Is Cisco Systems Inc. Destined for Greatness?

Let's see what the numbers say about Cisco.

Jun 2, 2014 at 6:30PM

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does Cisco Systems, (NASDAQ:CSCO) fit the bill? Let's look at what its recent results tell us about its potential for future gains.

What we're looking for
The graphs you're about to see tell Cisco's story, and we'll grade the quality of that story in several ways:

  • Growth: are profits, margins, and free cash flow all increasing?
  • Valuation: is share price growing in line with earnings per share?
  • Opportunities: is return on equity increasing while debt to equity declines?
  • Dividends: are dividends consistently growing in a sustainable way?

What the numbers tell you
Here are Cisco's key statistics:

CSCO Total Return Price Chart

CSCO Total Return Price data by YCharts.

Passing Criteria

3-Year* Change

Grade

Revenue growth > 30%

10.1%

Fail

Improving profit margin

(0.6%)

Fail

Free cash flow growth > Net income growth

23.7% vs. 9.5%

Pass

Improving EPS

15.9%

Pass

Stock growth (+ 15%) < EPS growth

53.7% vs. 15.9%

Fail

Source: YCharts. * Period begins at end of Q1 (April) 2011.

CSCO Return on Equity (TTM) Chart

CSCO Return on Equity (TTM) data by YCharts.

Passing Criteria

3-Year* Change

Grade

Improving return on equity

(13.8%)

Fail

Declining debt to equity

5.5%

Fail

Dividend growth > 25%

216.7%

Pass

Free cash flow payout ratio < 50%

32.4%

Pass

Source: YCharts. * Period begins at end of Q1 (April) 2011.

How we got here and where we're going
We looked at Cisco last year, and it has lost two of the six passing grades it earned then to finish with a modest four-of-nine score in its second assessment. The company's sales growth has stumbled amid fierce competition in the networking market, which has also hurt Cisco's profit margin (though only barely) and return on equity. Despite that weakness, a fast-growing dividend has drawn investors into Cisco's stock, which has outpaced the gains in the company's net income since last year, when the situation was quite the opposite. Can this networking giant reclaim its legacy of outperformance in the future, or will Cisco's fundamental weaknesses catch up to it? Let's dig a little deeper to find out.

Cisco recently came through with market-topping third-quarter earnings despite declines in revenue and earnings per share as fierce competition from Alcatel-Lucent (NYSE:ALU) and Juniper Networks (NYSE:JNPR) pushes networking equipment costs lower. Cisco also endured a 7% decline in orders from emerging markets, most notably from the BRIC nations. However, the company nonetheless repurchased more than 90 million shares at a cost of approximately $2 billion to prop up its weaker earnings on a per-share basis, and it still holds around $10.1 billion at the ready for further share buybacks. Deutsche Bank upgraded Cisco from hold to buy shortly after the report, citing strong demand for the company;s new platforms in data-center switching, next-generation routing, and security products, as well as a growing wireless and cloud-computing services business.

CEO John Chambers recently jumped into the ongoing privacy and government-spying controversy by urging President Barack Obama to end efforts by the National Security Agency to tamper with and infiltrate Cisco's networking devices destined for foreign customers, as the company generates much of its business abroad and can ill-afford to lose its international customers' trust. Fool technology specialist Anders Bylund points out that Edward Snowden's photographic evidence of Cisco routers compromised by NSA-installed "snoopware" has made the Chinese government fearful of spying, which could result in a loss of orders from Chinese companies -- to say nothing of other nations that likely hold similar concerns. Beijing is already shifting orders of networking equipment to Chinese suppliers, dragging on Cisco's fortunes in the rapidly connecting country of more than 1 billion people.

Cisco's networking routers-and-switches business has been plagued by the rapid adoption of software-defined networking, or SDN, by major tech companies. My fellow writer Subhadeep Ghose notes that Cisco recently unveiled plans to invest up to $1 billion in a portfolio of cloud-based offerings in an effort to reverse its sagging fortunes. However, the cloud arena is already more competitive than Cisco's home-field industry of networking equipment -- Hewlett-Packard (NYSE:HPQ) jumped on the cloud bandwagon with a $1 billion investment in its own initiative, HP Helion, and HP now plans to set up 20 data centers by 2015. IBM (NYSE:IBM) also plans to invest more than $1.2 billion to build 40 cloud services-based data centers around the world this year. This is only a small slice of the massive cloud buildout that has been led by a number of large-cap tech companies with resources similar to Cisco.

But Cisco is hardly abandoning its core hardware segment, as it recently unveiled a new line of switches called Nexus 9000, which already boasts a strong pipeline of orders from over 1,000 customers. Cisco has also invested over $250 million into Internet of Things start-ups, as it believes this market will be worth a whopping $19 trillion by 2020. With nearly $50.5 billion in cash and investments and $20.9 billion in debt, Cisco has a strong financial position from which to make further investments in highly touted new technologies businesses such as SDN, cloud computing, and the Internet of Things.

Putting the pieces together
Cisco has some of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.

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Alex Planes has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

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