Investing

Why Credit Suisse Just Went Mega-Bullish on Cisco, With 3 Buyout Targets

Jon C. Ogg

Published: April 27, 2017 10:40 am

Last Updated: January 12, 2020 12:35 pm

Cisco Systems Inc. (NASDAQ: CSCO) is one of the top technology companies in the world. The company is a Dow Jones Industrial Average component and is one of the top members of the Nasdaq 100. Credit Suisse has been negative on Cisco for quite some time, but now the firm’s Kulbinder Garcha is becoming a serious bull on Cisco.

Credit Suisse raised its rating on Cisco to Outperform on Thursday in a total reversal from its prior Underperform rating. Garcha also raised his old price target from an unimpressive $27 all the way up to $40.

One issue driving the change from “a screaming sell” to a “screaming buy” in the bias is the firm’s Ideas Engine, where its performed proprietary M&A analysis for potential Cisco buyout targets based on 12 metrics.

Garcha identified three top targets, and he included an outlook that simultaneously assesses capital return in a tax-repatriation environment. The firm also is segmenting Cisco’s switching business by vertical for the first time and has built out a conservative long-term scenario that shows earnings growth despite switching pressure.

Garcha’s report admits that this is a double upgrade (hence to Outperform rather than just to Neutral). Investors need to also consider that Credit Suisse’s old $27 price target was actually the most negative sell-side target on all of Wall Street. Garcha’s report said:

We believe that the company is assembling a portfolio of businesses, which should allow it to produce low single digit revenue growth and continued operating leverage. Furthermore, we believe the possibility of an upcoming repatriation and balanced approach towards M&A and capital return could drive long EPS power towards $3.30-$3.50. This would diversify Cisco away from the challenged economics in networking, which we believe we have fully embedded in our estimates.

In a repatriation effort, Cisco has a major balance sheet that could be unleashed. The report noted:

In an environment of tax reform, we believe the company has the capacity to accelerate the company’s transition towards a diversified IT player. We see potential for a an incremental $30 billion capital return over five years, bringing it to a total of greater than $75 billion over the 5 years (approximately 45% of the market cap), comfortably leaving up to $20 billion for more transformative M&A.

The three identified top takeover targets for Cisco, with the company having made about 45 deals in the past five years were identified as Splunk, ServiceNow and Palo Alto Networks. About 70% of Cisco’s deals have been in software, for roughly $14 billion. Cisco actually dropped its ratings on each of these three companies in the summer of 2016.

Palo Alto Networks Inc. (NYSE: PANW) is actually no longer rated (since 2016) at Credit Suisse, despite being one of the top data security players for enterprises. The stock was up 1% at $110.35 on Thursday, in a 52-week range of $107.31 to $165.96 and with a consensus analyst target price of $145.19. Palo Alto has a $10.1 billion market cap and its 2016 revenues (July year-end) were $1.38 billion.

ServiceNow Inc. (NYSE: NOW) shares were last seen up 5% at $95.60, in a 52-week range of $63.51 to $96.89 and with a consensus target price of $102.41. ServiceNow has a market cap of $16 billion and its 2016 revenue was almost $1.4 billion. The company offers service management solutions for customer support, human resources, security and other enterprise departments.

Splunk Inc. (NASDAQ: SPLK) was also terminated from coverage at Credit Suisse in 2016. Splunk shares were up 1.7% at $64.79 on Thursday. The 52-week range is $45.07 to $66.46 and the consensus target price is $72.33. Splunk has a $9 billion market cap and its revenue was $950 million in 2016 (January 2017 year-end). It is one of the newer leaders in real-time operational intelligence for enterprise level clients.

Garcha gave several points for a repatriation environment leading to benefits of larger transactions:

1) They accelerate the transition away from networking,
2) Improve top line prospects
3) Make the revenue stream more recurring (versus 31% today).

While M&A and transformations are key issues, the reality is that earnings per share eventually has to come into play for an established tech stock. Garcha now believes that Cisco’s earnings power is underappreciated, and that is a reversal of the past views for quite some time now. Garcha said:

In our M&A analysis, we see long term Cisco EPS power of $3.30 to $3.50, over 40% above current levels, of which 22% is driven by buyback with the rest from M&A accretion. Our standalone base case allows for continued growth in areas such as Security and Services to offset switching Data Center share loss and gross margin pressure (we explicitly assume a 1000 basis points long-term contraction in switching gross margin), even in such a scenario we see standalone EPS trending towards $2.50, suggesting upside.

As for the $40 price target, it implies upside of 20% from the $33.40 prior closing price. For a total return analysis, there is also the 3.5% dividend yield to consider.

Cisco shares reacted positively to this call, rising 1.4% to $33.87 Thursday morning. Its 52-week range is $25.81 to $34.53, and the prior consensus analyst price target was $35.39.

Going from the most negative analyst price target to above consensus is one thing. Now Cisco’s $40 target price is just $2 shy of the official highest sell-side analyst price target on Wall Street.