Cisco Systems

Company background Cisco Systems, Inc. is a worldwide leader in the networking communication equipment industry. They design; manufacture, and sell networking and other related products to the communications and information technology industry as well as providing services associated with these products. Their clients include corporations, public institutions, telecommunications companies, commercial businesses and private residences.1

In FY 2006, approximately 84% of Cisco’s net sales were generated from product revenue with only 16% coming from service revenue.

Industry settingThe primary drivers of the industry are corporate information technology spending and telecommunication capital expenditures. The popularity of the Internet increases the bandwidth demand, and internet-related companies are constantly upgrading and replacing relatively obsolete network equipment to meet this increased demand. Companies in the networking communication equipment industry definitely benefit from this upward demand and will continue to experience steady growth despite a high penetration in the some segments by competitors.2

As a leader in the VoIP market, Cisco definitely benefits from this growth as the “US cable companies continue to push into the VoIP market by offering an attractive “triple play” bundle of voice, video, and data.”3

Company Analysis Business Strategy Cisco believes that “the key to long-term success in the high-tech industry is ongoing strategic investment and innovation”4 To support their innovative vision, the company spends heavily on Research and Development. To support its growth strategy, Cisco aggressively acquires companies operating in different niche markets. For example, Cisco acquired Linksys, a home-networking hardware company, KiSS, a network-enabled DVD player company, and Scientific-Atlanta, which is a set-top box manufacturer that controls 50% of its market.5 These acquisitions mark a major strategy shift for Cisco, which has increasingly expanded its business into private residences.

In line with its global growth strategy, Cisco recently announced that it would invest $1.1 billion over next three years in India and expected to increase headcounts6 as well to take advantage of India’s low-cost raw materials and labor.

1 Cisco Systems, Inc . Corporate Overview, Retrieved Oct 8, 2006 http://newsroom.cisco.com/dlls/company_overview.html2 S&P Industry Survey: Communication Equipment. Retrieved Oct. 10, 2006. 3 Mergent Online. IT industry. Retrieved Oct.10, 2006. 4 Cisco Systems. Annual Report. Retrieved Oct.10, 2006.5 Ibid. 6 CNN Money. Cisco looks to India for growth, workers. Retrieved Dec. 6, 2006 from http://money.cnn.com/2006/12/06/news/international/bc.cisco.india.reut/index.htm?source=yahoo_quote

Products and Market

Cisco’s core product lines include routing, switching and advanced technologies such as IP communications, network security and wireless LAN, etc. As shown in Exhibit 1, switching is Cisco’s major product line and represents approximately 45.3% of their total product sales. All product lines experienced growth between FY 2005 and FY 2006, resulting in a 14.7% increase in total net product sales. In particular,, Advanced Technologies experienced a significant increase of 34%, which mainly resulted from the increase in net product revenue from the acquisition of Scientific-Atlanta.7 Cisco anticipates the synergies of the acquisition will continue to add value to the company in the video market.8 Cisco also introduced a new product, TelePresence, into its advanced technologies line in October, 2006. This product enables users to have lifelike teleconferences over the Internet protocol (IP) network. Cisco expects this product to generate $1 billon in revenue by 2013. It is estimated that if overall video demand increases infrastructure sales by merely 1%, Cisco would gain $136 million in gross profits.9

Exhibit 2

Net Sales by M arkets

55%21%

9%10% 5%

United states andCanada

European Markets

Emerging Markets

Asia Pacif ic

Japan

(Source: Company report) As shown in Exhibit 2, Cisco’s business is comprised of five geographical regions. US and Canadian markets accounted for 55% of the overall net sales markets in FY 2006. Cisco experienced growth in every region, especially in the emerging markets. Although the Emerging markets represents only 9% of net sales, this market grew by 38% between FY 2005 and FY 2006. 7 Cisco Systems, 2006 Annual Report. Pg 26. Retrieved on Oct. 26, 2006. 8 1Q07 Company conference call 9 Stuarat, Donald, Willis, David. Cisco Heats up Competition in the Video Telepresence Market.(Oct.2006). Retrieved Oct. 30, 2006 from http://www.gartner.com/DisplayDocument?doc_cd=144493&ref=g_homelink

