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Who is the sucker now? Understanding the embedded expectations in Cisco Systems, Inc. Stock

Submitted by Value Expectations on 11/16/2010 08:14 -0400

CSCO
NASDAQ

Issue Date Thu, 11/11/2010
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Cisco Systems (NASDAQ:CSCO) delivered a shock to the investment world, lowering its quarterly and fiscal year sales guidance by a notable amount, causing the company's shares to suffer a 16% drop today. However, we question whether such a drastic drop in share price was justified given the adjustment to guidance.

To assess the reasonableness of CSCO's (NASDAQ:CSCO) current trading price using AFG's Value Expectations interface, let's look back at a historical time for the company, when its shares were trading at astronomical highs, as an example. In July 2000, shares of Cisco had 65% annual sales growth priced-in - expectations that were very high and later proved to be unrealistic. From 2000 to 2001, Cisco ended up underperforming the S&P 500 by around 62%, showing that unreasonable expectations can drive significant movements in a stock's price.

Embedded Expectations

Past Expectations:

By significantly falling short of these market expectations, Cisco has returned an annualized return 62% lower than the S&P 500 from 2000 to 2001.

Given yesterday's announcements, we will analyze the current expectations priced-in to shares of Cisco to see whether those expectations are realistic or not.

First, let's outline the issues that caused the adjustment to the company's revenue guidance:

1. U.S. State Spending dropped significantly.

2. Traditional North American cable set top box orders were down 40% year over year.

3. Public sector weakness in Europe due budget concerns and austerity programs.

All of these factors led to management guiding lower than consensus for Q211 by approximately $1.2 billion and for FY11 by $1.0 billion (or 3-5% growth and 9-12% growth, respectively).

Current Expectations:

To justify current trading price of $20.75, assuming realistic EBITDA margins of 27%, CSCO only needs to deliver 0.45% in revenue growth (essentially no growth) over the next 5 years. These expectations are extremely low relative to even very conservative estimates from the street.

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If we use conservative estimates for annual sales growth of 9%, based on the lowered guidance, and 27% EBITDA margins, shares of CSCO have good upside with a target price of around $29.

While lowered guidance and subsequent market reaction are a cause for concern we still believe that CSCO looks attractively priced with very realistic expectations embedded in its stock price.