Cisco: Too Cheap to Be Ignored for Too Long

Cisco is a well-positioned networking company with strong free cash flows that is valued in the bargain basement.
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Cisco Systems' (CSCO) - Get Report share price has fallen close to 20% in the past six weeks, slightly less than the rest of the market as measured by the S&P500, which has fallen close to 25%. 

But Cisco is a hidden gem that is remarkably well-positioned to rapidly recover once investors’ fears have calmed. For now, it's unjustifiably cheap as it trades for just 11 times free cash flow. Here’s why:

During the coronavirus outbreak, as workforces embrace work from home as the new normal, investors are scrambling to pick out which stocks are better to positioned to be winners and rapidly exit likely losers.

This is the wrong investment strategy, as attempting to pick out winners that aren't already fully priced is a challenging and largely foolish endeavor. A superior investment strategy is to buy stocks of established companies that are selling cheaply.

Presently, investors are still indiscriminately selling irrespective of valuation. The stocks that investors were doubtful about before the general selloff are now trading in the bargain basement, whereas investors’ favorites have remained somewhat fairly priced (vs. overpriced as they had been during the bulk of 2019).

Well-Positioned for Work-From-Home Environment

Cisco sells technology that allows companies to network and collaborate, making it well-positioned at this critical time.

Ironically, however, some of Cisco's smaller peers, such as Juniper Networks  (JNPR) - Get Report, possibly will still struggle in the coming months as we face a global recession. International Business Machines  (IBM) - Get Report, with its overextended balance sheet, will have to go into a defensive strategy at precisely the time when it should be playing offense.

On the other hand, Cisco - which was already trading cheaply - has now certainly fallen from grace. 

Further, given that its balance sheet carries $11 billion in net cash, Cisco has significant flexibility to navigate this economic contraction and more options at its disposal than its peers. Investors should watch Cisco turn toward M&A and pick up strategically important peers during this selloff.

Cash Flows Will Start to Matter Once Again

During the past couple of years, investors were willing to value companies’ rhetoric far above company cash flows. Today, investors are in a totally different mindset. Cash flow visibility and predictability will far outstrip any growth potential in the future. During a time of substantial uncertainty, strong and recurring cash flows are once more highly valued.

As it stood in the second quarter of 2020, Cisco derives approximately 30% of its revenue from software sales, which are mostly subscription-based. As companies look to cut back on any discretionary expenses during these uncertain times, companies such as Cisco, that are not having to entice customers to make purchases, are better positioned to withstand the downturn.

Valuation - Large Margin of Safety

The demand for fast and secure networking has huge secular tailwinds to its back and Cisco is a meaningful beneficiary of this continuously expanding sector. 

What’s more, although there are very near-term uncertainties regarding our economy, over the medium-term Cisco is highly likely to return to generating close to approximately $15 billion of free cash flow. 

Given that its market cap is only $165 billion, this puts this large and established business trading at just 11 times normalized free cash flows. 

Investors do not get this sort of compelling valuation for too long.

The Bottom Line

Cisco is very well-positioned to benefit from our new normal environment, one where we work from home and require secure connectivity. This well-known household name is too cheaply valued and will reprice higher when investors' fears have calmed down.