Exhibit 1(Numbers are in millions) FY 2006 FY2005 % changeNet product sales Routers $6,005 $5,498 9.20% Switches $10,833 $9,950 8.90% Advanced Technologies $6,228 $4,634 34.40% Other $851 $771 10.40% Total $23,917 $20,853 14.70%

Production and distribution Cisco had to write off $2.3 billion in inventory and lay off 8,500 workers when the high-tech sector experienced a sharp decline in 2001. Since then, the company overhauled its supply chain and “simplified its entire operating structure, from design through component sourcing to manufacturing and logistics”10 For example; more than “55 percent of Cisco's manufacturing was done internally in 2001, with the remainder being outsourced. Currently, contractors make more than 90 percent of the company's products.” To take advantage of the low-cost of raw materials and labor, Cisco has been shifting some of their operations to China and India.

In the third quarter of FY 2006, Cisco began the initial implementation of the lean manufacturing model. “Lean manufacturing is an industry-standard model that seeks to drive efficiency and flexibility in manufacturing processes as well as the broader supply chain.”11 This supply chain strategy enhances Cisco’s ability to cut manufacturing costs and better mange their inventory levels.

Cisco sells its products to approximately 115 countries and has built large product channels both domestically and internationally. Cisco offers its products and services primarily through its direct sales force, as well as through distributors and retail partners.12 This two-tiered distribution approach is a more effective way to help the company satisfy the order expectations of a wide variety of customers.

Qualitative AnalysisPorter’s Five Forces

Bargaining power of SuppliersThe bargaining power of suppliers in Cisco’s industry is low. As a powerful buyer in the industry, Cisco has been able to pick and choose among the various suppliers who dearly want Cisco’s business. To ensure suppliers ability to meet the company’s technology, manufacturing, volume, quality and delivery needs, Cisco has dramatically reduced the number of their suppliers.13 For example, “in early 2001 Cisco had nearly 1,500 suppliers, with 80% of its purchases focused on approximately 200 suppliers. Currently, the company has about 650 total suppliers and spends 90% of our overall expenditures with 93 suppliers.”14 The decrease in the number of suppliers has also reduced Cisco’s reliance on their suppliers. Because of this, the bargaining power of suppliers is low.

Threat of new entr ies The barriers to entry into the networking communication equity industry are extensive capital expenditures and advanced technology. In addition, a large economy of scale has 10 Crunching the number. 11 Cisco Systems.Inc. 2006 Annual Report. Cisco Systems. 2006 Annual Report. Retrieved Oct.27, 2006.12 Ibid. 13 Takahashi, Dean. “Crunching the Number.”(Nov. 2004) Electronics Supply and Manufacturing. Retrieved Nov. 26, 2006 from http://www.my-esm.com/showArticle.jhtml?articleID=51202436 14 Buyers link hands with designers. Carbone, James. (March. 2006). Retrieved Nov. 27, 2006 fromhttp://www.purchasing.com/article/CA6315330.html?industryid=2149

allowed dominant players like Cisco to operate efficiently over a wide geographic area. The start-ups in this industry are usually smaller companies attempting to compete in a niche market, and these companies generally do not have the same economics of sales as Cisco does in production and distribution. These smaller innovative companies will then often be acquired by the bigger players. Also, the huge capital investment in R&D necessary to be competitive in this industry makes it difficult for new entrants to adapt to the rapidly changing technologies.

Threat of Substitutes Threat of substitutes is low for Cisco. Cisco has a wide array of products and services to meet the different needs of their customers. Cisco has also kept a careful watch what their competitors are doing and they have the ability to quickly produce similar products with better features than their competitors. Therefore, continuous improvement on products and services is crucial to Cisco’s business operation.

Bargaining Power of BuyersBargaining power of buyers is moderate. Cisco differentiates itself from its peers by providing innovative products and high quality services. Cisco’s key customers are enterprise customers and telecommunication carriers. As the telecommunication industry continues to consolidate, the bargaining power of carriers will most likely increase. Therefore, Cisco should maintain a good relationship with the buyers and develop more innovative products to keep their customers delighted.

