Thursday, February 12, 2009

The Bargin Bin: Cisco Systems

Times have surely changed, if we can ask the questions, “Is Cisco Systems CSCO in the bargain bin?” “Is Cisco now a 'value” stock?” Is it a “value” trap?

Sales for the most recent quarter (MRQ) vs the quarter one ago are down from $9,831 billion to $9,089 billion or 7.5%. Sales, on a trailing twelve month (TTM) basis, are up about 5.2%. Standard and Poors projects a sales decrease of 9% in FY 09 reflecting the weak global economy.

Similarly, EPS for the quarter ending January 09 were down to $0.25 from $0.33 a year ealier. This represents a 23% decline. EPS (TTM) vs TTM one year ago are down 2.9%. S&P forecasts FY 09 EPS of $1.15. First Call reports consensus estimates of $1.25 for FY 09 with a range of $1.18 to $1.33.

Of greater concern to us, is margin contraction. Gross margins have been contracting since 2004 when GM stood at 68.6%. S&P forecasts FY 09 gross margins of 64%. Operating profit margins have also contracted. Reported FY 04 operating profit margins were 28.5%. For the TTM, operating profit margins contracted to 22.3%. On the plus side, net margins have held fairly steady at 20%.

Cisco's balance sheet is strong. It has about $5.04 in cash per share on hand and generates $2.03 in free cash flow. Long term debt to equity is about 0.17 and total debt to equity is about 0.19. The current ratio is a healthy 2.79.
Return on equity is a respectable 23.8% and ROA is 14%. These are very solid numbers and compare very favorably with industry averages.

Standard and Poors has given CSCO a twelve month price target of $16.00. First Call reports a mean price target of $19.20 with a range of $13 to $33. Price targets were lowered 14 times in the past four weeks.

Value staocks are most often defined in terms of low P/E or low P/BV ratios. Cisco is trading at 13X trailing earnings and in-line with the S&P 500. Its P/BV is 2.55; not low. In a recent post, I wrote about the use of the Price/Sales ratio. In this case, the PSR is no bargain at 2.4X.

Our preference is to use a less common measure to determine value; the Price/Free Cash Flow ratio. We think FCF is a better metric to use than earnings. Free cash flow can be used to fund growth (organic and through acquisition), reduce debt, pay a dividend or repurchase debt. Free cash provides value to the shareholder, if it is wisely invested.

Cisco has a current P/FCF ratio of 10X. A year ago, it was 16X. The five year average P/FCF for CSCO is 19X. Going back a few more years, the seven year average is 22X.

Cisco reported $1.72 in free cash flow for the TTM ending January 09. Over the next twelve months, we project CSCO to generate $1.96 in free cash. At current prices, the forward P/FCF is about 8.25X. Our target value for CSCO is $28.96, representing a forward P/FCF of about 14.8X. This is less than year-ago levels and reflects continuing weakness in the global economy.

Disclosure: I hold a long position in CSCO.
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