It's hard not admire Cisco Systems (CSCO). The titan of the corporate networking market, Cisco sports a gleaming balance sheet with a $15 billion in cash and no debt. Last year it generated a whopping $6.9 billion in free cash flow and $5.7 billion in net income. Its valuation, on the other hand, is another matter. As likeable as the company may be, its stock price is starting to look stretched.
Cisco shares have surged 26% since January. With the stock lingering below $18.00 for much of last year, the uplift is justified. But, in my mind, the correction is now complete. Even as the company pushes into sexy, new advanced technology markets like home networking, digital TV and IP telephony, Cisco is going to be hard-pressed to post growth numbers that warrant anything much higher than its $21.49 price tag.
My reservations stem from the law of large numbers. Like its high-tech cousins Intel (INTC) and Microsoft (MSFT), the bigger Cisco gets, the tougher it gets to grow. Even a few billion dollars in extra sales won't do much for a $125 billion company.
Cisco dominates the market for networking router and switch hardware. Nearly two thirds of Cisco's sales come from these solid, cash-generating product lines. Unfortunately, their sales grew at a meagre 7% last year. Fierce competition from Juniper Networks (JNPR), Redback Networks (RBAK), Nortel Networks (NT), Alcatel (ALA) and from China's low-cost provider Huawei Technologies could push it lower.
So, to boost its market value any higher, Cisco will need really big gains from outside of its traditional hardware business. By my reckoning, top line growth targets of 12-15% will demand 25-30% growth from Cisco's expanding advanced technology portfolio.
That's asking an awful lot. Consider two of Cisco's top growth drivers, home networking and digital TV. Sales growth from the Linksys home networking unit is expected to peak at about 20% per year. Digital TV sales meanwhile will come largely from acquired digital set-top box maker Scientific Atlanta. That company's sales have been growing at about 12%. It isn't obvious where the necessary growth will come from.
Then there is Cisco's profitability to worry about. Grabbing growth from consumer markets – selling home networking and TV set-top boxes – could taint Cisco's enviable 67%-plus gross margins. Consumer products typically carry lower margins, which could erode Cisco's bottom line earnings gains.
Of course, reducing its number of shares outstanding through share buybacks could boost earnings per share. The trouble is Cisco is already buying back shares to offset the effect of the generous stock options issued to employees.
Cisco looks pricey compared to the S&P 500. Cisco is now trading at 20 times earnings. Analysts expect the company to book annual earnings growth of 12% next year. By contrast, investors are paying 14.7 times next year's earnings for S&P 500 stocks, whose earnings are expected to grow by 13.1% next year.
Don't get me wrong, I think very highly of Cisco. Were I to buy a richly valued, mature tech stock, it would be among the first I would snap up. While Cisco is a great company, that doesn't mean you should pay any price for it.