The Market's Panic On Cisco Seems Overdone

By Stephen D. Simpson, CFA | August 15, 2013 AAA

Over time you eventually get used to the idea that the market seldom looks past one or two quarters (except, of course, when it's convenient to do so). So insofar as that goes, I can see how some investors may have listened to the Cisco (Nasdaq:CSCO) conference call, thought they heard a sniffle or two, and rushed to hit the panic button. Though I'm not going to say that Cisco is fully out of the woods and everything is wonderful again in IT-land, I think the long-term valuation on Cisco is getting pretty interesting now.

A Respectable Quarter In A Slow Market
Cisco came in with a fiscal fourth quarter report that was basically okay. Sales were ever so slightly light, while margins and operating profits were slightly better. Compared to other reports from major tech companies like IBM (NYSE:IBM), F5 (Nasdaq:FFIV), and Juniper (Nasdaq:JNPR) in the past month or so, Cisco was arguably a little bit on the weaker side, but not really to a concerning degree.

Revenue rose 6% from last year and 2% from the prior quarter. Routing was weak on sluggish service provider demand (and service provider demand has proven to be quite chaotic), but wireless and data center looked pretty strong.

Cisco did a little better than expected on profitability. Gross margin ticked up slightly from last year (and dropped almost a point sequentially) and was a little better than the Street expected. Likewise, Cisco's 9% operating income growth was slightly better than expected and the company saw good operating margin growth from last year.

SEE: A Look At Corporate Profit Margins

Not Many Surprises On Balance
Going through the revenue line items, it's hard to find many surprises. Switching was pretty strong (up 6%), but Cisco's high market share makes it harder to read through to Juniper or Hewlett-Packard (NYSE:HPQ). As mentioned, the routing number was weaker than expected, but it seems like carrier/service provider spending trends vary on a nearly company-by-company basis.

Service provider video was strong, but expected to be so. Wireless was surprisingly strong, and I'll be very curious to see what sort of quarter Aruba (Nasdaq:ARUN) reports next week, as market share shifts in the WLAN market have gotten very interesting. Security looked a little weak to me (even though it was ahead of the average estimate), or at least relative to what companies like Check Point (Nasdaq:CHKP) and Palo Alto (Nasdaq:PANW) have been saying.

Was The Tone Really That Bad?
The Street very clearly did not like how Cisco handled the forward-looking parts of the conference call. True, guidance was a little soft and the company cited particular caution about its major emerging markets. But it's hard for me to call that a surprise, or at least unless investors and analysts were really banking on a big second half turnaround (I wasn't, and still am not).

At a minimum, it sounds like the Street really didn't like the news that Cisco will fire another 4,000 workers. This doesn't sound so much like a cost reduction ahead of weaker revenue performance as it does a reallocation of corporate resources to higher-growth segments. Still, it doesn't instill confidence in the growth outlook to see thousands of workers losing their jobs.

The Bottom Line
If you want growth, Cisco is not likely a name you want to consider. Companies like Aruba, Ciena (Nasdaq:CIEN), and Palo Alto are more likely to provide that over the next couple of years. On the other hand, Cisco continues to bulk up its operations in attractive markets (like the recently-announced deal for Sourcefire (Nasdaq:FIRE)) and threats like software-defined networking (SDN) are still some distance away.

On a long-term basis, Cisco looks cheap. Even scant growth expectations (revenue growth of less than 4%, free cash flow growth of less than 2%) can support a $30 fair value, though cash flow-based valuation seldom stands up against Wall Street concerns about near-term growth in tech. Although Cisco will likely be a frustrating stock to own for stretches of time, I think the risk-reward balance is pretty favorable at this point.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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