There's a Reason Cisco Is Cheap

This week, networking Goliath Cisco Systems (Nasdaq: CSCO  ) reported fourth-quarter and full-year 2011 results that beat analyst expectations, sending shares up 16% in contrast to recent earnings-triggered selloffs. Full-year GAAP EPS declined to $1.17, compared with $1.33 a year ago, on sales of $43.2 billion. For the fourth quarter, EPS landed at $0.22, versus last year's $0.33, on $11.2 billion in revenue.

But even after the jump, the stock has still lost more than a fifth of its value this year. The company has been working to cut costs by axing employees and entire business divisions while trying to reassure investors of its market leadership.

What's a Fool to do?
Some Fools are buying because the stock looks cheap. I think there are reasons that the stock is trading at its lowest P/E in years, and those reasons prevent me from buying shares.

For starters, growth in revenue and earnings has been stagnant, unpredictable, and downright negative in recent years. Sales growth is one of the most important metrics to me as an investor, and Cisco isn't consistently delivering in that department.

Source: SEC filings. Figures reported on a GAAP basis.

In addition, Hewlett-Packard (NYSE: HPQ  ) has called Cisco out for lack of innovation, which adds some context for its mixed results. After all, technology advances quickly, so you need to spend money to make money. Cisco's R&D expenditures last year came in at 13.4% of revenue, which is in line with its long-term average. If Cisco wants to prove that it’s serious about the future, it needs to put its money where its mouth is and crank up the R&D.

Networking is evolving in many ways that could be opportunities for Cisco, yet it fails to capitalize in key emerging areas. F5 Networks (Nasdaq: FFIV  ) has carved itself a niche in application delivery, and Riverbed Technology (Nasdaq: RVBD  ) has been dominating the WAN-optimization space, despite that company's own recent revenue hiccup. Acme Packet's (Nasdaq: APKT  ) session border controllers that enable delivery of interactive communications have been driving its growth.

The company's core markets, routers and switches, aren't even safe. Juniper Networks (Nasdaq: JNPR  ) has been growing its share in routers, while HP gains traction in the switches market. Apple has proved that market share isn't everything if it can make up the difference in profit share, but Cisco is missing out in new markets and its bread-and-butter sectors.

A picture is worth a thousand words
The negative trend in margins paints an even grimmer picture:

Source: SEC Filings. Figures reported on a GAAP basis.

It's no surprise that this graph eerily resembles the stock's price chart over the past year. Gross margin took a big hit last year, which prompted questions from analysts during the most recent conference call. When asked whether management saw gross margin starting to stabilize, Cisco CEO John Chambers vaguely replied, 'We do not see a major falling off the cliff-type scenario on margins."

Despite the frightening imagery, the company disclosed its plans last quarter to reduce its annualized operating expense run rate by roughly $1 billion. Keep in mind that any operating cost savings won't help gross margin, since operating expenses come after gross profit on the income statement. Cost reductions would benefit operating and net margins.

Why ask why?
To get an even deeper insight into Cisco's declining performance, let’s do a quick DuPont analysis to see where the company’s weakness lies. This useful tool allows investors to break down return on equity into various components of performance.

Metric

2007

2008

2009

2010

2011

Net profit margin 21% 20.4% 17% 19.4% 15%
Asset turnover 0.65 0.67 0.53 0.49 0.50
Financial leverage 1.69 1.71 1.76 1.83 1.84
Return on equity 23.3% 23.4% 15.9% 17.5% 13.7%

Source: SEC filings. Figures reported on a GAAP basis.

We already knew net margin was on the decline. The asset turnover ratio measures how efficiently a company uses its assets to generate sales, which in Cisco's case has been softening. The financial leverage ratio measures the amount of debt being used to finance assets. By taking on more debt over the years, Cisco increases its leverage and financial risk. The product of these metrics yields return on equity, a measure of how well the company is growing your stake in it.

It's a (value) trap!
We've seen a lot of major technological advancements over the past several years, and somehow Cisco has missed the boat. If management can turn the ship around, then this stock could be a good value purchase now. With a market cap of almost $88 billion, it's a big vessel to redirect, and I'm skeptical.

Don't buy a stock just because it looks cheap. Cisco's anemic revenue growth, declining margins, operational inefficiencies, and lack of innovation all point toward a diminishing valuation.