Degree of Rivalry The degree of rivalry is moderate. Cisco’s primary competitor is Juniper Networks (JNPR) in its core market, which is an end-to-end networking solution. Juniper Networks is “nicely positioned in the telecom carrier market and has been chipping away at Cisco's market share.”15 Despite this market intrusion, Cisco has a larger customer base and stronger capital resources to expand their product offerings. “About 95% of Fortune 500 companies are Cisco’s customers.”16

3Com, a provider of voice and data networking equipment, is better positioned to tap Cisco’s domination in the Chinese market, and they recently bought out the profitable Chinese Joint venture with Huawei.17

The competitors that Cisco faces in the niche solution market are Avaya and Nortel. Cisco competes closely with them in the Enterprise VoIP(Voice over the Internet Protocol) market.

15 Mcclure, Ben. “Cisco vs. Juniper”. The motley fool. (Jun. 2004) Retrieved Nov. 27, 2006 from http://www.fool.com/news/commentary/2004/commentary040609bm.htm?source=eptyholnk303100&logvisit=y&npu=y&bounce=y&bounce2=y 16 ibid. 17Chen, shu-ching. 3Com’s big China Venture. Retrieved Nov. 20,2006 from http://www.forbes.com/2006/11/29/3com-huawei-merger-biz-cx_sjc_1129huawei.html?partner=yahootix

Stock performance As shown in Exhibit 3, Cisco’s stock outperforms the S&P 500 and the large-cap technology companies through all of FY 2006. The 52 week range of the stock price is between $16.87 and $24.78. After hitting its lowest price of $17.10 in August 2006, Cisco’s stock began to recover in September and has experienced significant growth over the past three months. Stock prices increased by $2.05 the day after Cisco announced its strong 1Q07 financial results. In November 2006, Cisco’s board authorized up to $7 billion in further repurchases of its common stock in addition to the remaining authorized amount of $3.1 billion.18 This move will enhance their shareholder stock value. Therefore, the stock price should continue to outperform its competitors as well as the S&P 500 for the near future as the company maintains its healthy growth.

Exhibit 3

Financials (Refer to Appendix A) Profitability

Profit margins in FY04, 05 and 06 were 19.96%, 23.15% and 19.59%, respectively. Profit margin decreased 3.56%, while sales increased by 2.35% to 14.85% from FY05 to FY06. The decline in profit margin in FY06 was due to the acquisition of Scientific-Atlanta, which has smaller profit margin than Cisco.

ROA declined 4% from FY05 to FY06 as a result of decreasing profit margins, while ROE did not decrease as much as the ROA, which experienced only a

18 Business Wire News. Cisco authorizes up to $7 billion in additional stock repurchases. (Nov. 2006) Retrieved Nov. 17, 2006 from http://news.moneycentral.msn.com/ticker/article.aspx?Feed=BW&Date=20061115&ID=6201275&Symbol=CSCO

slight decreased of 1.15%. Nevertheless, both the ROA and ROE were still higher than the industry average of 13.8% and 21.6%.19

Financial Condition Cisco does not face any short term liquidity and long term solvency problems. Operating cash flow to current debt ratio was relatively stable and high over the past three years. Cisco has experienced stable current ratios during the three-year period at a level in excess of 1.0, with the quick ratios following the same trend.

The long term debt to equity ratio in F06 was 0.26. The company issued six billion long term debt in 2006, which was a radical move considering that they incurred no long term debt during the past four years. Operating cash flow has been in an upward trend. In FY 04, 05 and 06, operating cash flow was 6.96, 7.57 and 7.90 billion, repetitively. The company has maintained 17.5 billion in cash and cash equivalent as of July, 2006.

Since Cisco is quite financially sound, its significant increase in debt indicates that the company intends to expand its business while trying to place its self in a favorable position from a tax deduction standpoint.

Capital expenditures Cisco’s expenditures for FY04, 05 and 06 were 3.29, 3.32 and 3.44 billion, respectively, which has been rather flat over the past three years as the company outsourced its manufacturing with contract companies and did not invest heavily in facilities. Cisco is likely to continue implementing this strategy as it expands business in India in the near future. Therefore, capital expenditures should not increase significantly in the near future.

Research and Development Cisco has a long term commitment to ongoing research and development. In FY 2006, Cisco invested more than four billion in R&D, which represents 14.3% of total net sales. R&D expenses for FY 2006 increased by 0.9% from FY 2005.

With enhancements to their core routing and switching product lines, introduction of three new advanced technologies, and ongoing development on several emerging technologies, we anticipate that Cisco will continue their investment in R&D in fiscal 2007 to support their vision of innovation.20

Quantitative analysisa. Relative valuation comparison Exhibit 4

19 Cisco Systems, Key Ratios. Retrieved Nov. 25, 2006 from http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=InvestmentReturns&Symbol=CSCO 20 Ibid. pg 10.

