Slight Downside to Network Switches Profitability, but Cisco Still Undervalued

Cisco (NASDAQ:CSCO) competes with Juniper (NYSE:JNPR) and Alcatel-Lucent in the network switches market. Its profit margin from the network switches business, which we estimate constitutes more than 25% of the company’s stock value, has remained in the range of 68%-70% historically – much higher than the industry average. With a leadership position in the network switches market, capability of economies of scale, and a strong distribution network, we expect Cisco will be able to maintain its high margin levels in the years to come.

We anticipate that the margin will stabilize slightly above 66% by the end of our forecast period. However, Trefis members expect Cisco’s network switches margin to decline towards 62%, representing a slight downside to our price estimate for Cisco’s stock. The pessimism by Trefis members might be attributable to the weak guidance management provided for 2011 during the recent earnings release. However, we believe that a strong brand image and the broader trend of high data usage will continue to drive demand for Cisco’s products.

We maintain a price estimate of $24.20 for Cisco’s stock, roughly 30% ahead of the current market price.

Large Scale and Reach Offers Cisco Economies of Scale

Cisco is by far the largest communication equipment provider and is the industry leader in virtually all the businesses in which it operates. It has a presence in all major global markets beyond the United States and Europe. This wide scale and reach helps it negotiate better terms from suppliers. For example, it is believed that Cisco gets far better terms from its Application Specific Integrated Circuits (ASICs) suppliers than any of its competitors. Further, Cisco ships by far the largest number of units. Costs are apportioned over a larger number of units and, hence, per unit cost works out to be lower.

Strong Sales and Distribution Network

Cisco has very strong sales execution and also enjoys excellent brand recognition. These factors ensure that Cisco is considered to be a trusted and reliable brand by both enterprises and service providers, enabling Cisco to charge a premium for its products. For example, enterprises that value network reliability much more than costs are willing to pay a premium for a reliable Cisco product over a cheaper product from another manufacturer.

See our full analysis and $24.20 price estimate for Cisco

Trefis Community Forecast

Trefis members forecast that Cisco’s network switches gross profit margin will decrease from a little over 64% in 2010 towards 62% by the end of our forecast period, compared to the Trefis base case of flat gross profit margin over the same period. The member estimates imply a slight downside to our $24.20 price estimate for Cisco’s stock. As our price estimate stands well ahead of market price, this individual member forecast (holding all else equal) still implies a buying opportunity for investors.