Cisco Investors Need to Watch These Key Areas

The global enterprise technology sector has been in somewhat of a rut lately as Europe stagnates, emerging markets slow, and the U.S. government tries to slash spending. 

All this has resulted in relatively slow growth for the world's dominant IT franchises like Cisco Systems (NASDAQ: CSCO  ) , Oracle (NYSE: ORCL  ) , and IBM (NYSE: IBM  ) as companies large and small sit on their idle cash rather than delaying critical investments like IT spending. However, it's not all doom and gloom.

Yesterday, Cisco knocked its most recent quarterly earnings out of the park, rejuvenating investors' hope and driving a huge rally in its share price. However positive the earnings report was, it only explains a fraction of the overall Cisco investment thesis. To better inform investors about three of the most critical areas to watch for Cisco, the Fool has included below a key portion of its new premium research report on the networking giant.

What to watch: How hungry is Cisco?
But Cisco also isn't just about selling network gear. Years of acquisitions have helped the company diversify. Management divides these newer offerings into five categories:

  • Service Provider Video, which includes a portfolio of set-top boxes that provide digital recording or Internet-delivered television. Most of these products are built for selling through cable and telecom carriers as vehicles to offer more advanced TV services.
  • Collaboration, which includes both software and devices for more sophisticated collaboration using the Internet. This category includes everything from instant messaging to social media, web conferencing, and web-based telephony.
  • Security, which refers to devices specifically designed to protect networks from Internet-based threats. Cisco will also imbue routers with firewalls and intrusion detection software in order to make them more competitive with offerings from security specialists such as Check Point Software and Sourcefire.
  • Wireless, which includes both personal and business wireless routers and access points, mostly built from technology introduced by Linksys, which Cisco acquired in 2003.
  • Data Center, a relatively new idea based on unifying entire infrastructures found in a data center: servers, storage, routers, switches, and virtualization software, among other things. It's an ambitious vision that our Foolish techies have embraced.

For the most part, Cisco hasn't developed these segments in-house. Take the video business, which is largely the result of a 2005 acquisition of Scientific-Atlanta. Research and development spending as a percentage of revenue has declined from 13.5% in 2008 to 11.9% in the just-completed fiscal year. Acquiring growth rather than developing it isn't necessarily a bad idea. Oracle has performed well since kicking off a huge acquisition spree that began in 2005 with the hostile takeover of business software developer PeopleSoft. The stock has more than doubled since, easily beating the S&P 500's return over the same period.

Cisco hasn't been as fortunate. While Oracle has seen both revenue and profit rise more than 15% annually over the past five years, Cisco has suffered mostly slowing growth as debt has soared. Management's appetite for acquisitions has come at a cost:

Key Metric Growth

Fiscal 2012

Fiscal 2011

Fiscal 2010

Fiscal 2009

Fiscal 2008

Gross margin**

(0.6 points)

(2.2 points)

0.1 points

(0.2 points)

(0.4 points)

Revenue

6.6%

7.9%

10.9%

(8.7%)

13.2%

Normalized net income

19.4%

(5.5%)

20.4%

(23.2%)

6.8%

Levered free cash flow

23.2%

(5.3%)

15.9%

(3.0%)

19.3%

Cash and investments

9.3%

11.9%

13.9%

33.4%

17.7%

Total debt

(2.9%)

10.1%

48.5%

49.4%

7.6%

Source: S&P Capital IQ. **Gains and losses in percentage points.

But is this really so bad? Free cash flow has ballooned in at least three of the past five fiscal years, helping Cisco accumulate more than $32 billion in cash and investments — and that's above and beyond the company's debt load. War chests rarely come much bigger, and management is already getting aggressive with its treasure trove.

Recently, Cisco announced plans to hike its dividend by 75%. In the long term, management plans to return at least 50% of its free cash flow to shareholders through dividends and stock buybacks. The rest will be put to work generating higher returns on assets, equity, and capital, which are rising again:

Fiscal Year

Return on Assets

Return on Capital

Return on Equity

2012

7.4%

10.0%

16.3%

2011

6.5%

8.8%

14.2%

2010

7.7%

10.6%

18.7%

2009

7.3%

10.2%

16.8%

2008

10.6%

15%

24.5%

5-Year Average

7.9%

10.9%

18.1%

Source: S&P Capital IQ.

Why does this matter? Cisco has averaged about five or six acquisitions per year since 2008, and in March 2012, it bid $5 billion for NDS Group of the United Kingdom, which helps pay TV operators bring their content to set-top boxes like those manufactured by the Scientific-Atlanta unit. Management's skill at curating and cultivating the tech and expertise found in these businesses impacts returns, and returns -- in particular, returns on available capital -- impact profits.

Looking for more?
This was just a small segment of our new premium research report on Cisco. If you want to get a complete perspective on whether Cisco is a buy or sell at its current levels, the report will shed invaluable light on this IT powerhouse. Not only that, but the report also comes with an update each quarter to keep subscribers fully informed on the timeliest news driving Cisco's share price. To get your copy, just click here now.


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