Cisco Systems Inc. (Nasdaq: CSCO): The Story That Wall Street Missed

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It was another good week for U.S. stocks, despite the whipsaw-trading that resulted from alternating good news/bad news/good news developments on the earnings and geopolitical fronts throughout the week. The Dow Jones Industrial Average rose 1.5% for the week, while the Standard & Poor's 500 Index advanced 1.4%. The tech-laden Nasdaq Composite Index only managed to edge up by 0.7%, having been held back by Cisco Systems Inc. (Nasdaq: CSCO).

Although the Nasdaq lagged its U.S. stock-market counterparts, the 0.7% advance it put together last week did follow a 1.5% advance the week before. What's more, the U.S. high-tech sector has actually been the third-best-performing sector so far this year, with a 7.75% year-to-date gain that trails only energy and industrials.

According to MarketWatch.com, of the 76 technology companies that are part of the S&P 500, 64 companies, or 84.2%, have reported their fourth-quarter earnings. The results: A total of 52, or 81.3%, have surprised to the upside. Four firms have reported earnings that were right in line with expectations. And eight, or 12.5%, have disappointed (surprised to the downside).

Cisco was the biggest of those disappointments. But there's a much bigger story here than meets the eye.

And perhaps a much bigger profit opportunity….

The Story That Wall Street is Missing

The tech sector underperformed for most of the week last week for a very simple reason: Several brokerage analysts were so disheartened by Cisco's tiny year-over-year revenue gain for the 2010 fourth quarter that they downgraded numerous peers.

In doing so, however, those Wall Streeters likely missed the real story here – let's call it the "story behind the story:" Several of Cisco's competitors ripped higher in value as evidence emerged that they are taking away gobs of market share from the wounded networking giant.

Some of the companies that traders anointed as potential giant-killers were some of our favorites, including Juniper Networks Inc. (NYSE: JNPR), Citrix Systems Inc. (Nasdaq: CTXS), and a third company that is our one absolute favorite – we've actually dubbed it as "The One Company That Will Win the ‘Mobile Internet' Gold Rush." All three of these companies saw their stocks advance 4% on Thursday, the same day that Cisco's shares endured a double-digit drop.

[On the downside were some companies in the commodity end of the networked-media-delivery business, including Akamai Technologies Inc. (Nasdaq: AKAM), which posted a big earnings decline as margins contracted.]

The really big problem for Cisco – as is true of so many large, sclerotic companies that count on the government for a lot of their business – is that the prices that the firm can charge for its core business are dropping faster than sales.

Think about that for a moment.

Revenue for switches – a huge part of Cisco's business – fell.

That was bad enough. But margins thinned – which is even worse.

Tale of the Tape

Cisco's management team ran through a number of excuses. But investors are losing patience – and with good reason: This was the third consecutive quarter that the networking heavyweight had essentially claimed that the dog ate its homework. You get the impression that investors just want management to "man up" and admit it just has the wrong mix of products.

So what is the story behind the story?

Well, Cisco is the largest vendor of the equipment that connects businesses, individuals, governments and phone carriers to each other. And, going forward, the incredibly fast increase in Web usage will absolutely drive demand for network upgrades. Plus, emerging markets amount to 12% of revenue at Cisco, and they are growing at double the rate of developed countries.

Yet the elephant in the room is the fact that competitive pressures are forcing Cisco to move customers to new products more quickly than it intended, according to research analysts for Signal Hill Capital LLC. Channel checks suggest that sales of the company's largest switching platform, the Catalyst 6500, slowed at the end of 2010 as the product rapidly become uncompetitive from a price and functionality perspective.

Responding to this trouble like a SWAT team, Cisco did finally migrate customers to its hot new product lines, the Nexus switch family and the ASR routers family. Both of thesearemore competitive– but at much lower margin. Ouch!

As aresult, the analysts say that the Nexus family of switches are growing more than 100% year over year and the ASR family of routers are growing more than 68% year over year, but they are cannibalizing legacy products.

Management indicated they have increased the gross margin on the Nexus product line by 800 basis points over the past several quarters, but the margins are still significantly below the company's average, let alone the lofty margins of the Catalyst switches.

Now you see what I mean? This is not a problem that can be fixed in three months.

Personally I find it fascinating. We are watching the destructive force of innovation at work.

