My Old Valuation Project

So, I first got interested in valuation when I was in BM 401 (Corporate Finance) with Professor Couch two semesters ago. Since then I've had two internships where I did valuation and I've graded hundreds of analyst reports created by BM 401 students.

I'm publishing the report I did back in April of 2008, and it's interesting to see that I wasn't too far off with the stock price, however, my call to hold the stock might not have been good. Actually, I still think it's a hold, but the value today is $6 lower than it was when I did my project. At least I didn't suggest a strong buy.

I'm publishing it because it's interesting to see that I wasn't too far off with my sales and net income estimates. Additionally, my recommendation (HOLD) is exactly what S&P analysts are recommending right now. SO here it is in all its glory...

TELCOMMUNICATION EQUIPMENT INDUSTRY ANALYSIS
Telecommunication Equipment Industry Overview
In the last ten years, the telecommunication equipment has become a prominent industry in the technology sector. Innovation has been essential to this industry as companies seek to gain a competitive edge to provide consumers with the latest in voice, data, and video communication. Along with this however, is the weight of building an efficient infrastructure in anticipation of future demand. Facing competition from online communication, telecommunication equipment has sought to develop their product by switching from analog to digital and wireless devices. The five major players in this industry currently are Nokia (with 127.1 bil. in market capital), Qualcomm (with 64.9 bil. in market capital), Corning Incorporated (with 35.9 bil. in market capital), LM Ericsson (with 31.5 bil. in market capital), and The Direct TV Group (with 28.4 bil. in market capital).
The following factors account for the historical trends and expected future projections. Like most of the industries in the technology sector, telecommunication equipment has a trend of high growth compared to the rest of the market. The average industry returns for the last ten years is 21.7%. This is significant since the S&P 500 only had 2.1% returns for the same time period. A major factor for this growth is an increased demand for mobile devices and services. The Pew Internet & American Life Project recently released a study that show that Americans would find it harder to live without their cell phones than the internet, television, or land line phones. Consumers are demanding more features for their mobile devices, and this has put pressure on telecommunication to design hardware capable to meet this demand. The Wall Street Journal reports that telecom equipment manufacturers are meeting this demand by rolling out new cell phones that will integrate global positioning and voice information with talk and text systems. With equity betas ranging from 1.9 to 2.2, the telecommunication equipment industry has volatility comparable to e-commerce and entertainment. This volatility can, in part, be explained by the newness of the technology and concepts being produced. Although volatile, the outlook for this industry is bright due to cultural shifts causing people to rely on telecommunications equipment.
Financial Analysis of the Telecommunication Equipment Industry
A unique aspect of the telecommunication equipment industry is its comparatively low long-term debt to equity ratio. Out of the 32 industries in the technology sector, telecommunication equipment is the fourth smallest with a ratio of .19. This means that this industry relies heavily on its equity holders to finance new projects and operations. Low debt ratios are a sign that companies are growing and want to have more financial slack to finance new projects rather than being weighed down by debt interest payments. Other industries in the technology sector with comparable debt to equity are the Networking & Communication Devices and Personal Computers industries. As far as the P/E ratio and ROE, telecommunication equipment holds average values compared to the rest of the other industries in its sector. However, in the tech sector, this industry holds the fifth largest market cap with $360 bil. in assets. This value could most likely increase in the future as companies within the industry are merging with and acquiring other companies especially from the wireless communication industry, which holds $916 bil. in market cap.
In the last couple of years, companies in the telecommunication equipment industry have sought to add more depth to their products by merging or developing partnership with other firms. Two examples of this occurred in 2006 with the merger of Alcatel-Lucent and a joint venture between Nokia and Siemens. The mergers are the result of a young industry with many players consolidating to form key players and vie for market share. For example, the Alcatel-Lucent merger put the company ahead of LM Ericsson’s annual sales and gave the group an 18% market share.
FINANCIAL ANALYSIS OF CISCO
Overview of Cisco
Cisco Systems, Inc is a telecommunications equipment company that was established in 1984 by a husband and wife on the faculty of Stanford, Leonard Bosack and Sandra Lerner. They improved upon a multiple router protocol enabling compatibility with computers previously unable to use that functionality in networking. Today, Internet Protocol (IP) is the standard, so Cisco has had to shift its focus from multiple router protocol, and now provides a wide array of products and services including Ethernet switches, IP Telephony products including phones, routers, carrier and ATM switches, Storage Area Networks (SAN), remote access and gateways.
