csco corporate logoDue to the consistent decline in the stock price over ten years, many investors have thrown in the towel on Cisco. However, interestingly many value investors are picking up the stock as they see a bargain now. Tweedy Browne, who in 2003 declared Cisco as being overvalued and expressed bafflement regarding the trading of the company stocks at 68% premium, is now among those anxiously purchasing Cisco stocks. According to Tweedy Browne, Cisco has high dominance in a market which possesses extensive room for growth in the future. Moreover, the company has strong financials regardless of the declining stock prices which works to the favor of value investors who prefer statistically cheap companies. The stocks of Cisco have been trading at an approximate discount of 1/3rd of the intrinsic value owing to the increase in competition and resultant speculation of growth.

Cisco is a dominant player of the IT industry which designs, develops and sells infrastructure products which enhance Internet Protocol (IP) based network connectivity and improves high tech communication modes. It was founded in 1984 and since then has managed to establish an enterprise worth around $94 billion (exclusive of net cash). Despite the declining popularity of the company among investors, the performance of Cisco is not disappointing. It was able to generate more than $41 billion as revenue in 2010 and has reported a $10.75 billion as revenue in the 1st quarter of 2011. Moreover, the financial strength and consequent liquidity of the company can be demonstrated through the net cash on Cisco’s balance sheet which is more than $28 billion. The company has also announced a dividend payout of 1% to 2% in 2011.

Due to the increase in U.S debt and the federal, state and local spending, the expansive U.S. government business of Cisco faced a setback in North America and the consumer product, Flip camera, failed to acquire retail presence due to Cisco’s distribution management. However, Cisco has realized opportunities in countries like India and China to overcome the present problems and get back on track of profitability and growth. China is still a developing country with plans of mass urbanization and therefore, provides Cisco with extensive opportunity to extend their IT products and services to facilitate building of urban infrastructure in areas of education, health-care, and transportation. Cisco believes some of the strongest competition in the future would emerge from countries like China and India. Talking of competition, regardless of the notion of large amount of emerging competition eroding Cisco’s market share, history proves Cisco to be capable of maintaining its dominance in the market by efficiently realizing the capabilities required to compete in international market and effectively adjusting to the market transitions. Two of its biggest competitors, Nortel and Newbridge, failed to survive due to such problems.

Moreover, Cisco intends on improving its business model to exploit the available opportunities in China, particularly the automobile manufacturing industry of the country. Cisco has long been expanding through mergers, acquisitions and partnerships, and the company in looking into the prospect of adopting a new business model which could cater to the need of China’s automobile industry to establish joint ventures.

Furthermore, Cisco has a large market in Canada, the diversity of which helps generate consensus of opinions which can be generalized to international business. The key to maintaining market dominance is to stay ahead of time, and that is exactly what Cisco is doing and has been doing. Five years ago, it was able to anticipate the technological change of cloud computing, and now the company is investing heavily in the idea of video as they believe five years from now, technological advancements in the field of video communication would transform the business as well as consumer experience. Therefore, keeping the various opportunities being exploited by Cisco along with the financial strength of the company to support the innovative business models being developed, Cisco can appropriately be considered as a good long-term investment.

Just a really quick valuation here because as we will see the greatest value comes from the LEAPS and not from the stocks.

Cisco has ~45b in cash (including s/t investments), debt is ~17b, making net cash a total of 28b. Market cap is 86b-28b=58b market cap net of cash. 58b/5.5b o/s is 10. Consensus earnings (again I am doing a very rough valuation I am skeptical of street earnings) for FY 12 is 1.71, so pe is currently 10/1.71=5.8. It is easy to say if anything goes right that Cisco’s stock should be worth at least double and have a pe of 11.6. The stock is currently trading at 15.75.

Now lets see the best way to capture this cheap stock. In this case the long term leaps were absurdly cheap. I could barely believe my eyes when I looked at some of the options. The January 19th 2013 calls were and are currently trading at 11 cents.

 

Now, I would go farther out, but these were the longest term options available. Options also have their risks. Geoff Gannon had the following comment about options:

The problem with LEAPS is that they aren’t long enough dated. 5-year LEAPS would be good. 10-Year LEAPS would be virtually indistinguishable from a stock in terms of a correct analysis resulting in profit. But 2 years is not long enough for a value investor. If Warren Buffett had bought Washington Post 2-year LEAPS instead of Washington Post stock in the 1970s he would have lost his entire investment. By buying the underlying stock, he had a return of 30% a year compounded over the first 10 years.

He is right however the stock of Cisco has been depressed for so long that either A. I am wrong and this company is a buggy whip or B. The market will eventually recognize the value in the stock. Additionally, even if I am wrong Cisco has had such bad news lately that any positive news could drive the price up and the price of the option up dramatically.

These options were trading as high as $2.22 in the past year, when the stock was trading closer to $25 a share.

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I did not discuss the bear case, the truth is I was thinking of just discussing the options themselves and not the bullish case at all. Everyone knows the bear case and could read it on various sites; cloud computing, management mistakes, Government cutting back spending etc. However, look at the risk/reward ratio here.

 

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The options are basically being priced for exstinction. If the stock goes up to 25, and the options trade at the same price this is a 20 bagger. Obviously a lot depends on timing, volatilty etc., but even a jump of 30% would return several times the amount invested.

How do other options of companies compare? They are far more expensive. Let’s look

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