Fool contributor Evan Niu owns shares of Riverbed Technology and Apple, but he holds no other position in any company mentioned. Check out his holdings and a short bio. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Acme Packet, Cisco Systems, and Riverbed Technology. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 14, 2011, at 7:45 PM, BradReeseCom wrote:

    Hi Evan,

    Cisco is artificially inflating switch gross margins by using huge trade in discounts that are then later billed as a sales and marketing expense (Cisco's sales and marketing expense during the most recent 9 months increased +$878 million up +13.6% on a +$2.8 billion total net sales increase up +9.6%, page 4, over last year):

    http://www.sec.gov/Archives/edgar/data/858877/00011931251114...

    For example, according to Cisco's most recent 9-month financial statement (Page 38):

    Switches represented 31% of Cisco's total net sales (9,982 / 32,023).

    31% of Cisco's total sales and marketing expense growth is $272 million (.31 x $878 million).

    Cisco's switch sales grew by only $111 million (9,982 - 9,871).

    $272 - $111 = $161 million

    The portion of Cisco's marketing and sales expense growth attributable to switches grew $161 million more or 245% more than Cisco's switch sales grew (111 x 2.45 = 272).

    I mean, it certainly appears to me that Cisco is artificially inflating switch gross margins by using huge trade in discounts that are then later billed as a sales and marketing expense!

    http://www.bradreese.com/blog/8-1-2011.htm

    Cisco's Q4'FY11 operating cash flow, product gross margin and router sales sequentially declined.

    Most alarming to me was the -$408 million drop in Cisco's Q4 Y/Y (Year-Over-Year) operating cash flow:

    http://www.bradreese.com/blog/8-10-2011.htm

    Palo Alto Networks is the culprit behind Cisco's -8.4% FY11 security sales decline.

    Cisco reported a respectable +7.9% net sales increase for its FY11.

    Additionally, 6 of Cisco's 9 sales product reporting categories had robust average FY11 sales increases of +22.9%.

    Anxiously though, 2 of those 9 product categories, switches and video connected home (representing 41% of Cisco's total FY11 net sales), had slight to negligible sales declines of less than -1%.

    However, what really caught my attention was the unusual -8.4% drop in Cisco's FY11 security sales.

    So why would that specifically catch my attention?

    Well mostly because 25-days ago, security vendor Check Point Software Technologies reported a 2nd Quarter Y/Y (Year-over-Year) sales increase of +15%.

    Meanwhile by comparison this week, Cisco reported that its 4th Quarter Y/Y (Year-over-Year) security sales dropped a worrisome -21%.

    Wow I thought, so I put in a call to my Cisco security expert, Dual CCIE #18532 Security/R&S - George Morton, to find out why Cisco's security sales were in such a steep decline.

    Naturally, I expected Morton to blame the well known Check Point as the "culprit" in Cisco's security sales misfortune, but I was quite surprised to learn that according to Mortonit it was tiny little-known firewall vendor Palo Alto Networks causing the Cisco security sales decline.

    Heck, even though I'm already familiar with Palo Alto Networks because of previous blog stories that I've posted, I'm still surprised.

    I mean, what possibly could tiny little Palo Alto be doing to upstage the mighty Cisco?

    Well, Morton basically confirmed what Palo Alto Networks stated in its press release August 1st:

    "We are rapidly replacing the firewalls the incumbent vendors have sold to enterprises over the past 15 years."

    However Cisco security expert, Dual CCIE #18532 Security/R&S - George Morton, added a slight twist:

    "Palo Alto Networks is taking your firewall services from 1995 and moving them to 2012."

    View more...

    http://www.bradreese.com/blog/8-12-2011.htm

    Sincerely,

    Brad Reese

  • Report this Comment On August 15, 2011, at 12:39 AM, jhf678 wrote:

    After reading this article, I wonder why this come at a time when Cisco is doing great and is on its way back into game. I also notice that Mr. Brad Reese has been attacking every article that has something to do with Cisco. I understand that the author,Evan Niu, owns Riverbed Technology, which is a competitor of Cisco that is why his intend for the article is logic.

  • Report this Comment On August 15, 2011, at 7:16 AM, TMFZahrim wrote:

    @jhf678,

    that's exactly the right time to write this article. Evan unearthed plenty of signs that the superficial success of the moment may indeed run only skin deep. If Evan's analysis is correct -- and I'm with him every step of the way here -- reading about it could save investors plenty of pain when Cisco's stock crashes again.

    That's why it's called a value trap, after all. More on this trap here:

    http://www.fool.com/investing/general/2011/06/27/cisco-deep-...

    ...and here:

    http://www.fool.com/investing/value/2011/08/11/the-downgrade...

