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Are Cisco Shares Too Cheap to Ignore?

Shares of the networking giant have tumbled over concerns that a weakening economy may dampen the company's growth. Likely, Wall Street has overreacted.

You probably wouldn't consider a tech stock a good buy in a bear market and slumping economy. But it's hard to pass up a big, brand-name company that, on key measures of value, is about as cheap as it's ever been.

Cisco Systems is the type of company investors should gravitate toward during an economic slowdown. Cisco (symbol CSCO) is huge, highly profitable and has a manageable amount of debt. But the stock of the leading network-equipment maker has tumbled 32% since November 7 amid concerns that Cisco may be more vulnerable to a recession than many analysts had believed.

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The selloff began November 7 after chief executive John Chambers warned about a slowdown in technology spending. On February 6, Chambers confirmed fears that U.S. companies were spending less on tech. During the company's earnings conference call for the quarter that ended January 31, he announced that orders for the company's equipment -- which, among other things, enables corporate data transfer and helps boost Internet capacity -- dropped significantly in January.

Chambers forecast that the slowdown in orders would continue and said that Cisco's sales would grow only 10% in the quarter that ends April 30, below the 15% that analysts had expected.

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But some Cisco bulls say Wall Street is overreacting to Chambers's comments. "Cisco is getting a hiccup in demand based on opinion that everything is going to zero, not based on fact," says Jerry Jordan Jr., manager of Jordan Opportunity fund (JORDX).

Jordan says Cisco is too cheap to ignore. He added Cisco to his fund's holdings after the company's February 6 conference call. He says that he expects the economy to rebound during the second half of the year and that "the people who spend money on Cisco's equipment will accelerate spending then." By the end of the year, he predicts, Cisco's stock should be back to $30.

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Cisco has supporters in the analyst community, too. "We expect CSCO to outperform other names in the sector in an up or down market, and for the stock to rebound barring a significant recession," Bear Stearns analyst Philip Cusick wrote in a February 7 research note. His price target for the stock, which closed at $23.20 on February 20, is $28.

Many analysts consider the San Jose, Calif.-based company to be well positioned to weather an economic downturn because of the breadth of its product line, its broad customer base and wide geographic reach.

Cisco has 20 product families, so its fortunes don't rest on just one or two products. Its customers include telecommunications-service providers, Internet businesses, factories, hospitals, public safety departments and government agencies. And overseas activity accounts for almost half of its sales, nearly $38 billion over the past 12 months.

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Cisco actually topped earnings estimates in fiscal 2008's first quarter, which ended October 31. And it met estimates in the second quarter, reporting net income of $2.4 billion, or 38 cents per share, up 24% from the same quarter a year ago.

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Revenue in the second quarter grew 16%, to $9.8 billion, marking the tenth consecutive quarter of year-over-year growth in the high teens or better. That's why Chamber's 10% growth guidance for the third quarter came as a shock. He still projects that Cisco's revenue will grow 12% to 17% for the entire fiscal year.

"In spite of what happens with macro economic and other issues in the short-term, we remain comfortable with our long-term growth projections," Chambers said during the February 6 conference call. Phase two of the Internet -- or Web 2.0 -- will drive Cisco's growth over the next five years, he said.

This phase entails, among other things, people interacting with the Web - rather than just retrieving information -- by using technologies such as video conferencing. Cisco will benefit as "corporations and telecom carriers invest in their networks to take advantage of new technologies being delivered over the Internet," writes Morningstar analyst Jordan Zounis.

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The company also had made significant investments in its emerging markets operations. For example, it plans to double its investment in China, to $16 billion, over the next five years. Orders from China rose 30% in the second quarter, and orders from India soared 50%.

Cisco is also expanding into high-growth markets domestically through acquisitions. It has gobbled up such companies as Scientific Atlanta (a maker of digital-video equipment), WebEx (a maker of web-conferencing software) and Navini Networks (a maker of WiMax networking equipment).

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However, profit margins in some of these new product areas are much lower than for Cisco's traditional products, such as routers and switches. As a result, some analysts worry that Cisco's industry-leading margins could shrink even as sales growth accelerates.

The company, though, has high hopes for its newest product: the Nexxus 7000 system, a switch that allows much more rapid Internet data transfer. It's due out in late spring and is expected to put pressure on competitors Juniper Networks (JNPR) and Brocade Communications Systems (BRCD).

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Recession or no recession, Cisco's long-term prospects remain robust, says Argus Research analyst Jim Kelleher. Although he personally owns Cisco stock, he rates it a "hold." There's just too much risk given the uncertainty of the company's prospects during the current economic slowdown, he says.

But Jordan says that, historically, larger companies do better in recession. And Cisco, he says, will do better than other larger telecom-equipment companies.

In early 2000, Cisco shares traded above $100 and its market value reached $579 billion, making it the world's most valuable company for a while. Worth about $139 billion now, Cisco's market capitalization still dwarfs those of its close competitors.

The stock trades at 15 times the $1.54 per share that analysts expect the company to earn in the year that ends in July and less than 14 times fiscal 2009 estimates of $1.70 per share. Over the past ten years, according to Value Line, Cisco's average annual price-earnings ratio ranged from 21 to 42 (that doesn't count 1999 through 2001 when the P/E ratio was so high as to be meaningless).

If you wait too long, says fund manager Jordan, you'll miss an opportunity to buy this extraordinary company at such a reasonable price.

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