As shown in Exhibit 4, Cisco has the biggest Market Cap among its direct competitors. Initial screening indicates that Cisco’s operating margins and earnings per share are the highest in the industry. In contrast, the tailing PE ratio is the lowest compared to Avaya(AV) and Juniper(JNPR). However, we believed that it may not be advisable to simply conclude that Cisco is undervalued based on the low tailing PE ratio. Therefore, a second comparison was conducted. Since Cisco significantly outperforms Avaya(AV) and Nortel(NT) in terms of sales growth and profitability, we eliminated these two companies from our second comparison.

As Cisco’s major competitor, Juniper has a Market Cap that is much smaller than Cisco’s. However, sales growth and gross margin seemed to be higher than Cisco’s. Unfortunately, high gross margin does not yield higher profit as much as net profit margins do. To identify which company generates higher profit and better return to shareholders, key financial ratios were compared in Exhibit 5.

Since Juniper was delinquent in its regulatory filings for FY06 due to its back-dating of stock options problem, financial information for FY06 was available. Therefore, we compared the FY05 financial ratios for both companies.

As indicated in Exhibit 5, Cisco’s profit margin was 23.15%, which was 5.85% higher than Juniper’s. The difference in profit margin indicates that Cisco has a more competitive advantage over Juniper. ROA, ROE and ROC for Cisco are four times better than Juniper’s which means that Cisco is more efficient in squeezing higher profits from its assets, generating more value to its shareholders, and getting better returns to pay its cost of capital. In terms of Pricing-earnings, Cisco trades at 28.25 times its 2005 earnings, while Juniper trades at a lofty 55 times.21 Simply put, “Bigger, stronger, and cheaper, Cisco is the better buy”.22 21 Mcclure, Ben. “Cisco vs. Juniper”. The motley fool. (Jun. 2004) Retrieved Nov. 27, 2006 from http://www.fool.com/news/commentary/2004/commentary040609bm.htm?source=eptyholnk303100&logvisit=y&npu=y&bounce=y&bounce2=y 22 ibid.

  CSCO AV JNPR NT Industry

Market Cap: 162.99B 5.80B 12.03B 9.28B 170.32M

Qtrly Rev Growth (yoy): 24.90% 5.20% 26.20% 17.40% 22.00%

Revenue (ttm): 30.12B 5.15B 2.18B 11.08B 89.56M

Gross Margin (ttm): 65.46% 46.43% 68.25% 38.64% 49.47%

EBITDA (ttm): 9.87B 636.33M 617.65M 167.00M 707.00K

Oper Margins (ttm): 24.99% 7.13% 20.52% -1.07% -6.02%

Net Income (ttm): 5.93B 201.00M 354.36M -2.21B -419.52KEPS (ttm): 0.95 0.42 0.59 -0.51 N/AP/E (ttm): 28.25 29.93 36.17 N/A 40.62PEG (5 yr expected): 1.27 1.89 1.59 N/A 1.59P/S (ttm): 5.43 1.13 5.59 0.84 2.32Enterprise Value/EBITDA (ttm)3: 15.193 7.703 17.84 66.73  

Source: MSN Money& Yahoo Finance        

Exhibit 5 　 　　 CSCO JNPRProfit Margin 23.15% 17.20%ROA 16.90% 4.40%ROE 24.80% 5.10%ROC 21.50% 5.00%Source:MSN Money 　 　

b. DCF Valuation To estimate the value of Cisco’s stock price, a DCF valuation was conducted. (See Appendix E for details). The following are the key assumptions in the model: We based our assumptions on historical information and 1Q07 financial results as

well as financial guidance provided by the company. The three-year average of sales growth is 14.71%. Our top-line growth rate

increased to 16% for FY07 and FY08 as an indicator of Cisco’s sound 1Q07 financial performance. We used the historical rate of 14.71% in the intermediate high growth period (from 2009-2011), then 10%, 8% and 6% for the declining growth period. The terminal growth rate is 4%.