    Anders Bylund (TMFZahrim)

  • Report this Comment On August 15, 2011, at 12:54 PM, DavidWMcCulloch wrote:

    Evan - I posted an extensive comment on your story yesterday evening on behalf of Cisco. I note that you have declined to allow my comment while allowing blatantly anti-Cisco commentary from other contributors.

    Is there a good reason for that?

    Best regards,

    David McCulloch

    Director, Corporate Communications

    Cisco

  • Report this Comment On August 15, 2011, at 11:23 PM, BradReeseCom wrote:

    ----- Original Message -----

    From: Brad Reese

    To: John Earnhardt (jearnhar)

    Cc: Cara Sloman ; Sandra Livinghouse ; Neil Becker ; Lee Davis ; Kristin Carvell ; Gareth Pettigrew ; David McCulloch

    Sent: Monday, August 01, 2011 10:33 PM

    Subject: Brad Reese

    Hi Cisco,

    I'm looking for an "official response" from Cisco as to whether it is artificially inflating switch gross margins by using huge trade in discounts that are then later billed as a sales and marketing expense:

    http://www.bradreese.com/blog/8-1-2011.htm

    Sincerely,

    Brad Reese

    ------------------------------------------------

    David,

    You were copied on the above email message to your fellow Cisco executives back on August 1st, why have you nor any of your other fellow Cisco executives responded?

    I mean, how much more easier can a question be to answer, does Cisco bill its "trade in discounts" as a sales and marketing expense?

    David, is there a good reason for not answering that question?

    Please be a good contributor and tell Cisco's side!

    Sincerely and most gratefully yours,

    Brad Reese

  • Report this Comment On August 16, 2011, at 9:26 PM, TMFNewCow wrote:

    Hi David,

    Thanks for reading. Actually, last night a friend of mine pointed me towards your comments on one of the Fool's many portal partners (I believe it was dailyfinance.com). I don't believe comments posted on portal sites get auto-reposted onto fool.com, and I certainly wouldn't filter feedback. You'll notice in our disclosure that we Fools encourage a healthy discussion/debate from different viewpoints.

    You have some good counter points with regards to Cisco's R&D spending compared to HP in $/% terms. Some of the lack of innovation I was a referring to was more focused on was newer networking areas where FFIV, RVBD, and APKT have excelled that could have been opportunities for CSCO.

    I think CSCO is at a pivotal point and your company has the opportunity to turn around. I just happen to be in the bearish camp. If CSCO ends up successfully turning around, I will humbly resign my criticisms. In fact, my dad has been a CSCO shareholder for upwards of 20 years.

    As a courtesy, I will repost the entirety of your entire previous comment below.

    Evan

    ----------

    Hi Evan,

    I respect you've taken care with your analysis overall, but your dismissive assessment of Cisco's technology innovation track record is really without substance.

    Cisco has been consistently ranked #1in its industry for the quality of its innovation. As recently as July 19th, the Patent Board reiterated Cisco's top tanking for the application of R&D. Foolish readers might be interested to read more about that from our CTO, Padmasree Warrior, here: http://blogs.cisco.com/news/innovation-engine-cisco-ranked-1...

    Accolades such as this emphasize the quality of our innovation but I should also point out that in cash terms Cisco also investments more in R&D ($5.3 billion) than all of its major rivals in the networking sector combined.

    As you cite a criticism from HP, I feel I should also point that that company invests a paltry 2.3% of revenues in R&D, considerably less than Cisco in percentage AND cash terms - and that despite HP having revenues 2.5 X of Cisco based on a comparison of our last full financial years.

    To be more specific, In the past year, Cisco has revamped every one of its major switching and routing platforms. Our switching share of customer ports has held very consistent for the past two years, and Cisco has actually GAINED share in routing in each of the past two quarters. Check out ACG's latest market share press release of 2 days ago and note that it is Juniper who is losing share, not Cisco. http://www.prweb.com/releases/2011/8/prweb8716365.htm

    Look beyond our core businesses (30%+ of revenues now comes from new products) and you'll see that Cisco's TelePresence, Unified Computing System and Unified Communications technologies are all category leaders, and growing at 24%, 129% and 11% Y/Y respectively. I should add that of the 20 categories in which Cisco plays, we are #1 or #2 by market share in 16.

    To be fair, Cisco sill has some work to do to turn our ship around. We were clear about that on our most recent quarterly earnings calls. But as we have also stated very clearly, those challenges are not about innovation but operational efficiency and organizational agility. We are very confident that we are addressing those challenges, and when we kick back into full gear, your readers can be assured that our innovation engine will be our greatest asset.

    Best regards,

    David McCulloch

    Director, Corporate Communications

    Cisco

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