Cisco currently trades on the NASDAQ under the ticker symbol “CSCO” and currently trades around $23.96. A brief history of the stock’s progress over the last 10 years shows that CSCO was a victim of the dotcom boom. In the beginning of 1999 the stock traded at around $22.00, then rode the dotcom wave to a price of $79.37 before plummeting in mid 2000 to hit a low of $13.92 in the first quarter of 2001. CSCO has risen in price steadily in the long-term but still showcases volatility familiar to its industry as seen by the high and low over the last year (High: $34.24, Low: $21.77). The volatility in the past year is blamed on economic woes in the credit market that are hitting almost every industry. February news from Citi analysts upgraded CSCO to “buy” because the company had toned down its growth expectations to around 12-17%, lower than the industry average, historically around 21%. As it turns out, more telecom equipment companies are adjusting down their growth rates. A bright spot for Cisco, however, is that its innovation, a key factor in maintaining the competitive advantage in the telecom equipment industry, is winning out. Sales of Cisco’s Fastest Router have surged in the past 9 months and Cisco is blazing a new trail with its marketing campaign, offering business solutions for enterprises during NCAA tournament games. Cisco is also making the smart move to go green with its routers and switches, designing more energy efficient, environmentally friendly equipment.
Cisco competes against companies such as Motorola, Cisco Systems, LM Ericsson Telephone, Alcatel-Lucent, and Nortel Network. Cisco’s direct competitors include Alcatel-Lucent, Juniper Networks, and Nortel Networks. Of the three direct competitors, Cisco is by far the largest company with 61,535 employees compared to the next best, Nortel with 32,550 employees. Reported revenue for these companies is as follows: Cisco $37.68 billion, Alcatel-Lucent $28.04 billion, Juniper $2.84 billion, and Nortel $10.95 billion.
Growth over the past year has been somewhat volatile for each of these companies, with Cisco managing a 22.6% increase in sales growth, Juniper 23.1%, Nortel -4.1%, Alcatel-Lucent 4.2%. Growth is based on the success of business projects and Cisco has experienced growth most recently as a result of its goal to move into more aspects of the telecom industry, including its big push to provide IP telephony systems. As project manager for BYU’s Office of IT, I have seen Cisco’s resurgence over the past two years as a formidable opponent in telecom. Cisco has successfully gained BYU contracts for routers, switches, IP Telephony, Gateways, and other campus systems that I deal with on a daily basis. BYU has a new campus initiative called pervasive wireless that will supply all of campus with wireless Ethernet and Cisco is the main provider of wireless systems for BYU. These smart decisions to move into all arenas of telecom equipment are directly helping Cisco to increase its sales year over year.
Valuation of Cisco
Discount rates for Cisco
In valuing Cisco, I first went to the SEC website and downloaded the past five years of financial statements. I used these statements to find growth rates, ratios, trends in growth or ratios, and then made assumptions which I used to forecast the financial statements for the company for the next five years into 2012. In computing the WACC I used the return on the 5-year T-bill as the risk-free rate (2.49%) and contrary to our group’s initial observation of the return of the market (12% when valuing QCOM) I took an average of the past 5 years’ return on the S&P 500 and used that as my market return, 8%. I used Google’s equity beta of 1.59, which implies that the stock is a little more volatile than the market, which holds true for this telecom stock. One interesting note is that CSCO has yet to pay a dividend.
Including the firm’s debt ratio of 21% I was able to calculate the WACC for CSCO at 9.63%. Note that the WACC is very sensitive to its inputs, specifically the terminal value and the expected return on the market. The next section will explain growth rates and the DCF with a final recommendation on whether or not to hold CSCO stock.
Growth Rates and Cisco’s Stock Price
Using the estimated 5-year growth rate from MorningStar.com (13.05%), I estimate that Cisco’s sales will increase from $39,479 million in 2008 to $64,484 million in year five with a terminal value of $72,899. Growth thereafter was adjusted down after I learned about CSCO’s own actual downward growth adjustments. The rate I used was 6%, which is on the low end for the telecom industry (We used 8% with QCOM, I’m just a little more conservative and CSCO isn’t currently growing as fast as QCOM.).
Recall that the telecom industry is relatively young in the financial world and firms are constantly trying to grow by increasing market share through taking on big projects. Issuing equity is preferred to issuing debt because debt is “more expensive” to growth firms according to the pecking order theory. As a result, Cisco does not have a lot of debt, but I experimented with an assumption that debt would begin to grow in accordance to sales, and that by 2012 Cisco would have around 66% debt financing (as opposed to 41% in 2007). As the company increases its debt, the WACC will lower because of tax shields (5-year average tax rate I calculated at 26.75%) and the stock price should be higher.
In conclusion, Cisco’s forecasted financial statements are impressive and my estimate of the stock price at $20.16 is just a little lower than the market price of $23.96. I toned down the increases in Goodwill for the next 5 years (Goodwill has more than tripled since 2004!) and I also levered-up the company as one of my key assumptions. Based solely on the numbers, a “Sell” recommendation would be given, but I believe that Cisco is doing something unique with recent ad campaigns and the sale of new and innovative routers, switches and wireless communications systems. My recommendation is “Hold” on CSCO stock. I believe the price will hover around the $20-$25 dollar range until next year when this year’s sales are actually realized and new growth forecasts can be made after CSCO sees the fruits of this year’s advertising and innovative products.