales, an 15% increase over the prior period, to $8.9 billion.

SINGLE-VENDOR MODEL. Cisco also boasts a strong position in advanced technology areas. It's focusing on six advanced technologies: Home networking, IP telephony, optical networking, security; storage area networking, and wireless technology. We believe these are clear growth engines. The overall unit is experiencing robust growth, with sales increasing 70% during fiscal year 2004. We expect this success to continue and see the division accounting for roughly 25% of total sales during fiscal year 2005.

We see the widespread proliferation of next-generation technologies like Internet telephony and home networking generating additional demand for network-switching equipment. For example, Cisco claims that every dollar of IP equipment sold pulls through three to five dollars of demand for its networking equipment. We also see the outfit benefiting from a shift to integrated products. We believe that enterprise customers are increasingly looking for a product that can offer routing and switching connectivity, security applications, and voiceover IP all in one box.

Cisco is best-positioned to offer such gear because it has the broadest product portfolio in the industry. Indeed, the business is now embedding existing routing products with extra applications, such as virtual private networks, firewalls, intrusion detection, Internet telephony, and wireless access -- features that were previously purchased separately as add-on modules.

BUYBACK PLAN. The giant 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 product 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 advanced technologies segment.

In the meantime, Cisco has been wisely using its cash to buy back stock. During the quarter ended Oct. 31, Cisco repurchased some $3 billion of its common stock, on top of $9 billion of purchases during fiscal year 2004. Since the start of its repurchase program in September, 2001, the quarterly weighted average diluted shares outstanding have decreased 9.5%. As of the end of October, Cisco had authorization to repurchase an additional $15 billion of common stock, which, based on the recent average share price, is enough to buy back roughly 10% of the outstanding shares.

We also think Cisco's valuation is attractive. The stock trades at a price-earnings multiple of 19 times our fiscal 2005 earnings-per-share estimate, slightly below the peer mean. Using our five-year earnings growth rate projection of 13%, the shares trade at a forward p-e-to-growth (PEG) ratio of 1.5, below the industry average. We believe these discounts are unwarranted. Our discounted cash flow model, which assumes a weighted average cost of capital of 11.5%, indicates an intrinsic value of more than $22. Applying a blend of relative and intrinsic analyses, our 12-month target price is $23.

CORE HOLDING. In our view, Cisco is maintaining its dominant market position in the large network routing and switching markets while successfully positioning itself in attractive subsegments. Its balance sheet is one of the industry's best, with over $20 billion in cash and no long-term debt, and we see strong cash-flow generation at an average clip of $600 million per month. We view Cisco as a core holding for investors seeking exposure to what we view as an improving networking-equipment market. We have a buy recommendation on the shares.

Risks to our recommendation and target price include a weakening network-spending environment for enterprises or service providers, slower than expected product traction in the advanced technology segments, and industry-wide predatory pricing tactics, especially from Asia-based vendors.

Note: Ari Bensinger has no stock ownership or financial interest in any of the companies in his coverage area. All of the views expressed 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. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Analyst Bensinger follows communications equipment stocks for Standard & Poor's Equity Research


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