Once the Planet's Most Valuable Company, Cisco Systems Inc. (Nasdaq: CSCO) Now Seeks to Rebound From a Decade of Stagnation

[Editor's Note: Intel, Cisco and Microsoft were once "must-own" stocks. But not anymore. As investors well know, these three tech giants have been "dead money" for a decade. Can any of the three pull off a turnaround? This week, in our "Leaders to Laggards" series, Money Morning looks at each of those companies - and brings you the answer.]

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At the height of the 1990s Internet boom, Cisco Systems Inc. (Nasdaq: CSCO) wasn't merely the ultimate tech titan.

It was the most valuable company on earth.

Cisco – the maker of the switchers and routers that form the backbone of the Internet – saw its shares zoom 66,000% during that decade, thanks to booming PC sales, the exploding popularity of the Internet, and the widespread realization of the value of networking.

That mesmerizing surge gave the San Jose-based company a peak market value of $555.4 billion, a total that's never been approached again – by Cisco or any other firm.


In 2000, however, the Internet bubble burst – derailing the Cisco Express. Now one of the world's biggest tech firms, the growth rates of 40% to 50% that had propelled Cisco throughout the 1990s became impossible to sustain – and even fell to the single digits by the end of the 2000s.

The upshot: Over the last 10 years, while the Nasdaq Composite Index gained 34%, Cisco investors lost 12.5%. It's been even worse of late: In the past year alone, as the Nasdaq shot up 20%, Cisco stockholders watched their shares plunge 35%.

"This is absolutely dead money," Steven C. Cortes, a founder of Veracruz LLC, a researcher for institutional investors, told CNBC recently.

Not an Easy Fix

Given this decade-long stagnation – which has been punctuated by the steep sell-off of the last several months – Veracruz's Cortes questioned whether Cisco Chief Executive Officer John T. Chambers should still be running the company.

It's not an easy question to answer.

Problems have come from all directions. And the company is not an easy one to manage.

Cisco's numerous acquisitions – a strategy commonly adopted by large companies struggling to create growth – have distracted the company from its core business of networking.

Meanwhile, Cisco has endured more aggressive competition in recent years, suffered from cutbacks in government spending, and self-inflicted a complex and burdensome management structure.

"Cisco is in a period of transition. There's a very negative camp that believes that Cisco is in a long decline … which is why the stock is so inexpensive," Evercore Partners Inc. (NYSE: EVR) analyst Alkesh Shah told Reuters.

To better understand some of the challenges that Cisco currently faces, let's take a look at the unit that makes "switches" for the Internet. It accounts for a full third of Cisco's overall business, making it the company's single-largest segment.

Cisco still has nearly 70% of the switching market, but has seen sales fall 9% in the most recent quarter. And that follows a 7% dip in the previous quarter.

Hungry rivals such as Juniper Networks Inc. (NYSE: JNPR) and Hewlett-Packard Co. (NYSE: HPQ) have eaten into Cisco's lucrative switching business with lower-priced products.

They're pressuring Cisco by taking margins of 40% to 50%, well below Cisco's margins of 75% to 80%.

"Cisco needs to choose between protecting share or preserving margins," Citigroup Inc. (NYSE: C) analyst John Slack wrote in a note to clients. "It simply can't do both."

And Cisco's woes aren't limited to its switching business. Take routers, another of the firm's core businesses. Cisco leaders have seen the company's market share in that business dwindle from 53% to 42% over the past three years as a growing number of customers turn away from the standardized networking products that have long been a Cisco strength.

Mobile Computing Market Shifts

The emergence of the so-called "mobile Internet" or "mobile Web" – driven by the proliferation of smartphones and such tablets as the Apple Inc. (Nasdaq: AAPL) iPad – has changed the market forever. Indeed, this technological tectonic shift has created demand for the more-specialized networking gear produced by such rivals as Juniper, H-P and F5 Networks Inc. (Nasdaq: FFIV).

And Cisco dawdled while those rivals got a head start on a technology – known as the unified network platform (UNP) – that is tailor-made for addressing the explosion in mobile-computing traffic.

Cisco has "been lagging," Shin Umeda, an analyst with research firm The Dell'Oro Group, told The New York Times. "As a result, the competitors have been able to move in."

Magnifying Cisco's travails are public-sector cutbacks in IT spending, both in the United States and overseas, as debt problems have forced governments to reduce costs. Revenue from Cisco's public-sector segment, where the company enjoys a 70% market share, fell 8% in the most recent quarter.

Not surprisingly, Cisco's problems are showing up very clearly in the company's financial results – which is why the firm has posted four straight disappointing quarters. Although sales for the most recent quarter were up 5%, net income slipped from $2.2 billion last year to $1.8 billion this year – an 18% drop.