Cost of Goods Sold (COGS) as a percentage of revenue is on an upward trend with an annual 1% increase over the past four years. We increased our COGS percentage 1% each year for the coming five years. In the declining growth period, we estimated that because the company now has more of its products outsourced in India, COGS as a percentage of revenue should decline to 36% over the next six years and remain at 35% thereafter.

SG &A expenses fluctuated over the past four years. The historical average rate was 24.55%. We increased SG&A expenses at an annual rate of 1% for the incoming five years, assuming that the company would increase its headcounts in India in the future. SG&A as a percentage of revenue should decrease the declining growth rate as the company takes advantage of India’s low-cost labor.

Net P&E as a percentage of revenue experienced decrease on a year-over-year base. Net P&E as a percentage of revenue in FY04, 05 and 06 were 14.92%, 13.39% and 12.08%, respectively. Therefore, we used 10% Net P&E rate in the short run and 9% thereafter.

Based on the above assumptions, our DCF arrives at a value of $35.55 from the FCFF model and $34.30 from the FCFE model, assuming a 4% terminal growth rate and a 9.49% weighted-average cost-of-capital. As of December 1, 2006, Cisco has been trading at $26.69, which is undervalued. (Appendix F)

Recommendation Cisco’s 1Q07 reflects that they have out-performed their competitors in every product line across the regions. Cisco will continue to grow through acquisition and the introduction of new technologies. With a strong financial position and sound business performance, we are optimistic that its stock price will continue outperforming both the industry and S&P 500. Therefore, we recommend adding an additional 70 shares to the current holdings in our PSU portfolio.

Appendices

Appendix A Key Ratios

2006 2005 2004ProfitabilityProfit Margin 19.59% 23.15% 19.96%Asset Turns 0.74 0.71 0.61ROA 12.90% 16.90% 14.00%ROE 23.3% 24.8% 19.2%

Finnancial Condition  2006 2005 2004operating cash flow to current debt 0.70 0.80 0.80 current ratio 2.15 2.18 1.51 Quick ratio 2.27 2.31 1.65

L-T Debt/Equity ratio 0.26 0.00 0.00

Appendix B Income Statement

Annual Income Statement (Values in Millions) Jun-06 Jun-05 Jun-04 Jun-03 Jun-02Sales 28,484.00 24,801.00 22,045.00 18,878.00 18,915.00Cost of Sales 9,737.00 8,130.00 6,919.00 5,645.00 6,902.00Gross Operating Profit 18,747.00 16,671.00 15,126.00 13,233.00 12,013.00Selling, General & Admin Expense

7,200.00 5,680.00 5,397.00 4,818.00 4,882.00

Other Taxes NA NA NA NA NAResearch & Development 4067.00 3322.00 3192.00 3135.00 3448.00 Other Operating Expenses, Total 0.00 0.00 0.00 0.00 0.00 Unusual Expense (Income) 91.00 26.00 3.00 4.00 65.00 EBITDA 7389.00 7643.00 6534.00 5276.00 3618.00 Depreciation & Amortization 393.00 227.00 242.00 394.00 699.00

         EBIT 6996.0 7416.0 6292.0 4882.0 2919.0 Interest Income 607.00 552.00 512.00 660.00 895.00 Gain (Loss) on Sale of Assets 0.00 0.00 0.00 (520.00) 0.00 Other, Net 30.00 68.00 188.00 (9.00) (1104.00)Pre-tax Income 7633.00 8036.00 6992.00 5013.00 2710.00 Income Taxes 2053.00 2295.00 2024.00 1435.00 817.00 Income After Taxes 5580.00 5741.00 4968.00 3578.00 1893.00

Special Income/Charges 0 0 0 0 0

Net Income from Cont. Operations

5,580.00 5,741.00 4,968.00 3,578.00 1,893.00

Net Income from Discont. Opers.          Net Income from Total Operations

5,580.00 5,741.00 4,968.00 3,578.00 1,893.00

Normalized Income 5,580.00 5,741.00 4,968.00 3,578.00 1,893.00

Extraordinary Income0 0

(567.00)0 0

Income from Cum. Eff. of Acct. Chg. 0 0 0 0 0Income from Tax Loss Carryforward 0 0 0 0 0Other Gains (Losses) 0 0 0 0 0

 Total Net Income 5,580.00 5,741.00 4,401.00 3,578.00 1,893.00

Appendix D Cash Flow

Appendix E DCF Valuation Forecast

Appendix F DCF Valuation