Cisco Systems (CSCO) controls nearly two-thirds of the market for Ethernet switches and sells more than half of the world�s routers. But that reflects yesterday�s growth track.
These days, it is aggressively pushing into networking services and software, as well as high-growth niche hardware markets.
While the stock has treaded water since we recommended it as a Long-Term Buy last February, we see several reasons for optimism about Cisco over the next year.
More-profitable business mix
Services now account for about 21% of sales, with software generating 15%. The services business has delivered at least 12% revenue growth in each of the last two fiscal years.
Cisco�s future growth depends on its ability to parlay expertise in networking into new and creative products and services. For example, the company is working with Internet and television providers to make software that connects viewers� tablets to televisions, allowing them to access information on programs and chat with friends.
On the product side, Cisco is seeing stronger demand for equipment geared toward data centers (about 4% of product sales) and wireless communications (5%).
Valuation
At 11 times trailing earnings, near their lowest point in more than a decade, Cisco�s shares reflect plenty of pessimism. Given its market reach and potential to tap into new markets, Cisco seems unduly cheap at discounts of 27% to its five-year average P/E and 42% to its peer group.
Excluding net cash, Cisco�s P/E is just over eight. If the P/E ratio reverts to its 12-month average of 13 and Cisco meets the consensus profit estimate for the fiscal year ending July 2013, the stock would rise 18% by August.
Sharing with stockholders
Cisco has pledged to funnel at least half of its annual free cash flow to investors through dividends and share repurchases. In the 12 months ended October, Cisco returned $4.99 billion of its $8.57 billion in free cash flow to shareholders, with dividends accounting for $1.92 billion.
While Cisco raised the dividend 75% in August, it still accounts for less than 30% of earnings, leaving room for more growth.
Cisco expects sales to rise 5% to 7% annually over the next three to five years. Per-share profits could climb at a faster clip, given Cisco�s focus on more-profitable businesses and stock buybacks.
Operating profit margins reached 29.4% in the year ended October, up from 25.4% three years ago. The consensus estimates seem achievable, calling for per-share profits to rise 6% in fiscal 2013 and 8% in 2014.
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