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Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours. (More...)
Summary
- 2014 ended well for Cisco shares.
- Positive demand trends for Nexus 9K.
- SDN concerns over-exaggerated.
- My Levered Returns model illustrates a fair value estimate of approximately $38 – a 35% premium to CSCO’s January 12th closing price.
Overview
Cisco (NASDAQ:CSCO) shares performed well in 2014, growing 21%, despite a year-on-year decline in company revenues. Add the 2.8% dividend yield on top of that, which acts as a sweetener. There may in fact be further upsides for 2015, which may come about by way of higher gross margins as well as subsiding SDN concerns which have acted as a drag on the stock price for some time. In addition, the rising inter-cloud division may add further value going forward. In view of these factors, I have used my Levered Returnsmodel to calculate the fair value of Cisco's stock and found that it is trading at a significant discount as of its January 12th closing price.
Growing Gross Margins to Impact MultiplesFor Cisco, gross margins have an impact on multiples, and this is what has resulted in the stock price re-rating over the course of 2014. Management's effort to keep gross margins in the 61-62% range has helped grow earnings that has resulted in multiple expansion (PE multiple from a recent low of 8x to 12x). Amid a competitive environment, Cisco is re-thinking its products and streamlining the supply chain which has helped improve margins. Finally, a higher software component in the revenue mix may enable the company to hold the current gross margin level of 62-63% for the foreseeable future.
Nexus 9K will Help Augment RevenuesApart from growth in gross margins, revenue traction could come from the Nexus 9k, which is seeing robust demand trends. According to this article, Cisco is expected to announce its 1,000th Nexus customer at the Cisco Global Editors Conference in San Jose. The company will likely be able to see revenue growth in its switching segment in 2015, which saw a decline in 2014. In addition, the company's routers experienced stable demand while services will continue to augment revenues.
SDN Threat Over-ExaggeratedThe SDN threat for Cisco has been playing for some time, acting as a catalyst dragging down the stock price. However, while storage vendors are more prone under this technology via price deflation and virtualization, it is a different ballgame for networks as it is not easy to dis-intermediate them. It appears that the same trends that are devastating storage vendors will take at least 5-10 years to have any detrimental effect on networking. Significant comfort may also be derived from Cisco's FY 15' Q1 conference call, in which John Chambers said it was apparently "game over" in the company's war against SDN. Hence it may be assumed that for now at least, the SDN threat is over-exaggerated.
Levered Returns Valuation ModelIn spite of the numerous growth angles listed above, I'm assuming a modest revenue growth rate of 3%-2% for the next five years. I use a long-term EBITDA margin of 30%, slightly higher than the 27.3% achieved in FY 2014. I believe this is conservative given management's resolve to keep gross margins in focus.
Despite a decline in revenue for FY 14', things appear to be changing for Cisco, especially in view of Nexus 9k's strong numbers. Moreover, it appears the SDN threat is over-exaggerated, as it will take at least 5-10 years before the technology eventually begins to eat into networking. With growing service revenue as well as management's focus on maintaining or even improving gross margins Cisco is a great investment at current prices.
Source: Cisco Significantly Undervalued
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