Cisco Sees Better Margins, Small Growth

By Stephen D. Simpson, CFA | February 13, 2012 AAA

The challenge for Cisco (Nasdaq:CSCO) these days is pretty clear - show the Street that it can not only improve its margins, but also reignite growth and reclaim market share that it has lost to emerging competitors over recent years. Judging by the company's fiscal second quarter results, it looks like the company is making solid progress on the first goal, but has a ways to go on the others.

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Better Than Expected Results for Fiscal Q2
Cisco did reasonably well relative to expectations for the second quarter. Revenue rose 11% from last year and 2% from the prior quarter to over $11.5 billion - beating the average analyst guess by a couple of percentage points.

Unlike other companies with exposure to carrier spending like Juniper (Nasdaq:JNPR) and Acme Packet (Nasdaq:APKT), Cisco did pretty well in those businesses. Routing was down (about 2%), but not as much as at Juniper (down 8%), while categories like set-top boxes, telepresence and security were solid performers.

Cisco did quite a respectable job when it came to margins, and the company seems ahead of plan on those opex improvements. Gross margin (on a GAAP basis) did improve a full point from last year and exceeded analyst forecasts. The same was true of operating income, where the company reported better than 60% growth by GAAP and nearly 29% growth on an adjusted basis. (For related reading, see Analyzing Operating Margins.)

Growth Still Not Where It Needs to Be
Order growth of 7% wasn't terrible, but did represent a deceleration from the prior quarter (where orders rose 13%). While Cisco did relatively better with carriers, enterprise sales growth was a bit more moderate .

Going a little further, it looks like Cisco is doing pretty well relative to Juniper and Hewlett Packard (NYSE:HPQ) but less well with respect to F5 (Nasdaq:FFIV) or Riverbed (Nasdaq:RVBD). Although guidance was solid relative to prior expectations, I would suspect that Cisco is going to have to show better enterprise momentum (especially in high-profile markets like WAN optimization and application delivery controllers) to really get institutions excited about owning the stock.

Buy, Build, Maintain
The company did talk fairly openly about its renewed interest in deals, and the company certainly has the financial means to do so. Still, I would be surprised if Cisco made a big move for a company like Riverbed, F5 or even Brocade (Nasdaq:BRCD). Instead, I would think Cisco would target some of the up-and-coming private companies that are targeting the enterprise market.

Certainly the company should do more to shore up its growth in high-end/high-margin categories. Although Cisco did well in its margin improvements, Huawei continues to emerge as a bigger and bigger threat - not only to market share but margins as well.

The Bottom Line
Cisco is arguably past the worst of its reset, but expectations are still pretty modest. By my calculations, the current valuation on Cisco shares (including net cash) predicts exactly zero free cash flow growth over the next decade. So to the extent that you believe Cisco can grow at all, these shares are worth a look as an underpriced play on technology spending. (For related reading, see Free Cash Flow: Free, But Not Always Easy.)

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

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