And it isn't getting any better, at least in the near term: Cisco warned on May 11 that revenue for the current quarter would be flat to 2% higher on a year-over-year basis, a revelation that caused investors to take another 4.8% bite out of the stock.

Time to Refocus

With so many dark clouds gathering, Chambers, the Cisco CEO, realized that drastic action was needed if the company were going to reverse its fortunes.

In April, Chambers yanked the plug on its Flip consumer camera line, which Cisco had acquired in its $590 million purchase of Pure Digital Technologies Inc. only two years earlier.

Cisco's consumer ventures – which include other acquisitions such as Linksys and Scientific Atlanta, as well as home-grown projects like the pricey Umi video chat product – have been a drag on the company, with sales in the most recent quarter falling 49% from the previous year.

Cisco is expected to shrink or eliminate more of its low-margin consumer businesses, but is unlikely to miss them much: Consumer sales account for less than 3% of the company's revenue.

In a mea culpa memo to employees last month, Chambers promised to carefully refocus Cisco's efforts.

"Today we face a simple truth: We have disappointed our investors and we have confused our employees," Chambers wrote. "Bottom line, we have lost some of the credibility that is foundational to Cisco's success – and we must earn it back. Our market is in transition, and our company is in transition. And the time is right to define this transition for ourselves and our industry. I understand this. It's time for focus."

Chambers said the company would concentrate on five priorities: "leadership in core routing, switching and services; collaboration; data center virtualization and cloud; architectures; and video."

Earlier this month, Chambers announced he would eliminate the Byzantine management structure that had top executives serving on multiple "councils." The organizational structure had been created to "cross-pollinate" ideas across the company. Instead, it just created a sluggish bureaucracy that wasted time and slowed needed change.

The company unveiled a sweeping plan that would trim costs by $1 billion. The crux of the plan was a 4% reduction in the worker ranks – which equates to 3,000 to 4,000 jobs. That would exceed the company's previous layoff record of 2,000 positions – a marked set back in 2002, in the wake of the dot-com bubble.

"They have had a come-to-Jesus moment," Ashok Kumar, a Rodman and Renshaw Capital Group Inc. (Nasdaq: RODM) analyst told Marketwatch.

Cisco also can look to some of its better-performing sectors – such as its services division – which Technology Business Research Inc. analyst Beau Skonieczny thinks could provide a much-needed source of growth.

"From the services perspective, Cisco has been driving pretty aggressively," Skonieczny told The Street. ""Cisco's efficient use of their [services] channel partners allows them to offload a lot of their costs so that they can focus on development. This has been boosting their services margins."

In 2009, Cisco entered new territory – the server-and-data-center market. Expanding into high-margin businesses more closely tied to its core business clearly is a better strategy than buying low-margin consumer companies. But it does increase the odds of a competitive counterstrike from the tech titans that already occupy those sectors – most notably such firms as H-P and International Business Machines Corp. (NYSE: IBM).

All the strong medicine should help. But just how much and just how fast remain open questions.

In a recent note to clients, Gleacher & Co. Inc. (Nasdaq: GLCH) analyst Brian Marshall summarized the challenge succinctly: "While we applaud Cisco's recent moves, we believe it will take a nontrivial amount of time to move this tanker ship."

[Editor's Note: "Leaders to Laggards" is afour-part Money Morning special report that makes an honest assessment of the financial outlooks for Intel Corp. (Nasdaq:INTC), Cisco Systems Inc. (Nasdaq:CSCO) and Microsoft Corp. (Nasdaq:MSFT).

The series consisted of anoverview story,followed by an in-depth analysis of each company. TheIntel analysis ran first, followed by Cisco and Microsoft. We intend to continue this as an occasional series going forward, adding updates on Intel, Cisco and Microsoft, and perhaps also looking at such other firms as Nokia Corp. (NYSE ADR:NOK). As the series concluded, star hedge fund manager David Einhorn called CEO Steve Ballmer "the biggest overhang on Microsoft's stock" - and called for his head.

If you have comments on the series, or suggestions for additional "leaders to laggards" companies we should write about, please feel free to drop us a line atmailbag@moneymappress.com.]

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  1. Billy Surles | May 28, 2011

    Recently loaded up on CSCO shares @16.90. After hearing this negative prognosis of the future, I am almost ready to cut my losses and dump them at market. At this point I would
    lose approx $.45 cents per share. What would be the best stock to reinvest in to recover my losses? Or do you anticipate CSCO moving back up to the $17 dollar lever in a short term recovery, and then dump shares ?

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