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Cisco Study

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Ticker: CSCO Sector: Technology Industry: Communications Equipment Recommendation: DON’T BUY Pricing Closing Price $26.60 (4/9/10) 52-wk High $26.85 (4/9/10) 52-wk Low $17.13 (4/9/10) Market Data Market Cap $152.07B Total assets $68.128B Valuation EPS (ttm) $1.04 P/E (ttm) 25.58 Profitability & Effectiveness (ttm) ROA 9.7% ROE 16.8% Profit Margin 17.0% Oper. Margin 25.3% Analyst: Jeff Griffith jmgxb6@mail.missouri.edu

JOHN LOTHMAN jdlrzf@mizzou.edu Ticker: CSCO Sector: Technology Industry: Communications Equipment Recommendation: DON’T BUY Pricing Closing Price $26.60 (4/9/10) 52-wk High $26.85 (4/9/10) 52-wk Low $17.13 (4/9/10) Market Data Market Cap $152.07B Total assets $68.128B Valuation EPS (ttm) $1.04 P/E (ttm) 25.58 Profitability & Effectiveness (ttm) ROA 9.7% ROE 16.8% Profit Margin 17.0% Oper. Margin 25.3% Analyst: Jeff Griffith jmgxb6@mail.missouri.edu

JOHN LOTHMAN jdlrzf@mizzou.edu Overview:
Cisco Systems Inc, currently the largest company in the Communications Equipment industry, offers a variety of communications products and services. The company supplies most of the Internet Protocol (IP) networking equipment used for the Internet and is the world’s largest supplier of high-performance computer internetworking systems. The company offers products in four segments: switches, routers, advanced technologies, and other. As of the end of Cisco’s fiscal year in July 2009, switches made up 41% of sales. Cisco has become the dominant market leader in Ethernet switches with 70% market share. Cisco also leads the market in overall routing, with more than 50% market share. For core high speed routers (more than 2.5 GB/sec), Cisco and Juniper Networks together have a combined market share of more than 95%. The advanced technology segment is currently composed of seven segments: home networking, unified communications, security, storage area networking, wireless technology, application networking services, and video systems. According to the S&P report from March 20, 2010, this segment will be the primary driver of company sales growth. The company also offers a broad range of services, including technical support and advanced services. Cisco’s recent major acquisitions activity includes: October 2009, Cisco agreed to acquire Tandberg (a Norway-based communication solution provider) and Starent Networks (a mobile system provider), each for $3 billion in cash. Both are expected to close in the first half of 2010, subject to necessary approvals.
Recommendation: After spending a lot of time carefully analyzing this company, I recommend that the we DON’T BUY stock in CSCO. There are many attractive aspects of Cisco. The company does have a long operating history since it was founded in California in 1984. Cisco also has strong financials, including $40 billion of cash and investments. According to the S&P report, Cisco has one of the best financial profiles in the industry. The company is currently well positioned in the market. Cisco’s enormous budget for R&D of $5.2 billion promises continued innovative products. This industry also has a promising future. The Portfolio Committee determined the Communications Equipment industry to be an attractive growth opportunity because as the economy improves it is likely that companies will spend more on increasing their bandwidth.
Despite all of the attractive aspects discussed above, we should not buy stock in Cisco because it is significantly overvalued, does not pay a dividend, and there is currently a trend to shift toward technology convergence. As this happens, HP, the largest technology company in the world, will likely steal market share from Cisco. Also, as convergence continues, our portfolio will have more exposure to this industry through HP because we currently hold a significant position in HP in our portfolio.
Using conservative growth rates for Cisco, an intrinsic value per share of $11.90 was calculated using Warren Buffet’s Discounted Cash Flow model. This indicates that the company is signifcantly overvalued because its stock currently trades at more than twice that value. The are some people that think this company is undervalued. The S&P analysts calculated a value of $30.00 per share, indicating it is undervalued. I made some adjustments to my model to figure out what they did to get that value. I believe those analysts did not make adjustments for the average increase in working capital as well as for average capital expenditures. In order for my model to value CSCO at $30, I had to remove both of those adjustments. It is important that we do make adjustments for both of these because they do affect the earnings available for shareholders. I think that while Cisco appears to be a good company, at this time it would not be a good addition to our portfolio.
Major Characteristics:
Cisco is by far the largest company in the Communications Equipment industry.
Cisco is the 57th largest company on the Fortune 500 Ranking.
Cisco is the dominant market leader in enterprise routers with almost 69% market share.
Cisco is also the dominant market leader in Ethernet Switches with about 67% market share.