Web traffic is growing exponentially and customers are beefing up their networks to take the rising load, but they want to do so cheaply. Cisco is obliging, but because it has so many employees and so much overhead this increased business is not dropping to the bottom line.

Multiply Cisco's dilemma times the Fortune 500 and you can see why employment is not growing. Customers of everything want more new products now, and they want them cheaper than ever. The first place that companies look to cut back is in personnel, forcing current employees to work harder. That comes out in great productivity numbers, but it also makes the remaining work force less happy. The better employees then leave to join start-ups and that leaves the less capable ones behind to do twice as much work. Ugh.

So what's the end game? Well, after being shellacked again Cisco is getting really cheap, trading around 12 times next year's estimates. It's getting into the zone in which it will be considered a real value. The turnaround is going to take months and it might never work out. But if you are bullish on the whole concept of "cloud computing" and the expansion of worldwide web usage, then Cisco will – at some point – find itself to be in a terrific long-term position at some point.

Erik Suppiger, who follows Cisco for Signal Hill, said the company's long-term outlook is solid: It is particularly well-positioned to benefit as an increasing number of companies outsource their IT needs through the use of cloud-computing technology.

Cisco does have "a pretty rich new product portfolio [it's] working on," Suppiger said. "But there's a fairly long transition period here."

Cisco is adding more products and shedding employees to "right-size" its business, and will likely emerge on the other end a leaner, meaner, more focused company. My expectation is that the board will get fed up with longtime manager John Chambers, and kick him upstairs. So a great catalyst for the start of a position would probably be the hiring of a new leader.

The bottom line: "Buy-and-hold" investing works if you buy low enough and hold long enough. Cisco is transforming itself into the perfect candidate for such an investment play.

Action to Take: After disappointing investors for three consecutive quarters, and apparently underestimating the speed at which customers are transitioning to new-technology products, the shares of Cisco Systems Inc. (Nasdaq: CSCO) have been beaten down so much that they're almost in "buy-and-hold" territory. What will be the "Buy" signal to watch for? There could be several. But if the company makes a management change at the top, that will be a definite signal that investors should take a very close look at Cisco's shares.


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  1. Cuyler Salyer | February 14, 2011

    Very good article about some of the specifics, but a big part of Cisco's slow down is big picture things that you missed. By the way it's only normal in times of Depression for needs not to go away but clients to demand a product for a whole lot less price. Thats a big part of what Depressions are about. Don't kid anyone we started down this Depression road with the Crash of the Stock Markets in 2000 and the bottom will probably be in 2014-2016. This is a huge one that is a 240 year event, not like the smaller one in the 1930's!

    1.) Over the last 10 years a huge part of Cisco's increase in Gross Sales and then Profit came not from product that they make, but from constantly buying Tech. Companies to grow their top accounting line and then after deducting Good Will, they booked those as Profit. Legal with today's crazy accounting but what gimerky?

    2.) Next Cisco is very prone to be beaten up from Competition including from China.

    3.) Cisco has built a huge straw house in my book, by the directing of customers to have to employ very high priced people to constantly update Security lists, stating on which ports who can talk, and who can't. Needed, but DUMB placement. They've been shoving a lot of their needed programing on the customer as this should be mainly done with programing at the factory and the customer would just get promps to put in addresses to filter in or not. BAD
    Engineering! Oh, and it makes customers hire several if not dozens of six figure salary Network Engineer's to maintain these lists in every company. .Very time consuming of very valuable people for what should be a simple task, if Cisco had done the programing as described above at the factory. It's a huge Billions of Dollars drain every year combined for the US Economy. Definitely NOT helping any productivity factor.

    Oh, and when they don't have these CCIE's, they have to hire them from Cisco's Engineering Services for thousand's of dollars per day including expenses for weeks, or months on end.

    Do, you get my drift – Cisco is VERY vulnerable to competitors doing their homework, doing the programing at the Factory of those switches to make it very user friendly to input their Security Lists in those switches and maintain them. Mark my words, they will be taken out and flogged by competition – in just the way I'm describing above.

    Cordially,

    R. Cuyler Salyer

    Networking Engineer and Tech. Trainer for over 19 years

  2. Magnus | February 14, 2011

    Time to buy is now, it is a great value play.

  3. howard thomas | February 14, 2011

    reads different than Jack Barnes' article.

  4. dinesh | February 17, 2011

    cisco

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