No love for Cisco after weak forecast

The turnaround story deserves more respect now that the company has surpassed expectations for four quarters.

By TheStreet Staff May 10, 2012 12:46PM

By Richard Saintvilus

 

It amazes me that Wall Street still does not fully appreciate the turnaround story that is networking giant Cisco (CSCO). Even more disappointing, many analysts do not really seek to understand, but instead carry on the notion that they've got it all figured out.

 

I will concede that Cisco has indeed made more than its shares of mistakes -- some of which have allowed newcomers like F5 (FFIV) and Riverbed (RVBD) to encroach on its territory and steal some market share. For this, it is clear that Wall Street still carries a grudge. But leading into the company's fiscal third-quarter results and coming on the heels of three consecutive earnings beats, I was optimistic in thinking that it was time to let bygones be bygones. Investors had different ideas.

 
Cisco continues to be treated by investors as if it were priced to perfection. Case in point, on Wednesday the company reported third-quarter earnings results of 48 cents per share -- topping analysts' estimates of 47 cents. This number represented an increase of 14% from the 42 cents it earned in previous year.

 

The company reported net income of $2.2 billion or 40 cents per share on revenue of $11.6 billion -- topping net income of $1.8 billion or 33 cents per share for the same period last year. According to estimates, analysts had expected $11.58 billion in revenue. The major concerns for Cisco have always been its ability to execute effectively in the face of economic weakness.

 

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For me, the report served to alleviate these worries as the company demonstrated it is moving in the right direction. But the market saw things a bit differently.

 

While dismissing the company's current performance, investors latched on to its guidance. The company said that fourth-quarter earnings expectations were going to arrive in the range of 44 cents to 46 cents per share on revenue growth of 2.5%.

 

Far from terrible, the estimates are slightly below analysts' projections of 49 cents per share and 7% growth in revenue. As a result, the stock was punished to the tune of an 8% drop in after-hours trading. This is an overreaction to a string of performances that have been absolutely solid.

 

As an investor I have to appreciate that the company's conservative approach to guidance is absolutely the best play right here for a stock that is highly exposed to the uncertainties of Europe. From that standpoint, management has gotten it right.

 

What continues to be a disappointment is the finicky reaction from investors who are quick to dismiss Cisco's strong fundamental standing and market lead -- one where it continues to outperform in some of the largest areas over its top rivals in Hewlett-Packard (HPQ) and Juniper (JNPR).

 

Cisco still owns over 60% share in the all-important switching business and over 50% in routing. There isn't another competitor that comes close. Granted it is clear that from the earnings report that those businesses are no longer growing as investors would like but, as I have said recently, this area of Cisco's business is just about to heat up. A recent study suggests that bandwidth for increased data will soon come at a premium and there will be no other company better positioned to capitalize on that growth than Cisco.

 

Having said that, I will admit the company does have some important areas of its business that it needs to fix -- areas such as data center fabric switching where it has lagged behind Brocade (BRCD) or key growth areas like WAN optimization, where both F5 and Riverbed fare moderately better.

 
Bottom Line: While Wall Street still tries to figure out whether or not Cisco is a value play or a value trap, investors need to focus on the reality that (for a tech company) the stock is now trading with minimal expectations. For that matter, I continue to maintain my near-term target of $30 and my three-year target of $60. Even on the most conservative assumptions the stock would be fairly valued at $28 when factored in its cash on the balance sheet with 4% FCF growth annually. Investors would be wise to add Cisco as it just might become the most undervalued stock on the market.
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