SWOT Analysis
Strengths: Relative to its competitors, Cisco has a broad portfolio of different operating segments allowing fairly diversified earnings. Approximately 46% of Cisco’s net revenues come from international markets, and the company continues to expand into emerging markets. HP is a leader or among the leaders in each of their business segments. With Cisco’s current acquisitions in process of Tandberg and Starent Networks, Cisco will be able to offer better video and mobility for its communication network. Also, as stated earlier in this report, Cisco has one of the best financial profiles in the industry. The company also has dominant market share in the large routing and switching sectors and successful positioning in several advanced technology areas.
Weakness: Because of Cisco’s diversified earnings, it is less specialized in its different operating segments. To keep its competitive position, Cisco offers many innovative products which results in high R&D costs that must be expensed when they occur. The demand for Cisco’s products is very difficult to forecast which often leads to surpluses or shortages of its products. Also, from an investor standpoint, Cisco may not as attractive of an investment because it does not ever pay a dividend.
Opportunities: Cisco’s high R&D budget, which is used to create many diverse and innovative products, allows the company the ability to find many opportunities with the creation of new products. Cisco continues to expand into emerging markets which will bring in future revenues. The demand for technology will continue to grow because the world is becoming increasingly more connected. As the condition of the economy improves, it is expected that many companies will seek to increase their bandwidth, which can be done using products that Cisco offers.
Threats: Cisco’s financial performance is largely dependent on the market conditions. If we are to see a second dip in the market, the company will likely be greatly affected by it. Also, if as the economy improves, there is a slower-than-expected recovery in enterprise or telecom spending, this will also greatly affect Cisco’s performance. Also, if Cisco is to meet increased competition or to see pricing measures intensify, this would have a great affect on its performance as well. Like many IT industries, the Communications Equipment industry is currently undergoing a shift toward technology convergence which results in the market segments become more intertwined and Cisco finding itself in more competition with the larger IT companies, such HP and IBM.

Competitors: Cisco is a large company with many different business segments and the list of competitors is enormous. Although there is a large difference in company size, Juniper Networks is the company that has products that are most similar to Cisco’s. Cisco’s competitor that most closely mirrors its size and operations is probably Hewlett Packard (HPQ). DIRECT COMPETITOR COMPARISON | |

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| CSCO | HPQ | JNPR | Industry | Market Cap: | 147.89B | 124.85B | 15.87B | 351.31M | Employees: | 65,550 | 304,000 | 7,231 | 786 | Qtrly Rev Growth (yoy): | 8.00% | 8.20% | 1.90% | 33.40% | Revenue (ttm): | 35.53B | 116.92B | 3.32B | 167.54M | Gross Margin (ttm): | 64.47% | 23.44% | 65.08% | 42.68% | EBITDA (ttm): | 9.42B | 16.22B | 660.86M | 4.17M | Oper Margins (ttm): | 21.41% | 9.84% | 15.46% | 2.87% | Net Income (ttm): | 6.07B | 8.05B | 117.00M | N/A | EPS (ttm): | 1.039 | 3.317 | 0.219 | N/A | P/E (ttm): | 24.86 | 16.05 | 139.04 | 50.11 | PEG (5 yr expected): | 1.38 | 0.89 | 1.45 | 1.53 | P/S (ttm): | 4.19 | 1.07 | 4.82 | 2.27 | |

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| HPQ = Hewlett-Packard Company | JNPR = Juniper Networks, Inc. | Industry = Networking & Communication DevicesBelow is a comparison of some key ratios for Cisco over the last 4 years: | 2009 | 2008 | 2007 | 2006 | EPS | 1.05 | 1.31 | 1.17 | 0.89 | P/E | 22.86 | 12.48 | 23.13 | 30.72 | Price/Tangible Book | 4.15 | 3.37 | 2.76 | 2.07 | Price/EBITDA | 15.32 | 8.98 | 16.90 | 20.46 | ROE | 16.8% | 24.5% | 26.5% | 23.7% | Debt/Assets | 0.35 | 0.34 | 0.37 | 0.41 | Current Ratio | 3.2 | 2.6 | 2.4 | 2.3 | |

It is important to notice a few different things from the chart above. EPS overall is increasing, which is good for current shareholders. The increasing Price-to-Tangible Book Value ratio indicates the increased risk of shareholders receiving a greater potential loss in the event of liquidation. The decreasing ROE indicates that the shareholders are increasingly getting less of a return on their investment in CSCO. The company has a good capital structure, especially with debt being used to finance less than 40% of total assets and with that decreasing over time. Cisco’s liquidity is also increasing over time, which indicates that it is increasingly more capable of paying off its short-term obligations.

