Cisco: No Growth Today, Try Again Tomorrow

By Stephen D. Simpson, CFA | May 16, 2011 AAA

Value investors have a tough time with tech; the good, growing companies are often far too expensive, and the value-priced companies struggle to grow their businesses. Cisco (Nasdaq:CSCO) is a good case in point - the company looks cheap by many metrics, but most tech investors have washed their hands of this name until the company proves that it can shore up its switching and routing businesses, and find new growth opportunities.

TUTORIAL: Risk and Diversification

A Mediocre Fiscal Third Quarter
Arguably the best that can be said about Cisco's fiscal third quarter is that it was not any worse than most people expected. Revenue rose almost 5% from the year-ago level to $10.87 billion, basically matching the averaged analyst guess. Within the top line figure, product revenue rose almost 3%, with switching down almost 10% year-on-year, routing rising more than 7%, and new product revenue growing about 15%. On a sequential basis, a different pattern emerges - switching was up a bit less than 5%, routing was up better than 11%, and new products were up a bit below 2%.

Profitability continues to be an issue. GAAP gross margin fell 260 basis points, though product gross margin rose almost four full points. Operating income fell 7% and operating margin contracted by 250 basis points. Though the non-GAAP figures are different, directionally they were the same. Although CSCO did not disappoint on the non-GAAP per-share earnings number, guidance for the fourth quarter revenue number was quite weak and that is likely to dominate a lot of discussion of this stock.

Cisco's Switching Getting the Pinata Treatment
Cisco is still a significant player in switching, but this business is getting thumped from many sides. Hewlett-Packard (NYSE:HPQ), Huawei and Alcatel-Lucent (NYSE:ALU) have been aggressive on pricing, and that has created some margin pressure for Cisco in the low and mid-range market. On the other hand, Juniper (Nasdaq:JNPR) and Brocade (Nasdaq:BRCD) are putting other pressures on other sides of the business.


Rivals All Around
It's not just switching that is an increasingly competitive market. Companies like Riverbed (Nasdaq:RVBD) and F5 (Nasdaq:FFIV) are chipping away in other niches. Even strong businesses, like telepresence right now, have some risk - Microsoft's (Nasdaq:MSFT) acquisition of Skype could ultimately prove to be a threat.

Pricing the Risk
Cisco is no longer the untouchable champion of networking, and the company has had a pretty dodgy record of making successful acquisitions. That is not tantamount to saying that Cisco is a lost cause. Instead, management needs to get more realistic about its operating structure and its prospects - getting more aggressive on cost cuts and taking unrealistic forward growth guidance off the table are good starts.

Interestingly, Wall Street is skeptical about this stock to such a degree that the company could see free cash flow decline 3% a year for roughly two decades and the fair value of that cash flow would be about the same as May 12th's stock price. Maybe that is as it should be for skeptics who believe that the competition from Juniper, Hewlett-Packard, and others will only intensify and perpetually erode the value of the business.

The Bottom Line
Value investors may find it worthwhile to take the other side of that trade. Cisco is not likely to be a rewarding stock for a while yet, but value investors should be accustomed to waiting. Provided that Cisco can stabilize the business and reinvest its cash flow into R&D that provides a stream of competitive products, the risk/reward on this name seems to tilt toward "reward" for long-term investors.

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