Thursday, August 11, 2011

Cisco Systems Not Back to the 1990s

Cisco Systems (NASDAQ: CSCO) was a darling stock of the 1990s. In the last 11 years, though, it's lost 78% of its value and it keeps falling. Wednesday it reported better than expected earnings on big cost cuts. Is it finally time to buy Cisco stock?

Why was Cisco such a great stock? It consistently boosted revenues by as much as 40% a quarter and beat earnings expectations. At the core of its success was an acquisition strategy that I described in my book, Net Profit: How to Invest and Compete in the Real World of Internet Business. Instead of letting a competitor get a foothold into a customer's computer network, Cisco would buy the competitor.

But after the dot-com crash, companies stopped spending so much to build their networks and Cisco stock tumbled from a June 2000 high of $63.56 to its current $13.73. Interestingly, Cisco still dominates the market for routers (54.2% share) and switches (68.5% share) although its share of routers has fallen 6.4 percentage points while its switch share is down 5.8 percentage points, according to Dell'Oro Group.

Nevertheless, Cisco beat analysts' estimates when it reported its fourth quarter results. Adjusted EPS of $0.40 was two cents higher than analysts expected and sales rose 3.3% to $11.2 billion in the period -- $200 million higher than expected. And it plans to cut 6,500 people while shuttering its unprofitable video camera business.

Do these market share losses mean you should stay away from Cisco or are its better-than-expected results a sign of a brighter future?

Here are three reasons to consider buying Cisco:
  • Expectations-beating earnings reports. Cisco has beaten analysts’ expectations in all of the last five reporting periods.
  • Reasonable valuation. Cisco's price to earnings to growth of 0.89 (where a PEG of 1.0 is considered fairly priced) means it is reasonably valued. It currently has a P/E of 10.7 and is expected to grow 11.6% to $1.67 in 2013.
  • Rising sales, wide profit margin, stronger balance sheet -- but declining profit. Cisco has been grown revenues and despite declining profit, its net margin is high. Its $43.3 billion in revenues risen at a compound annual growth rate of 5.5% over the last five years while its net income of $7.8 billion has declined at a compound annual growth rate of 4.8% over the last five years -- yielding a wide 18% net margin. It has no debt and its cash has risen at 18.9% annual rate from $22.3 billion (2006) to $44.6 billion (2010).
One reason to pause is that Cisco is under-earning its cost of capital -- and getting worse. Cisco is earning less than its cost of capital – and it’s in decline. How so? It produced negative EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In fiscal 2011, Cisco’s EVA momentum was -5%, based 2010 revenue of $40 billion, and EVA that fell from $1.3 billion in 2010 to negative $589 million in 2011, using a 10% weighted average cost of capital.

Cisco cannot cut its way to success -- until it out-earns its cost of capital due to market share gains, its shares are not likely to be a great investment.


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