Performance over the past 5 years compared to competitors: HPQ, JNPR, S&P500 and the NASDAQ. Over the last 5 years, HP appears to be the leader with Cisco in second.

Stock price change over the past 2 years: Cisco, as well as its competitors, stock price begins to rise as the market turns around, but unlike the S&P 500, Cisco as well as its major competitors have reached their prices from before the market crashed.

Stock price change over the past year compared to competitors: Cisco, as well as its competitors, is seeing rising stock prices in the past year, but compared to the majority of its competitors, Cisco has not seen as large of an increase.

Discounted Cash Flow Some of the growth rates used in the DCF above were from Yahoo Finance. The only growth rates that did not come from Yahoo were the 5% for 2016-2019 and the 2.5% second stage growth rate. I used these growth rates because I felt that they were both conservative and reasonable.

The table below shows a sensitivity analysis, where I changed the first stage growth rates as well as the discount rate. Please note that the first stage growth rates that I used in the sensitivity analysis were held steady for the first 10 years.

Sensitivity Analysis | Growth Rate | Discount Rate | 2% | 4% | 6% | 8% | 10% | 12% | 14% | 10% | $7.64 | $8.82 | $10.18 | $11.77 | $13.61 | $15.74 | $18.20 | 12% | $6.16 | $7.04 | $8.05 | $9.22 | $10.57 | $12.13 | $13.92 | 14% | $5.20 | $5.89 | $6.68 | $7.59 | $8.63 | $9.83 | $11.20 | 16% | $4.53 | $5.09 | $5.73 | $6.46 | $7.30 | $8.25 | $ 9.34 | 18% | $4.03 | $4.50 | $5.03 | $5.63 | $6.32 | $7.10 | $7.99 | 20% | $3.65 | $4.05 | $4.50 | $5.01 | $5.58 | $6.24 | $6.98 |

The intrinsic value for CSCO of $11.90 is much lower than the current stock price of about $26.60 (as of 4/9/10). The sensitivity analysis above shows that even with a 10% discount rate with a 14% constant growth rate, CSCO is still significantly overvalued.

Wall Street Analysts’ Opinions:

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| Current Month | Last Month | Two Months Ago | Three Months Ago | Strong Buy | 14 | 14 | 14 | 15 | Buy | 16 | 15 | 14 | 14 | Hold | 6 | 7 | 8 | 8 | Underperform | 1 | 1 | 1 | 1 | Sell | 0 | 1 | 1 | 1 | |

Data provided by Thomson/First Call |

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S&P Recommendation: 12 Month Target Price as of March 20, 2010 = $30.00
Qualitative Risk Assessment: Medium
S&P Quality Ranking: B+ (Average)
S&P Fair Value Rank: 4+ (Stock is moderately undervalued)
Volatility: Low (CSCO had low price volatility over the past year)
Technical Evaluation: BULLISH (since Feb. 2010)
4 STARS = BUY

Sources

Bigcharts.com netadvantage.standardandpoors.com google.com/finance/
yahoo.com/finance/

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Cisco Case Study

...In the past ten to fifteen years, Cisco has changed its marketing channel strategy majorly. While in the past Cisco was only focused on the volume of their business, they reconfigured their strategy to focus in on the value of business. Previously business was transferred through Cisco’s partners and retailers, who worked with customers to make deals and fill orders. Under their newer value-based strategy, their VARs, or value-added channel resellers, work directly with customers to ensure they are receiving the best value products and latest technologies. These VARs were able to work with large accounts as well as small to mid size accounts by offering specializations and value in niche markets or specific regions. Using this method makes it impossible to structure the strategy based on volume, because it is unfeasible to rate resellers effectively based on volume of sales when the focus is so highly placed on quality and value of the sale. Resellers and channel members were rated based on the value that they brought to the table rather than the volume of sales, making it easier for lower-tiered members to gain high status based on the value that they brought to the table. For example, a member that previously did not generate nearly enough sales to be considered a top-tiered reseller would now be able to achieve a higher status if the value of their service and specializations were up to par. This creates a stronger relationship between the customer and the VAR, thus increasing...

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