Cisco Systems Stock Upgraded: What You Need to Know

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Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Shares of networking equipment supplier Cisco Systems (NASDAQ: CSCO) shot up 30% over the past year -- nearly twice the rise in value of the S&P 500 during the same period. And yet, according to analysts at Goldman Sachs, Cisco stock is still a bargain. So much so, in fact, that this morning Goldman Sachs upgraded Cisco Systems from buy to "Conviction Buy," the analyst's highest rating.

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Here's what you need to know.

Why'd Goldman Sachs do that?

The Dow Jones Industrial Average is down nearly 900 points already this week -- not quite enough to mark a market correction, much less a bear market, but still enough to instill a certain amount of fear in investors. But Goldman Sachs argues that "[a]s market volatility increases we ... see Cisco as relatively defensive, " as explained this morning on StreetInsider.com (requires subscription).

Cisco may not have a P/E ratio, you see. But that's only because the company recorded a big $12 billion charge related to tax reform last quarter. Add that one-time expense back onto Cisco's income statement, and the company would have earned $10.5 billion last year. And Cisco did generate free cash flow (FCF) of $13.7 billion (which is largely unaffected by one-time non-cash charges), according to data from S&P Global Market Intelligence.

Profitable, and growing

Goldman argues that Cisco could earn even more profits in years to come, because its "end markets remain healthy and improving." Goldman predicts that "US top 4" telecom carriers will spend 13% more on capital improvements this year than last, while "hyperscale" telcos (presumably referring to internet backbone businesses, one level up from telecoms such as Verizon and AT&T) will grow their capital spending by 29%.

Cisco, of course, sells equipment to both these types of businesses, and should be a prime beneficiary of greater spending by them. Additionally, Goldman points to the results of a December 2017 survey of industry chief information officers, suggesting that overall "enterprise networking" spending across the entire economy will grow 3.4% this year -- again benefiting Cisco.

A bargain in the tech space?

Valuation may be the final argument in favor of Cisco. In a separate note on the analyst's upgrade, covered on TheFly.com, Goldman is said to have raised its cash flow estimates for Cisco stock based on the "healthy and improving" sales environment described up above. That means that this year, it's possible Cisco will generate more than the $13.7 billion in free cash flow it churned out last year, pushing Cisco's valuation even lower, and supporting Goldman's argument that the stock trades at a "significant discount."

How significant is "significant"?

Is Goldman Sachs right about all this? Does Cisco deserve a Conviction Buy rating?

Running a quick numbers check, at its current market capitalization of $207.5 billion, I see Cisco stock selling for a price-to-FCF ratio of just 15.1. While not obviously expensive, this still seems a mite high relative to the stock's 5.3% projected long-term earnings growth rate (as estimated by S&P Global).

Factor in $34.3 billion in net cash on Cisco's balance sheet, and the company's enterprise value drops to $173.2 billion. Cisco's enterprise value-to-free-cash-flow ratio, however, still only drifts down to 12.6. That appears to be an expensive price to pay for a company paying a 2.7% dividend and growing at only 5.3%.

Fact is, when evaluating Cisco stock today, the final answer on whether this stock is a buy comes down to whether you agree with Goldman Sachs that the company is going to grow faster than other analysts think it will. If you agree that Cisco can grow twice as fast as the rest of Wall Street says it will (10%), then the stock is fairly priced. If you think Cisco can grow three times faster than Wall Street says it will (15%), then Cisco is cheap.

But if you think Cisco will only grow as fast as most analysts -- other than Goldman Sachs -- think it will, then this stock is actually no buy at all.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.