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CSCO Is Ready To Roll

After a 16% drop in share price, it looks like Cisco is now ready to move higher again.

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November 11, 2010, Cisco had reported earnings the night before, and the market looked ready to take Cisco lower. Why? Cisco reported $.42 a share, a couple of cents ahead of forecasts. It was what Cisco said about future earnings that really killed the share price. Cisco said that they are expecting a $500 million shortfall from state and local government customers and a slowdown in the cable set-top box division in the second quarter.

After nearly a month of Cisco’s share price going sideways, it seems that Cisco is ready to start climbing again. Cisco’s P/E ratio is less than 15, which is less than the S&P 500 as a whole and less than the expected growth rate for Cisco’s revenues and earnings per share (EPS). Cisco’s P/E ratio typically runs in the mid to upper teens and was as high as 25 as recently as this past March.

John Chambers, chief executive officer of Cisco since 1995, insists that the market is playing out precisely as he anticipated it would. According to a recent article in Barron’s (Barron’s 27 December 20120, Michael Santoli): His expectation is that large corporate technology buyers have become less interested in a product by product sales proposition than a set of core “architectural” solutions, with one or a few providers offering integrated solutions to manage their data centers and other crucial information functions. Further Cisco executives point out that this has been the company strategic premise for some time. There are several new products including videoconferencing for the home consumer that should give Cisco a significant boost to earnings. According to Cisco’s estimates video will rise to 64% of telecom and cable carriers’ traffic by 2013, from 4% today, and will represent some 90% of total traffic growth. Cisco is well-positioned to have a significant part of that market.

Finally, Street estimates for fiscal 2011, at $1.61 per share, are on the low-end range of Cisco’s own estimates. Even at this low range estimate, and given the P/E ratio of 15, it looks as if a realistic target price for Cisco is about $24 per share.

For those who trade options, there are a number of different ways to take advantage of this expectation. You can certainly buy the stock outright. Even buy a covered call. A collar trade would work. I have simply chosen to by July long call options and ride them for 50% return. Just remember, a strategy such as a directional long call still needs to have its primary and more importantly, its secondary exits well-defined. The students of OptionsANIMAL know what to do if the trade starts to go against them. Before placing any trade make sure that you understand exactly what you do if the trade goes against you. To draw an analogy that I often use in class, if you are boarding an aircraft from New York to London and you happen to see the Captain and ask the Captain “What are we going to do if we get to London and the fog is so bad that we can’t land?” If the Captain’s answer is “I don’t know, I’ll figure it out when we get there”, you would turn around and get right back from that airplane. The question I would ask you, is why would you put your capital at risk without knowing exactly what you’re going to do should the trade go against you? It just makes sense.

Here’s to a happy and prosperous 2011.

Jeff McAllister
OptionsANIMAL Instructor

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