The world economy may be struggling to recover from the depths of the Great Recession, but there are still pockets of the market that are seeing explosive growth. Demand for electronic gadgets held up amazingly well during the credit crisis, which suggests consumers consider their smartphone or tablet computer necessities along with food and shelter. In fact, the housing bust demonstrated that shelter isn't worth all that much these days.
And it isn't actually the hardware that people crave, but rather the content that their connection to mobile devices provides. Data, in the form of email, texting -- and increasingly multimedia from the likes of YouTube and Netflix (Nasdaq: NFLX) -- are driving explosive growth in Internet content and the need to route it over fixed and wireless networks across the globe.
This growth shows few signs of abating. Networking giant Cisco (Nasdaq: CSCO) effectively controls the market for Internet Protocol (IP)-based networking and predicts an 18-fold jump in Internet data traffic by 2016. Specifically, it expects an eventual traffic rate of 10.8 exabytes per month, or 130 exabytes annually. To put that into some additional context, this equates to 33 billion DVD downloads, and literally quadrillions of music and text downloads.
Without fully understanding the level of traffic that equates to, I'm confident that means a rapidly growing amount of routers, switches and optical networking gear will be needed. Cisco sells billions of dollars of these products each year. The company reported total revenue of $43.2 billion last year, but it still has room to grow.
Last year, Cisco was criticized for focusing on its "new products" category, such as video that connects households and its Linksys-branded routers for the consumer market. It admittedly took its eye off the ball and lost some of its competitive edge in the bread-and-butter routers and switches that accounted for $20.5 billion, or 47.4% of last year's total revenue.
But in relatively quick fashion, Cisco shuttered or jettisoned a number of lagging divisions, such as the Flip video camera device. CEO John Chambers characterized it as one of the most transformative years ever at Cisco, and committed to refocusing on the core networking operations. He also ruthlessly cut more than $1 billion in annual costs and also initiated a dividend payment to shareholders to prove that Cisco will be more mindful of steady profit growth and is willing to share it with loyal investors.
Even through the minor hiccup to its operations, annual revenue grew 8% last year. Analysts expect similar levels of growth over the next couple of years, and nearly $50 billion in sales by 2013. They also project earnings of about $2 per share, which translates into growth of more than 70% from the $1.17 reported for all of 2011.
Cisco is already a prodigious generator of excess capital. Last year, it generated nearly $10 billion in free cash flow, or $1.76 per diluted share. This represented a cash flow margin of 23.1%, which is well above the market average of around 14%.
Overall, Cisco operates in one of the most appealing markets in the world and should garner more than its fair share of future industry growth. It controls roughly 60% of the switch market and also possesses a leading share of routers. With Internet traffic conservatively expected to grow at least 50% a year for the foreseeable future, there is plenty of growth potential for most of Cisco's operations.
Risks to Consider: Cisco has managed to maintain its leading market share, but competitors such as Juniper Networks (Nasdaq: JNPR) continue to nip at its heels. Cisco was at risk of losing significant share last year, but managed to innovate and also reduce selling costs. This helped it maintain its customer base.
Action to Take --> Cisco is profitable, growing, operates in a hugely appealing space in the technology industry, and also happens to be very reasonably valued. It trades at a forward price-to-earnings (P/E) ratio of less than 11. To put this into context, Cisco's average P/E during the past five years has been 17.7 and the market average is currently 15.5.
Growth and momentum investors no longer seem to be interested in Cisco because it is no longer growing more than 20% a year like it was back during the dot-com bubble. And though it now pays a dividend yield of 1.6%, it still hasn't caught the eye of income and more conservative investors (although that could change as the company announced future dividend increases). For now, I'll call it "growth-at-a-reasonable-price" stock, and I think now is a great time to invest.
At a minimum, I think Cisco can trade up to the market P/E (15.5), which when multiplied by earnings expectations of $1.84 per share, suggests a stock price of $28.50 (15.5 * $1.84), That's about 40% ahead of the current share price.
[Note: I'm not the only one who's bullish on Cisco. Paul Tracy, StreetAuthority's Co-Founder and Chief Investment Strategist of Top 10 Stocks, thinks the stock is headed for big things. In fact, he's so confident that he bought 300 shares for his Top 10 Stocks real-money portfolio. To learn more about his favorite picks, go here.]