Cisco Making The Best Of A Tough Environment

By Stephen D. Simpson, CFA | November 15, 2012 AAA

With a host of tech companies taking their licks through earnings season (or shortly thereafter), including companies like F5 (Nasdaq:FFIV), Riverbed (Nasdaq:RVBD) and Juniper (Nasdaq:JNPR), investors were nervous going into Cisco's (Nasdaq:CSCO) earnings report. While Cisco's numbers don't reflect all that much strength in the tech markets as a whole, it was a solid result in a tough time and the guidance for the next quarter wasn't bad either. Cisco continues to look meaningfully undervalued, but this stock is likely going to need some time to work out.

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Better Than Expected Performance for Fiscal Q1
These aren't great days for tech companies, but Cisco nevertheless delivered a solid quarter. While minimal order growth and management conservatism suggest no immediate turnaround, investors can rest a little easier with the overall profit performance.

Revenue rose about 6%, as reported, or a little less than 4% excluding NDS. On a sequential basis, Cisco saw 2% sequential growth. Cisco's two largest businesses, switching and routing, were both weak (down 2% and 3% from last year), but segments like video, wireless, security and data center were considerably stronger.

Cisco also showed solid performance with its profitability. Gross margin eased off about a quarter-point from last year, but improved almost a half-point sequentially and beat most expectations. Operating income, too, was surprisingly strong - rising 20% as the company's restructuring and cost-cutting efforts appear to be making a difference.

SEE: Understanding The Income Statement

Takeaways Seem Positive ... Mostly

All in all, I would think that tech investors are going to be pleased with what Cisco had to say. Although orders were flat, service provider order growth (particularly from AT&T (NYSE:T) and Sprint (NYSE:S)) has to be good news on balance for others like Juniper, Alcatel-Lucent (NYSE:ALU) and Cienna (Nasdaq:CIEN). Likewise, I think investors in stocks such as F5 and Riverbed will be encouraged that conditions aren't getting significantly worse.

That doesn't mean that Cisco's relatively good news might not carry a sting in the tail. Strong growth in wireless is likely good news for Aruba (Nasdaq:ARUN), but Cisco's performance could mean that it's taking share from Juniper and it's clear focus on security could be something of a threat to the growth ambitions of companies like Palo Alto (Nasdaq:PANW).

Adapting With the Times
Cisco continues to work to stay relevant in the always-evolving IT hardware marketplace. Routing and switching are still huge businesses, but Cisco is moving aggressively to establish its presence in areas such as wireless and data center. Likewise, the company seems to be trying to form stronger bonds with companies like Citrix (Nasdaq:CTXS), NetApp (Nasdaq:NTAP) and Red Hat (NYSE:RHT) to keep its rivals off-balance and keep its hand in the game in other areas.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
In some major respects, the story at Cisco really hasn't changed much. The stock's valuation continues to suggest that the company is too big (and/or in the wrong markets) to produce much growth, and tech investors just don't care much about it. Along similar lines, Cisco's resources could tempt the company to make additional deals, and acquisitions haven't always gone to plan for Cisco.

How cheap might Cisco stock be? If you assume that free cash flow will growth between 2% and 3% from fiscal 2012 levels, and that the stock gets a slightly better discount rate than the average S&P stock, the stock should trade in the high $20s. In fact, assume that Cisco's free cash flow declines 4% a year in perpetuity and you still can reach a fair value near $20. That makes Cisco an interesting option for patient value hounds, but "patient" is likely to be a key word, as there still isn't the sort of top-line growth here that excites most tech investors.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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