Cisco Systems (CSCO)

[chmcnfunds]

Citi Is Late And Wrong On Cisco

Dec 11 2013, 13:08 | about: CSCO

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Cisco (CSCO) is the worst performer on the Dow today with shares down 2% after Citigroup initiated coverage at a "sell" with a price target of $18 (details available here). This is perhaps a perfect example of a "Johnny-come-lately" analyst recommendation. Shares of Cisco have fallen by 14% over the past six months thanks to two consecutive poor quarters. A downgrade would have been a lot more useful for investors when CSCO was at $26 than $21. Still with another 14% of downside according to the analyst, it could be argued that it is better late than never. However, I strongly disagree with the analyst that Cisco shares will finish 2014 lower than where they are currently trading

(Click to enlarge)(click link for chart)

Citi argues that Cisco's routing and switching business, which account for half of CSCO's revenue, will see continued declines in 2014. I don't disagree with this, and I believe Cisco said as much when they guided to 8-10% lower revenue in the next quarter (guidance and quarterly data available here). In fact, I would add to the list of Cisco's troubles its set-top box unit, which should also see continued pressure in 2014. However, these are known problems, and after two bad quarters and even worse guidance, I would suggest this weakness is pretty much baked in to the share price.

Citi also fails to mention the good parts of Cisco, which is basically a Dr. Jekyll and Mr. Hyde company in that it has very weak and very strong units. The company is making progress in "new IT" with cloud infrastructure and security. Its new services businesses are seeing some growth and are helping buoy gross margins, which have remained a solid 62% despite fierce competition. Citi suggests Cisco might be losing share, but I put forth that management had decided to not undercut itself on price and threaten future profitability for short term market share gains.

Also in the wake of NSA spying, many American tech companies like Cisco and IBM (IBM) saw disastrous sales in emerging markets like China, Brazil, and Russia. As NSA revelations move further into the rear view mirror and these companies assure customers they are not wittingly aiding U.S. spy efforts, sales in these regions should return to normalcy, which could solidly boost earnings.

Cisco will earn at least $1.90 in 2014 and has cash of $4.88 per share. At $18, Cisco would trade at a 6.9x multiple, which borders on absurd, especially as I expect 2014-2015 to be bottoming years as Cisco transitions towards its growth business. At current prices, Cisco already sports a free cash flow yield in excess of 14%. While Citi is right that Cisco has challenges, I believe these problems are already baked in with a current ex-cash multiple of 8.4x and FCF yield of 14%. Citi has missed the run to the downside and is compounding that mistake by putting a sell recommendation here.

In fact, earlier this week, Bank of America declared Cisco a top pick for 2014 citing its low valuation and cash generation (more information here). The company pays a 3.3% dividend and will repurchase $15 billion in stock in 2014, which will be great for EPS, especially with shares at such a depressed level. Cisco is on pace to buy back over 10% of outstanding shares over the next 12 months and is finally putting some of its excess cash to use. With a growing dividend and massive buyback, capital returns provide an extremely bullish tailwind for Cisco shares.

Citi is sending shares of Cisco lower, but I would not follow Citi and sell shares as I believe Cisco should trade at least 10-11x earnings ex-cash, which suggests a stock price of at least $24-$26. Investors also get paid to wait with a solid 3.3% dividend. As I have said in the past, below $22, Cisco is a great long term buy; however given the name's underperformance, there will likely be some tax-selling over the next three weeks. I personally plan on initiating a position in January and see it as one of the top investments in 2014.
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