Why Cisco’s Drop Today Means it’s a Screaming Buy

If I were to reverse engineer the ideal company to invest in, it would be one that is a leader in its industry, operates in a fast-growing market, has a globally diversified revenue stream that emphasizes emerging economies, has a strong balance sheet with no debt, boasts high profit margins and double-digit returns on invested capital.

Sounds like an investor’s dream, doesn’t it? But wait, it gets better…
Cisco Systems (Nasdaq: CSCO) nearly owns the market for communications equipment. The tech titan just completed a year in which global sales grew +11% in a very challenging economic environment, reported +35% growth in emerging markets, has a net cash hoard of $28 billion, logged a net profit margin of 19.4% and returns on invested capital (ROIC) of 16%. (If you remove excess cash from the equation, ROIC is even higher).

Yet for some reason the market knocked the shares down more than -9% in Thursday trading, as fourth quarter sales came in a bit lighter than analysts expected. There were also grumblings that gross margins ticked down a bit. This combined with a more subdued tone on the state of the technology industry resulted in a wave of broker downgrades, and that likely sent momentum investors running for the hills.

Cisco’s fiscal year ended on July 31st, and total sales reached $40.0 billion as product sales grew +11% to $32.4 billion, while lucrative service revenue improved +9.0% to $7.6 billion. Net income also jumped +26.6% to $7.8 billion, or $1.33 per diluted share.

In addition to the impressive emerging market growth, sales in Europe expanded more than +20%, while the Asia-Pacific, U.S. and Canadian markets also increased about +20%. Growth was balanced across the globe — 13 of its top 15 markets saw double digit growth.

Doesn’t sound like the kind of numbers that justify a -9% decline, does it?

Management expects sales to grow between +18% and +20% for the full year. In other words, despite a global economic recession and fears of a “double dip” recession in the United States, there is ample and growing demand for Cisco’s routing, switching, and related products that are used for Internet Protocol (IP) networking and related communication infrastructure.

In addition to all this, Cisco generated more than $10 billion in operating cash flow for the year. Capital expenditure needs are surprisingly low and came in at only $1 billion, which means free cash flow was approximately $9 billion, or more than $1.50 per diluted share. That means the company has plenty of dry powder to pursue acquisitions and buy back shares, which it did to the tune of $7.8 billion, and should continue to do so going forward.

Action to Take –> Cisco is a company riding a secular trend that has survived the dot-com bust, the credit crisis and should continue well into the next decade. Yet for some reason, shortsighted investors have sent the stock back toward $20 a share, where it stood in early 2001.
At current levels, the shares can be had for less than 14 times trailing free cash flow. Based on current analyst projections, the forward P/E is even more reasonable at about 12 times — not bad for a tech stock.

At these levels, the growth expectations baked into the stock are very modest. Cisco only needs to grow cash flow about +8% annually during the next five years. This should be a slam dunk, as Cisco has managed to grow sales and earnings at about +12% each year for the past decade. If it can do that for another decade, then the stock is easily worth $40 a share — almost double current levels. And even if the company can only grow in the double digits for another five years, then the shares are still undervalued by at least 50%.